short-term financial management chapter 1 - the role of working capital prepared by patricia r....

SHORT-TERMFINANCIAL MANAGEMENT

Chapter 1 - The Role of Working Capital

Prepared by Patricia R. RobertsonKennesaw State University

2

THE ROLE OF WORKING CAPITAL

Chapter 1 Agenda

Identify the cash flows associated with short-term financing decisions, understand how working capital flows and depreciation charges create a disparity between profit and operating cash flow, and identify the basic issues involved in managing working capital.

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Working Capital Management

Short-Term Financial Management (aka Working Capital Management) is the day-to-day management of the operating needs of a firm through its current assets and current liabilities.

It involves managing cash, accounts receivable, inventory, accounts payable, and accruals.

The goal is to ensure a firm has the ability to satisfy both upcoming operational expenses and maturing short-term debt.

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S.T. Finance Versus L.T. Finance

In other courses, you studied long-term financial decision-making.

For example, the asset investment decision evaluated the cash flows associated with long-term capital budgeting projects.

Short-term finance involves cash flows that occur within the year.

Since these cash flows are unsynchronized and uncertain, the timing of these cash flows is critical.

5

Newspaper Headlines

The following headlines reinforce the importance of cash and the disconnect between profits and cash flow.

Shell Expects Output, Cash Flow to Grow Facebook Cites Rapid Growth in Users, Cash

Flow Xerox Seeks to Reassure Investors Over Cash

Position Cisco Free Cash Flow Exxon Draws Down Cash Reserves Owens Lowers Expectations for Cash Flow Penney Sees Cash Gains Renault Swings to Loss, But Makes Cash Ford Earnings: Cash Flows a Concern? BHP Has the Cash, Needs the Growth Firms Weigh Options for Those Piles of Cash

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The Importance of Cash

“You can miss your earning’s targets and survive, but you can only run out of cash once.” -- Edward Liebert

Cash flow is the lifeblood of a firm.

The firm must design a cost structure to operate profitably or it will fail.

Similarly, profitable companies, if cash-strapped, can also fail.

Profits and cash flow are highly correlated in short-term decision-making.

Therefore, firms must manage cash flows and profits.

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Financial Statements

Financial statements report the performance of a firm, and include the: Balance sheet Income statement Statement of retained earnings Statement of cash flows

These interrelated statements show where money came from, where it went, and where it is now. We need to understand if and where the firm generated cash, and

where it was used. While this course focuses on short-term financial management, we

will review long-term sources and uses of cash, too. Understanding the sources and uses of cash historically allows for

the accurate prediction of future cash flows.

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Financial Analysis

Financial analysis is used to understand a firm’s historical and present financial position, as well as its prospects.

The objective of financial statement analysis depends on the perspective of the user:

Management

Creditors

Investors

Suppliers

Analysts

Regulators

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The Balance Sheet

The balance sheet is a snapshot of the financial accounts of a firm as of a particular date.

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Assets

Assets are categorized as current (CA) or fixed (FA).

• Assets are listed on the balance sheet in order of liquidity.

• Frequently, more than one timeframe is presented for comparison.

• Current assets are expected to be converted to cash within a year.

• Fixed assets have a relatively long life, and can be tangible (e.g. building) or intangible (e.g. patent).

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Liabilities & Owner’s Equity

Liabilities are categorized as current (CL) or long-term (LTD).

• Liabilities are also listed in order of liquidity.

• Current liabilities are expected to be paid within a year, and will require cash.

• Long-term liabilities have maturities longer than one year.

• The difference between assets and liabilities is owner’s equity (E).

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The Current Accounts

The relationship between current assets and current liabilities is critical to the ongoing operations of the firm.

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Current Assets

Cash & equivalents Cash and highly-liquid investments.

Short-term investments Investments to be liquidated within

the year.

Accounts receivable Sales made to customers on credit. Displayed net of doubtful accounts.

Inventory Some combination of raw materials,

W-I-P, and finished goods. Affected by valuation

method/inflation.

Other Generally, Prepaid Expenses.

“Cash Position” refers to cash on hand and in

the bank, as well as access to bank loans

and short-term investments.

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Current Liabilities

Accounts payable Amounts owed to suppliers

for purchases.

Accruals Expenses incurred but not

yet paid (e.g. salaries, rent, insurance, taxes, etc.).

Short-term debt Short-term debt and/or the

principal portion of long-term debt due within the year. The term of debt should

match the type of asset financed.

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Working Capital

(Net) working capital = current assets – current liabilities Working capital is the operating liquidity available to a company

and is generally positive in a healthy firm and varies by industry.

