Short-Term Financial Management

Short-TermFinancial ManagementChapter 1 - The Role of Working CapitalPrepared by Patricia R. RobertsonKennesaw State UniversityTextbook OutlinePart IIntroduction to LiquidityPart IIManagement of Working CapitalPart IIICorporate Cash ManagementPart IVForecasting & PlanningPart VShort-Term Investing & FinancingPart VISpecial Topics2Part I - Introduction to LiquidityChaptersCoveredChapter 1The Role of Working CapitalChapter 2Analysis of the Working Capital CycleChapter 3Cash Holdings

3The Role Of Working CapitalChapter 1 Agenda4Identify 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.

Working Capital Management5Short-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.

S.T. Finance Versus L.T. Finance6In 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.

Newspaper Headlines7The following headlines reinforce the importance of cash and the disconnect between profits and cash flow.Shell Expects Output, Cash Flow to GrowFacebook Cites Rapid Growth in Users, Cash FlowXerox Seeks to Reassure Investors Over Cash Position Cisco Free Cash FlowExxon Draws Down Cash ReservesOwens Lowers Expectations for Cash FlowPenney Sees Cash GainsRenault Swings to Loss, But Makes CashFord Earnings: Cash Flows a Concern?BHP Has the Cash, Needs the GrowthFirms Weigh Options for Those Piles of CashThe Importance of CashYou can miss your earnings 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.

8Financial Statements9Financial statements report the performance of a firm, and include the:Balance sheetIncome statementStatement of retained earnings Statement of cash flowsThese 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.Financial Analysis10Financial analysis is used to understand a firms historical and present financial position, as well as its prospects.The objective of financial statement analysis depends on the perspective of the user:ManagementCreditorsInvestorsSuppliersAnalystsRegulatorsThe Balance Sheet11The balance sheet is a snapshot of the financial accounts of a firm as of a particular date.

Assets12Assets 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).

Liabilities & Owners Equity13Liabilities 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 owners equity (E).

The Current Accounts14

The relationship between current assets and current liabilities is critical to the ongoing operations of the firm.Current Assets15Cash & equivalentsCash and highly-liquid investments.Short-term investmentsInvestments to be liquidated within the year.Accounts receivableSales made to customers on credit.Displayed net of doubtful accounts.InventorySome combination of raw materials, W-I-P, and finished goods.Affected by valuation method/inflation.OtherGenerally, Prepaid Expenses.

Cash Position refers to cash on hand and in the bank, as well as access to bank loans and short-term investments.Current Liabilities16Accounts payableAmounts owed to suppliers for purchases.AccrualsExpenses incurred but not yet paid (e.g. salaries, rent, insurance, taxes, etc.).Short-term debtShort-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.

Working Capital17

(Net) working capital = current assets current liabilitiesWorking capital is the operating liquidity available to a company and is 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.

Long-Term Assets & Liabilities18Long-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 (12.5 months or 12.5 years).The relative proportion of fixed assets is determined by the industry.18The 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.Stockholders Equity19

19Balance Sheet Identity20A = L + ENWC = CA - CLNWC + FA = LTD + ENWC = (Cash + Other CA) CLCash = LTD + E + CL CA Other Than Cash FA

Some activities increase cash and others decrease cash.Sources & Uses of CashBuy inventory on creditSell inventory for cashCollect receivablesBorrow short-term debtBorrow long-term debtSell fixed assetsSell common stockLiquidate investmentsBuy inventory with cashMake sales on creditPay suppliers (A/P)Repay short-term loanRetire long-term debtBuy fixed assetsRepurchase stockPay dividends / taxesMake new investments21Sources (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. The Income Statement22

The income statement measures financial performance over a period of time.Income, earnings, and profit are used interchangeably.

The Income Statement23Revenue 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.

