Chapter 2Analysis of Working

Capital Cycle

OrderOrder Order Order Sale Sale CashCash PlacedPlaced Received Received ReceivedReceived Accounts CollectionAccounts Collection < Inventory > < Receivable > < Float >< Inventory > < Receivable > < Float >

Accounts Disbursement Accounts Disbursement Time ==>Time ==>< Payable > < Float > < Payable > < Float >

Invoice Invoice Payment Payment CashCash Received Sent Received Sent PaidPaid

OrderOrder Order Order Sale Sale CashCash PlacedPlaced Received Received ReceivedReceived Accounts CollectionAccounts Collection < Inventory > < Receivable > < Float >< Inventory > < Receivable > < Float >

Accounts Disbursement Accounts Disbursement Time ==>Time ==>< Payable > < Float > < Payable > < Float >

Invoice Invoice Payment Payment CashCash Received Sent Received Sent PaidPaid

Solvency Vs. Liquidity Solvency concerns whether assets Solvency concerns whether assets

exceed liabilities, whereas exceed liabilities, whereas liquidity refers to the firm’s ability liquidity refers to the firm’s ability to meet short-term obligations to meet short-term obligations with cash while remaining a with cash while remaining a going-concerngoing-concern

Solvency Measures Current RatioCurrent Ratio

Quick RatioQuick Ratio

Net Working CapitalNet Working Capital

Working Capital RequirementsWorking Capital Requirements

Financial Statements - Basic Source of

Information Balance SheetBalance Sheet

Income StatementIncome Statement

Statement of Cash FlowsStatement of Cash Flows

Net Working Capital Implication of positive NWCImplication of positive NWC Implication of negative NWCImplication of negative NWC Larger value- Adequate solvency Larger value- Adequate solvency

and less default riskand less default risk For larger firms, the absolute For larger firms, the absolute

value of NWC will always be value of NWC will always be higher.higher.

Standardization of NWC by either Standardization of NWC by either assets or revenue assets or revenue

Traditional NWC figure includes Traditional NWC figure includes accounts that are not directly accounts that are not directly related to the operating related to the operating component of the working capital component of the working capital cycle.cycle.

Specifically, cash holdings and Specifically, cash holdings and notes payable result from internal notes payable result from internal financial decisions or policies financial decisions or policies enacted by management. enacted by management.

Decomposing the NWC into Decomposing the NWC into operating and financial operating and financial components can be useful to components can be useful to management when assessing management when assessing working capital policies.working capital policies.

NWC and its Component Parts

CashCash

Mkt SecMkt Sec

A/RA/R

InventoryInventory

PrepaidPrepaid

N/PN/P

CashCash

Mkt SecMkt Sec

A/RA/R

InventoryInventory

PrepaidPrepaid

CashCash

Mkt SecMkt Sec

A/RA/R

InventoryInventory

PrepaidPrepaid

CA CL CA CL CA CLCA CL CA CL CA CL

NWC = CA - CL WCR = A/R + INV +Pre NLB = Cash + M/SNWC = CA - CL WCR = A/R + INV +Pre NLB = Cash + M/S- A/P - N/P - CMLTD- A/P - N/P - CMLTD

Net Working Capital Net Working Capital

Working Capital Requirements Net Liquid BalanceWorking Capital Requirements Net Liquid Balance

A/PA/P A/PA/P A/PA/P

N/PN/P

CMLTDCMLTD

N/PN/P

CMLTDCMLTDCMLTDCMLTD

AccrualsAccruals AccruaAccrualsls

AccrualsAccruals

- Accruals- Accruals

Working Capital Requirements

The working capital requirement The working capital requirement (WCR) is the difference between (WCR) is the difference between current operating assets (i.e., current operating assets (i.e., noncash current assets) and noncash current assets) and current operating liabilities (e.g., current operating liabilities (e.g., accounts payable and operating accounts payable and operating accruals). accruals).

These accounts represent These accounts represent spontaneous uses and sources of spontaneous uses and sources of funds generated over the working funds generated over the working capital cycle.capital cycle.

All other factors constant, an All other factors constant, an increased WCR implies that the increased WCR implies that the working capital cycle requires working capital cycle requires additional financingadditional financing

A negative WCR implies that the A negative WCR implies that the working capital cycle provides working capital cycle provides financing for long-term assets, financing for long-term assets, positively impacting solvency.positively impacting solvency.