If a firm has negative working capital, it might have to sell assets at ‘fire sale’ prices to raise cash.

Note: ‘Capital’ is used interchangeably with ‘assets.’ Net working capital is an exception.

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Long-Term Assets & Liabilities Long-term assets represent the investments made by the

firm.

Long-term liabilities (LTD) represent the long-term financing sources for those investments.

‘Long-term’ is anything longer than one-year.

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The residual interest in assets after deducting liabilities.

Includes Common Stock (at par), Additional Paid-In-Capital, Retained Earnings, and Treasury Stock.

Retained Earnings is not idle cash; rather reinvested earnings.

Stockholder’s Equity

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Balance Sheet Identity

A = L + E

NWC = CA - CL

NWC + FA = LTD + E

NWC = (Cash + Other CA) – CL

Cash = LTD + E + CL – CA Other Than Cash – FA

Some activities increase cash and others decrease cash.

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Sources & Uses of Cash

Buy inventory on credit Sell inventory for cash Collect receivables Borrow short-term debt Borrow long-term debt Sell fixed assets Sell common stock Liquidate investments

Buy inventory with cash Make sales on credit Pay suppliers (A/P) Repay short-term loan Retire long-term debt Buy fixed assets Repurchase stock Pay dividends / taxes Make new investments

Sources (Inflows) Uses (Outflows)

On the balance sheet, there are both short and long-term sources and uses of cash; they are the opposite of

each other.

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The Income Statement

The income statement measures financial performance over a period of time.

‘Income,’ ‘earnings,’ and ‘profit’ are used interchangeably.

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The Income Statement

Revenue is recognized when earned, not collected (accrual accounting).

Expenses are booked to match the timing of revenue recognition.

The income statement does not reflect cash flows.

We are concerned with cash flows.

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Earnings Quality

Earnings quality is affected by:

Accounting choices, methods, and assumptions.

Discretionary expenditures.

Non-recurring transactions.

Non-operating gains and losses.

Profits vs. Cash

Net income is not the same as cash flow (economic earnings). The firm earned $5,642 million,

yet cash decreased by $65 million.

We look to the balance sheet to reconcile changes in cash.

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24

Cash Flow Timeline Example

A brand new firm is created.

The owner puts in half the money and borrows the other half.

Cash 1,000$ Debt 500$

Stock 500$

Total 1,000$ Total 1,000$

Balance Sheet - Day 1

Assets Liabilities & Net Worth

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The next day, the firm buys a building and an initial supply of inventory.

They pay cash for the building and the inventory is bought on 45-day credit from the firm’s suppliers.

Cash 1,000$ Debt 500$

Stock 500$


Cash 400$ Accounts Payable 300$

Inventory 300$ Debt 500$

Fixed Assets 600$ Stock 500$






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Buying the inventory on credit creates the liability, accounts payable.

The size of the firm increases by $300.

Cash 1,000$ Debt 500$

Stock 500$



Inventory 300$ Debt 500$







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Here’s where we are at month-end.

The firm offers credit sales to customers, creating a receivable and depleting inventory.


Accounts Receivable 700$ Accruals 200$

Inventory -$ Debt 500$


(Accumulated Depreciation) (100)$ Retained Earnings 25$



Balance Sheet - End of Month

Sales 700$

Cost of Goods Sold 300$

Gross Profit 400$

Operating Expenses

Salaries, Advertising, Etc. 200$

Depreciation 100$

Operating Profit 100$

Interest 50$

Taxes 25$

Net Profit 25$

Income Statement - End of Month

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As the firm operates, it incurs expenses (salaries, utilities, rent, etc.), which are accrued until paid.









Sales 700$


Gross Profit 400$

Operating Expenses


Depreciation 100$


Interest 50$

Taxes 25$

Net Profit 25$


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Depreciation, a non-cash charge, is expensed.









Sales 700$


Gross Profit 400$

Operating Expenses


Depreciation 100$


Interest 50$

Taxes 25$

Net Profit 25$


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Cash is used to pay interest and taxes.









Sales 700$


Gross Profit 400$

Operating Expenses


Depreciation 100$


Interest 50$

Taxes 25$

Net Profit 25$


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Profits are added to the balance sheet as retained earnings.









Sales 700$


Gross Profit 400$

Operating Expenses


Depreciation 100$


Interest 50$

Taxes 25$

Net Profit 25$


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At the beginning of the next month, the bills for the accruals are paid with cash.

The balance sheet decreases in size.








Accounts Receivable 700$ Accruals -$






Balance Sheet - Beginning of Next Month



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Cash is used to pay the accounts payable once due.

The firm made $25 but has spent cash it does not have.