Sales are shown net of returns and allowances. Sales can increase based on volume, price increases, or both. The gross margin gauges the ability of the firm to pass sales increases along to customers. Firms with multiple revenue sources display line item and corresponding CGS separately.23Earnings Quality24Earnings quality is affected by:Accounting choices, methods, and assumptions.Discretionary expenditures.Non-recurring transactions.Non-operating gains and losses.

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Profits vs. CashNet 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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Cash Flow Timeline Example26A brand new firm is created. The owner puts in half the money and borrows the other half.

Cash Flow Timeline Example27The 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 firms suppliers.

Cash Flow Timeline Example28Buying the inventory on credit creates the liability, accounts payable.The size of the firm increases by $300.

Cash Flow Timeline Example29Heres where we are at month-end.The firm offers credit sales to customers, creating a receivable and depleting inventory.

Cash Flow Timeline Example30As the firm operates, it incurs expenses (salaries, utilities, rent, etc.), which are accrued until paid.

Cash Flow Timeline Example31Depreciation, a non-cash charge, is expensed.

Cash Flow Timeline Example32Cash is used to pay interest and taxes.

Cash Flow Timeline Example33Profits are added to the balance sheet as retained earnings.

Cash Flow Timeline Example34At the beginning of the next month, the bills for the accruals are paid with cash.

The balance sheet decreases in size.

Cash Flow Timeline Example35Cash 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 Flow Timeline Example36In 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 Flow Timeline Example37Despite 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.

The Cash Cycle38We 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.The Cash CycleInventory, 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.39Cash flows in a cycle into, around, and out of a businessit 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.

Cash Flow Timeline40The cash conversion period is the time between when cash is received versus paid.The shorter the cash conversion period, the more efficient the firms working capital and more cash is generated.

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

Operating Versus Cash Cycle41The 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 firms payment to suppliers and receipt of customer payments.Here, the Cash Cycle is 75 days (105 30).

42The Cash CycleFirms 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.43

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 Flows44 Cash Collected From Customers- Cash Paid To Suppliers- Cash Paid For Operations- Cash Paid To Creditors- Cash Paid For Taxes= Cash Flow From Operations

Historical data (accounting statements) can be used to assess the timing of cash flows.44Operating Cash Flows45

We look to the income statement and changes on the balance sheet to reconcile changes in cash at a single point in time.This list is not exhaustive; it includes the most common balance sheet line items.45Converting I/S to Cash Flows46

Assets = Use = Source

Liabilities = Use =SourceThe asset, Cash, is an exception.46Converting I/S to Cash Flows47

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. Converting I/S to Cash Flows48

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.

Converting I/S to Cash Flows49

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.

Converting I/S to Cash Flows50

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.Converting I/S to Cash Flows51

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.Converting I/S to Cash Flows52

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. Converting I/S to Cash Flows53

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.

53Converting I/S to Cash Flows54

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.54Back To This Example55Presented are two points in timeDay 1 and the final view.Lets reconcile the change in cash from $1,000 to $525.

56Reconciliation of CashWe will do a more complex example in a minutefor now, become acquainted with the format.

57Reconciliation of CashIMPORTANT:EVERY line item on the balance sheet must be accounted for somewhere in the analysis.Dont 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.2The 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.

Operating Cash Flows5858Managing the Cash Cycle59Managing The Cash Cycle60Managing the cash cycle includes:Reducing idle inventoryStretching payablesAggressively managing receivablesReceivables and inventory absorb cash; payables supply cash.

Working Capital Management61The cheapest and best source of cash exists as working capital within the business:

Managing The Cash Cycle62The 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.Shareholder Value Creation63Value can be created from many short-term financial management activities.

Managing Inventory64Inventory levels should be adequate to meet uncertain client demand without investing cash in too much inventory.There is a trade-off between:Stock-out costsCost of excess inventory (holding costs)Ordering costs

More in Chapter 4.Managing Receivables65The 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 30The 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.

Managing Payables66Payables 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.A Few Introductory Thoughts67Short-Term Planning68The 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.How Much WC Is Enough?69Approximately 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).Early Warning Signs70Early 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.