Trend in the WCR indicates a substantial increase in net operating working capital.For each year, the observed WCR shows that more funds are tied up in receivables and inventory than is provided by spontaneous financing. For example, the WCR in 2012 implies that this business will need either internal or external funding in the amount of $3,994 to cover the gap in operating working capital.

Working Capital Requirements

($2,481+$273+$404) - ($2,397+$355+$943)($2,481+$273+$404) - ($2,397+$355+$943)WCR/S = -----------------------------------------------------------WCR/S = -----------------------------------------------------------

$18,243$18,243

($537)($537) = ----------- = -0.029= ----------- = -0.029

$18,243$18,243

1995 1996 1997 1998 19991995 1996 1997 1998 1999WCR/S .055 .082 -.030 -.039 -.029WCR/S .055 .082 -.030 -.039 -.029

($2,481+$273+$404) - ($2,397+$355+$943)($2,481+$273+$404) - ($2,397+$355+$943)WCR/S = -----------------------------------------------------------WCR/S = -----------------------------------------------------------

$18,243$18,243

($537)($537) = ----------- = -0.029= ----------- = -0.029

$18,243$18,243

1995 1996 1997 1998 19991995 1996 1997 1998 1999WCR/S .055 .082 -.030 -.039 -.029WCR/S .055 .082 -.030 -.039 -.029

Current Ratio

Current assetsCurrent assetsCurrent ratio = -------------------------Current ratio = ------------------------- Current liabilitiesCurrent liabilities

$6,339$6,339Current ratio = ----------- = 1.72Current ratio = ----------- = 1.72 $3,695$3,695

19951995 1996 1996 1997 1998 1999 1997 1998 1999Current ratioCurrent ratio 1.96 1.96 2.08 2.08 1.66 1.45 1.72 1.66 1.45 1.72

Current assetsCurrent assetsCurrent ratio = -------------------------Current ratio = ------------------------- Current liabilitiesCurrent liabilities

$6,339$6,339Current ratio = ----------- = 1.72Current ratio = ----------- = 1.72 $3,695$3,695

19951995 1996 1996 1997 1998 1999 1997 1998 1999Current ratioCurrent ratio 1.96 1.96 2.08 2.08 1.66 1.45 1.72 1.66 1.45 1.72

Values exceeding 1 imply that current Values exceeding 1 imply that current assets exceed current liabilities. assets exceed current liabilities.

Relationship between the current ratio and Relationship between the current ratio and NWC: Positive NWC means that the current NWC: Positive NWC means that the current ratio exceeds 1, and a negative NWC ratio exceeds 1, and a negative NWC implies a current implies a current

ratio of less than 1. The current ratio will ratio of less than 1. The current ratio will equal 1 only if NWC is $0. equal 1 only if NWC is $0.

Similar to the interpretation of the NWC, Similar to the interpretation of the NWC, increased values for the current ratio increased values for the current ratio traditionally imply improved solvency and traditionally imply improved solvency and reduced default risk.reduced default risk.

Despite this interpretation, keep in mind Despite this interpretation, keep in mind that higher receivables and inventory, while that higher receivables and inventory, while increasing the current ratio, also reduce increasing the current ratio, also reduce operating cash flow.operating cash flow.

Quick Ratio

Current assets - InventoriesCurrent assets - InventoriesQuick ratio = -------------------------------------Quick ratio = ------------------------------------- Current liabilitiesCurrent liabilities

$6,339 - $273$6,339 - $273Quick ratio = -------------------- = 1.64Quick ratio = -------------------- = 1.64 $3,695$3,695

19951995 1996 1996 1997 1998 1999 1997 1998 1999Quick ratioQuick ratio 1.57 1.57 1.63 1.63 1.51 1.36 1.64 1.51 1.36 1.64

Current assets - InventoriesCurrent assets - InventoriesQuick ratio = -------------------------------------Quick ratio = ------------------------------------- Current liabilitiesCurrent liabilities

$6,339 - $273$6,339 - $273Quick ratio = -------------------- = 1.64Quick ratio = -------------------- = 1.64 $3,695$3,695

19951995 1996 1996 1997 1998 1999 1997 1998 1999Quick ratioQuick ratio 1.57 1.57 1.63 1.63 1.51 1.36 1.64 1.51 1.36 1.64

Shortcomings of Traditional Working Capital Measures

First, although typically referred to as First, although typically referred to as measures of liquidity, the ratios presented measures of liquidity, the ratios presented earlier are more properly classified as earlier are more properly classified as solvency measures.solvency measures.