THE FIRM HAS PAID CASH FOR EXPENSES BUT HAS COLLECTED NO MONEY FOR SALES.







Cash (175)$ Accounts Payable -$






Balance Sheet - Middle of Next Month


Balance Sheet - Beginning of Next Month


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Cash Flow Timeline ExampleIn the final view, the A/R are collected.

The firm still has $25 in profit, but has $125 more in cash than it had after buying the building.

During the cycle, the cash ranged from a high of $525 to a low of ($175).

Cash (175)$ Accounts Payable -$






Cash 525$ Accounts Payable -$

Accounts Receivable -$ Accruals -$





Balance Sheet - Middle of Next Month


Balance Sheet - Final View


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Despite being profitable, why did the firm run out of cash during the operating cycle?

This is explained by differences in the timing of cash disbursements and cash receipts.

Firms must establish policies to manage working capital accounts so that an adequate amount of liquidity is available to run the business.

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The Cash Cycle

We are concerned with the amount of cash flow, as well as the timing.

We have to build and sell products before we can generate cash inflows.

In the meantime, we incur cash outflows for supplies and labor.

We are concerned with the success of operations, or cash generated internally.

Externally generated cash comes from investing and financing activities.

Temporary operating shortfalls can be satisfied with borrowing, but ultimately a firm must generate cash.

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The Cash Cycle

Inventory, if purchased on credit, creates an accounts payable.

Inventory, if sold on credit, generates an accounts receivable.

Receivables are collected in cash.

Payables are paid out of cash from sales, by drawing down liquid reserves, or by borrowing.

Cash flows in a cycle into, around, and out of a business…it is the lifeblood of the firm.

If the firm were to stop its operating activities, most (if not all) of the cash tied up in working capital would be released; the operating cycle affects the timing of cash flow.

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Cash Flow Timeline

The cash conversion period is the time between when cash is received versus paid.

The shorter the cash conversion period, the more efficient the firm’s working capital and more cash is generated.

The firm is a system of cash flows. These cash flows are unsynchronized and

uncertain.

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Operating Versus Cash Cycle The Operating Cycle is the length of time from

buying inventory to collecting cash.

Say, we buy inventory on credit and pay the bill 30 days later. We sell the inventory 30 days after that, and get paid after 45 days.

The Operating Cycle is 105 days.

The Cash Cycle (Cash Conversion Period – CCP) is the elapsed time between the firm’s payment to suppliers and receipt of customer payments. Here, the Cash Cycle is 75 days (105 – 30).

40

60

105

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The Cash Cycle

Firms must manage cash flows and profits to ensure it has the necessary cash for daily operations. Any gaps must be filled by short-

term borrowing or using cash reserves.

Alternatively, the firms can alter the cycle by changing the timing of the cash flows.

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We need to isolate the cash component of the accrual-based income statement entries:

Operating Cash Flows, together with other sources and uses of cash, explain the change in cash on the balance sheet.

Analysis also includes adjustments for non-recurring items.

Operating Cash Flows

Cash Collected From Customers

- Cash Paid To Suppliers

- Cash Paid For Operations

- Cash Paid To Creditors

- Cash Paid For Taxes

= Cash Flow From Operations

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Cash Flow Statement

Income Statement Adjustment Cash Flow Account

Sales - ∆ A/R = Cash Collected

- ∆ A/P

+ ∆ Inv

- ∆ Op Accr

- ∆ Dep

Interest - ∆ Acc Int = Cash Paid to Creditors

- ∆ Accrued Txs

- ∆ Deferred Txs

Net Profit Operating Cash Flow

CGS

Operating Expenses

Taxes

= Cash Paid to Suppliers

= Cash Paid for Op Exps

= Cash Paid for Taxes

We look to the income statement and changes on the balance sheet to reconcile changes in cash at a single point in time.

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Converting I/S to Cash Flows

Cash Flow Statement



- ∆ A/P

+ ∆ Inv

- ∆ Op Accr

- ∆ Dep


- ∆ Accrued Txs

- ∆ Deferred Txs


CGS

Operating Expenses

Taxes




Assets↑ = Use↓ = Source

Liabilities↓ = Use↑ =Source

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Cash Flow Statement



- ∆ A/P

+ ∆ Inv

- ∆ Op Accr

- ∆ Dep


- ∆ Accrued Txs

- ∆ Deferred Txs


CGS

Operating Expenses

Taxes




If A/R increased, then not all of the sales recorded during the period have been collected; less cash was collected than recorded on the accrual-based income statement.

If A/R decreased, cash from prior period sales was collected.

