One Thing Investors Should Understand

Working capital is the lifeblood of every business. Managers must walk a fine line between efficiency (having ample working capital for daily operations) and inefficiency (having an excess). The best technique for measuring a company's working capital efficiency is the cash conversion cycle.

The cash conversion cycle represents the time between when a company pays for its cost of goods sold and when it collects cash on the end sale. Year-to-year changes in the conversion cycle give investors a sense of management's commitment to efficiency improvements while also allowing investors to compare working capital requirements at various companies (and across industries). Here's the calculation:

Days Sales Outstanding + Days Inventory Outstanding - Days Payables Outstanding

Working capital requirements vary according to industry, so there's no "one size fits all" level that's right for every company. For example, defense companies generally make sales via long-term contracts, with payment terms that result in negative (or, at best, breakeven) cash flow until deliveries are made. Working capital is therefore required to finance these programs -- the reason industry giants Northrop Grumman (NYSE: NOC) and Lockheed Martin (NYSE: LMT) have run cash conversion cycles of 37 days and 43 days, respectively, over the last 12 months. Contrast this with Motley Fool Stock Advisor recommendation Dell Computer (Nasdaq: DELL), whose direct sales model collects cash up front, while keeping inventories low, resulting in a conversion cycle of negative 41 days over the last 12 months.

Yet this comparison is misleading, because the companies operate in two entirely different marketplaces. The cash conversion cycle is really a more effective comparison of players across a single industry. While cycle times at Northrop and Lockheed don't come close to matching Dell's, they're actually quite efficient compared with industry competitors such as General Dynamics (NYSE: GD), whose cycle time is around 84 days.

Improvements in a company's cash conversion cycle over time indicate a commitment to controlling working capital, a good example of which is Motley Fool Income Investor pick Heinz Foods (NYSE: HNZ). In fiscal 2002, Heinz's conversion cycle was a slow 93 days. Fast-forward to fiscal 2004, where the cycle has been reduced to 54 days. In response, free cash flow jumped from a drain of $157 million in 2002 to $900 million last year (Heinz's fiscal year ends in April).

Serious investors understand the importance of cash flow, particularly when it comes to paying dividends. U.S. companies continue to improve working capital management, and thanks to a renewed focus on dividends by investors, we should see companies returning much of this cash flow to shareholders.

Want insight into successful dividend-paying companies? Take a free 30-day trial of Motley Fool Income Investor.

Fool contributor Chris Mallon doesn't own any companies mentioned in this article.