A second problem is the static nature of the A second problem is the static nature of the aforementioned measures as the various aforementioned measures as the various balance sheet accounts are assumed to have balance sheet accounts are assumed to have equal “time-to-cash” conversion rates.equal “time-to-cash” conversion rates.

A third shortcoming concerns interpretation A third shortcoming concerns interpretation of the current and quick ratios, as can have of the current and quick ratios, as can have counterintuitive impacts depending on ratio’s counterintuitive impacts depending on ratio’s initial level. initial level.

THE CASH CONVERSION PERIOD

represents the time needed to represents the time needed to convert $1 of disbursements into convert $1 of disbursements into $1 of cash receipts.$1 of cash receipts.

Days Inventory Held (DIH) Calculation of the CCP involves three Calculation of the CCP involves three

measures, including days inventory held measures, including days inventory held (DIH), days sales outstanding (DSO), and (DIH), days sales outstanding (DSO), and days payables outstanding (DPO).days payables outstanding (DPO).

Conceptually, the DIH represents the average Conceptually, the DIH represents the average number of days inventory sits idle. Also, given number of days inventory sits idle. Also, given that COGS represents inventory production that COGS represents inventory production costs, the DIH can be interpreted as the costs, the DIH can be interpreted as the number of days of number of days of

inventory held on the balance sheet at a inventory held on the balance sheet at a given point given point

in time. in time.

Days Sales Outstanding (DSO)

DSO represents the average number of days DSO represents the average number of days it takes for a supplier to collect on credit it takes for a supplier to collect on credit sales, which reflects the efficiency of the sales, which reflects the efficiency of the credit and collections department. DSO is also credit and collections department. DSO is also referred to as the average collection period referred to as the average collection period and it is common to compare the DSO to the and it is common to compare the DSO to the trade credit terms offered by suppliers.trade credit terms offered by suppliers.

Days Payable Outstanding DPO is the elapsed time between DPO is the elapsed time between

receipt of inputs and when receipt of inputs and when payments are made to suppliers.payments are made to suppliers.

the CCP represents the length of time the CCP represents the length of time over which management must arrange over which management must arrange for nonspontaneous financing. Longer for nonspontaneous financing. Longer CCPs require increased financial CCPs require increased financial resources, reducing firm liquidityresources, reducing firm liquidity

Implications of CCP A positive CCP implies that additional A positive CCP implies that additional

financing is needed to fund the cash cycle. financing is needed to fund the cash cycle. A negative CCP occurs when the trade credit A negative CCP occurs when the trade credit

period received exceeds the operating period received exceeds the operating cycle. A negative CCP implies that suppliers cycle. A negative CCP implies that suppliers provide financing for the firm’s working provide financing for the firm’s working capital cycle and for non-operating working capital cycle and for non-operating working capital assets. capital assets.

This desirable working capital position is This desirable working capital position is attributable to the strong demand for both attributable to the strong demand for both firms’ products (short inventory holding firms’ products (short inventory holding periods), quick repayment by customers (to periods), quick repayment by customers (to retain a favorable relationship), and retain a favorable relationship), and generous trade credit terms received from generous trade credit terms received from suppliers.suppliers.

Practice Math 1 Suppose that a firm currently has a Suppose that a firm currently has a

CCP of 87 days and DIH equals 50 CCP of 87 days and DIH equals 50 days. Management would like to days. Management would like to reduce the CCP by 5 days through reduce the CCP by 5 days through changes in inventory policy. That is, changes in inventory policy. That is, the extension and use of trade credit the extension and use of trade credit policies will remain unchanged. With policies will remain unchanged. With this goal in mind, and assuming that this goal in mind, and assuming that the firm has annual revenues of the firm has annual revenues of $500M with COGS representing 40% $500M with COGS representing 40% of revenues, the treasury department of revenues, the treasury department wants to estimate the implied wants to estimate the implied reduction in inventory and the reduction in inventory and the subsequent increase in cash flow.subsequent increase in cash flow.

The Cash Conversion Period and Firm Value

The CCP directly impacts the value of the The CCP directly impacts the value of the firm as the gap between the operating cycle firm as the gap between the operating cycle and the DPO can be financed with either and the DPO can be financed with either debt or equitydebt or equity

An increased cash cycle implies increased An increased cash cycle implies increased interest expense.interest expense.

Practice Math 2