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Cash Flow Statement



- ∆ A/P

+ ∆ Inv

- ∆ Op Accr

- ∆ Dep


- ∆ Accrued Txs

- ∆ Deferred Txs


CGS

Operating Expenses

Taxes




If A/P increased, then not all of the inventory expensed in CGS has been paid for; less cash was paid to suppliers than reflected on the income statement.

If A/P decreased, we paid for items this period expensed in a prior period.

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Cash Flow Statement



- ∆ A/P

+ ∆ Inv

- ∆ Op Accr

- ∆ Dep


- ∆ Accrued Txs

- ∆ Deferred Txs


CGS

Operating Expenses

Taxes




If inventory increased, it represents an additional use of cash to purchase inventory not yet sold and not included in CGS.

If inventory decreased, the firm did not replenish inventory sold, freeing up cash previously held in the working capital cycle.

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Cash Flow Statement



- ∆ A/P

+ ∆ Inv

- ∆ Op Accr

- ∆ Dep


- ∆ Accrued Txs

- ∆ Deferred Txs


CGS

Operating Expenses

Taxes




An increase in accrued expenses indicates we expensed items for which cash has not yet been paid.

A decrease in accruals mean we paid for items expensed in a prior period.

Accruals can be recorded as assets or liabilities. In either case, it is simply a matter of timing; the transaction has occurred but money has not changed hands. An example is interest. For investments, interest income is an accrued asset. For a loan, interest expense is an accrued liability.

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Cash Flow Statement



- ∆ A/P

+ ∆ Inv

- ∆ Op Accr

- ∆ Dep


- ∆ Accrued Txs

- ∆ Deferred Txs


CGS

Operating Expenses

Taxes




Similarly (and not included on the chart), an increase in Prepaid Expenses is a cash outflow for items not yet expensed, so is added to Operating Expenses.

Accrued expenses are the opposite of prepaid expenses.

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Cash Flow Statement



- ∆ A/P

+ ∆ Inv

- ∆ Op Accr

- ∆ Dep


- ∆ Accrued Txs

- ∆ Deferred Txs


CGS

Operating Expenses

Taxes




We are interested in current period depreciation. If using the income statement, simply use the depreciation expensed during the year. If getting this information from the balance sheet, use the change in accumulated depreciation. Note that the latter could (and likely does) have ‘noise’ from the sale of fixed assets during the period that affected accumulated depreciation.

The income statement includes the non-cash charge, depreciation.

Adjust operating expenses to include current period depreciation, a non-cash expense.

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Cash Flow Statement



- ∆ A/P

+ ∆ Inv

- ∆ Op Accr

- ∆ Dep


- ∆ Accrued Txs

- ∆ Deferred Txs


CGS

Operating Expenses

Taxes




Deferred taxes result from timing (temporary) differences. Accrued taxes are permanent differences between tax returns and financial statements (e.g.: depreciation methods on fixed assets).

A deferred expense has been incurred but not yet paid; an accrued expense has not yet been incurred.

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Cash Flow Statement



- ∆ A/P

+ ∆ Inv

- ∆ Op Accr

- ∆ Dep


- ∆ Accrued Txs

- ∆ Deferred Txs


CGS

Operating Expenses

Taxes




A firm must be able to translate earnings (profits) into cash.

If a firm has negative operating cash flow, it did not generate cash from its primary operations and must liquidate investments or borrow.

53

Back To This Example

Presented are two points in time…Day 1 and the final view.

Let’s reconcile the change in cash from $1,000 to $525.

Cash 1,000$ Debt 500$

Stock 500$


Cash 525$ Accounts Payable -$

Accounts Receivable -$ Accruals -$





Balance Sheet - Final View




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Reconciliation of Cash

We will do a more complex example in a minute…for now, become acquainted with the format.

Cash Flow Statement

Inccome Statement 2009 Adjustment Change Cash Flow LT Sources/Uses Change

Sales 700$ - ∆ A/R -$ 700$ - ∆ Fixed Assets 500$

CGS 300$ - ∆ A/P -$ - Depreciation 100$

+ ∆ Inv -$ + ∆ Short-Term Debt -$

Operating Expenses 300$ - ∆ Op Accr -$ + ∆ Long-Term Debt -$

- ∆ Dep 100$ + ∆ Other Liabilities -$

Interest 50$ - ∆ Acc Int -$ 50$ - Dividends Paid -$

Taxes 25$ - ∆ Def Txs -$ 25$ LT Change in Cash (600)$

Net Profit 25$ Operating Cash Flow 125$

125$

-$600

(475)$

1,000$

(475)$

525$

Beginning Cash

Total Change in Cash

Ending Cash

Cash Reconciliation

300$

200$

Operating Cash Flow

LT Change in Cash


55

Cash Flow Statement

Inccome Statement 2009 Adjustment Change Cash Flow LT Sources/Uses Change

Sales 700$ - ∆ A/R -$ 700$ - ∆ Fixed Assets 500$

CGS 300$ - ∆ A/P -$ - Depreciation 100$

+ ∆ Inv -$ + ∆ Short-Term Debt -$

Operating Expenses 300$ - ∆ Op Accr -$ + ∆ Long-Term Debt -$

- ∆ Dep 100$ + ∆ Other Liabilities -$

Interest 50$ - ∆ Acc Int -$ 50$ - Dividends Paid -$

Taxes 25$ - ∆ Def Txs -$ 25$ LT Change in Cash (600)$

Net Profit 25$ Operating Cash Flow 125$

125$

-$600

(475)$

1,000$

(475)$

525$

Beginning Cash


Ending Cash

Cash Reconciliation

300$

200$

Operating Cash Flow

LT Change in Cash


Reconciliation of Cash

IMPORTANT:1) EVERY line item on the balance sheet

must be accounted for somewhere in the analysis.

2) Don’t double-count depreciation. Use EITHER the change in net fixed assets and add back change in accumulated depreciation OR use change in gross fixed assets.

2

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The analyst should be concerned with:

The success (or failure) of firm in generating cash from operations.

The underlying causes of (and magnitude of) positive or negative operating cash flow.

Fluctuations in operating cash flows over time.


57 Managing the Cash Cycle

58

Managing The Cash Cycle

Managing the cash cycle includes:

Reducing idle inventory

Stretching payables

Aggressively managing receivables

Receivables and inventory absorb cash; payables supply cash.

59

Working Capital Management The cheapest and best source of cash exists as

working capital within the business:

60

Managing The Cash Cycle

The cash flow cycle refers to the continual flow of resources through the working capital accounts. This results in periods of cash surpluses and deficits.

The faster a firm is growing, the more cash it needs.

While a firm can operate with negative cash flow for short periods of time, it must generate positive cash flow long-term.

Some firms try to manage working capital to zero. Zero investment in working capital increases cash.

Zero investment in working capital is a permanent increase in earnings.

61

Shareholder Value Creation

Value can be created from many short-term financial management activities.

Inventory Cash Management

Level Amount & Timing of Collections

Mix Amount & Timing of Disbursements

Timing Amount & Timing of Concentration

Customer Integration Receivables Banking System

Supply Chain Integration Quality Information System Integration

Information System Integration Quantity

Collection Short-Term Investing & Borrowing

Payables Timing Vendors

Utilization Customer Integration Maturity

Timing Information System Integration Hedging

Supplier Negotiation Yield

Purchasing Integration Diversification

Information System Integration Liquidity

Information System Integration

62

Managing Inventory

Inventory levels should be adequate to meet uncertain client demand without investing cash in too much inventory.

There is a trade-off between: Stock-out costs Cost of excess inventory (holding costs) Ordering costs

More in Chapter 4.

63

Managing Receivables

The Financial Manager decides: Which customers may buy on credit.

How much credit is offered and on what terms. e.g.: Net 30, 2/10; Net 30

The process for monitoring collections.

The procedures for processing remittances to minimize float. Float is time it takes to convert the remittance to cash.

More in Chapters 5, 6 & 9.

64

Managing Payables

Payables can be viewed as interest-free financing.

The financial manager wants: The longest and/or most favorable credit terms

available from its suppliers. Terms can include cash discounts.

The timing of the payment to be on the due date and not before depending on the benefit to the firm from the discount versus the foregone cash.

More in Chapters 7 & 11.

65 A Few Introductory Thoughts…

66

Short-Term Planning

The ultimate goal of short-term planning is to make sure there is enough cash on hand to operate.

Over the six-month planning period, this firm has ample cash. Yet, DURING the six-

months, it ran out of cash.

67

How Much WC Is Enough?

Approximately 40%-50% of assets in U.S. firms are invested in working capital accounts.

The firm must decide how much in resources to commit to working capital and, specifically, cash and liquid assets.

In typical economic times, 3.3% – 4.1% of the balance sheet would be in cash (10% in times of economic distress).

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Early Warning Signs

Early warning signs of insufficient working capital include:

Pressure on existing cash reserves.

Unusual cash generating activities (e.g. offering big cash discounts).

Bank overdrafts.

Emergency bank loans.

Partial payments to suppliers and creditors.

short-term financial management chapter 1 - the role of working capital prepared by patricia r....

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