Working Capital Management

Working Capital Management
In context with SSIs
Overview
Learning Objectives An integrated approach to working capital management Working capital management Summary and Conclusions
Learning Objectives
You should understand:
Why the management of net working capital is critical for the survival of the firm How managing receivables, inventory, and payables is related in an integrated approach to net working capital management How the financing and current asset investment decisions interact to determine a companys overall working capital position How some key financial ratios can be used to analyze a firms net working capital policies
An Integrated Approach to Net Working Capital Management
The way in which a firm manages both its current assets and its current liabilities.
Good Working Capital Management

Characterized by:
1. The maintenance of optimal cash balances 2. The investment of any excess liquid funds in marketable securities that provide the best return possible, considering any liquidity or default-risk constraints 3. Proper management of accounts receivable 4. An efficient inventory management system 5. Maintaining an appropriate level of short-term financing, in the least expensive and most flexible manner possible.

Importance of Cash Flow Management
Management of the firms cash flow is one of the greatest challenges facing the financial manager:
Exhaustion of liquid resources can leave the firm unable to pay its maturing obligations as they come due (a state of technical insolvencyan Act of Bankruptcy)

Exhaustion of Liquid Resources
Firms can run out of liquid financial resources in a number of ways:

Rapid growth in production and sales, can cause the firm to use up all of its cash pursuing growth, leaving it invested in illiquid assets such as inventories, accounts receivable and net fixed assets.
The surprising thing about this state is that the firm may be highly profitable in an accounting sense, but be on the verge of bankruptcy as it pursues uncontrolled growth in sales.
Continuing to produce inventory in the face of falling sales revenue. Selling products/services for less than their variable cost to produce.

The Cash Budget
The monthly cash budget is a management tool used to forecast the timing, magnitude and duration of both cash surpluses as well as deficits.
Table 23-2 ABC's Six-Month Cash Budget
$
Sales Cash inflow Cash outflow Current sales Inventory Operating cash Start cash End cash Required cash Surplus/deficit
1
1,000 1,000 750 0 250 1,000 1,250 200 1,050
2
1,500 1,000 1,125 375 -500 1,250 750 300 450
3
2,000 1,500 1,500 375 -375 750 375 400 -25
4
2,500 2,000 1,875 375 -250 375 125 500 -375
5
3,000 2,500 2,250 375 -125 125 0 600 -600
6
3,500 3,000 2,625 375 0 0 0 700 -700

Knowledge of the cash flow cycle of a firm gives the manager an awareness of the dynamics involved in working capital management. The cash flow cycle helps the manager visualize the impact of changes in variables on the cash account:
How increasing sales requires additional investment in inventory How increasing accounts receivable reduces cash How delaying payables preserves cash How speeding collections on A/R improves the cash position
The Cash Flow Cycle
Cash and Net Working Capital
The cash flow cycle where cash comes fromhow it is used to finance the operations of the firmand how it is recovered and how it grows over time is a crucially-important part of understanding how a business functions.

Activities that Increase Cash
Increasing long-term debt Increasing equity Increasing current liabilities Decreasing current assets other than cash Decreasing fixed assets

Activities that Decrease Cash
Decreasing long-term debt Decreasing equity Decreasing current liabilities Increasing current assets other than cash Increasing fixed assets Paying dividends
Example of Exhaustion of the Liquid Resources of a New Firm

A simple example of a $1.0 million equity investment in a business levering additional financial resources and the need to finance the growth of the business leaving it exhausted of cash resources.
7 steps to technical insolvency for an otherwise profitable firm.
This Exercise
This exercise reinforces the classic working capital problem illustrated in the text. Demonstrates:
How cash is utilized over time in the firm. How investment in assets such as accounts receivable and inventory deplete cash resources. How the delays in receipt of cash from sales can leave a firm without cash, despite overall profitability.
The entrepreneur opens a current account in the name of the business.
Cash Flow Cycle

Start
Step 1
Cash Account Balance = $0
The entrepreneur invests $1,000,000 in equity.
Cash Flow Cycle

Initial Equity Investment
Step 2
Cash Account Balance = $1,000,000
Owner/Shareholders invest and receive common stock

Cash
Balance Sheet
$1m
Common Stock
$1 m
= $1,000,000
_____________________________________ T. Assets $1m T. Claims $1m
The firm purchases fixed assets.
Cash Flow Cycle

Purchase of $500,000 Fixed Assets
Step 3
Fixed Assets
Cash Account Balance = $500,000
Owner/Shareholders invest and receive common stock = $1,000,000
Balance Sheet Cash $0.5 F. Assets 0.5 Common Stock $1 m ___________________________________ T. Assets $1m T. Claims $1m
The firm purchases $300,000 inventory from suppliers.
Cash Flow Cycle

Buy $300,000 of inventory on trade credit
Step 4
Fixed Assets
Cash Account
Inventory
Balance = $500,000
Balance Sheet
Cash $0.5 A/P $0.3 Inventory 0.3 F. Assets 0.5 Common Stock $1 m _____________________________________ T. Assets $1.3m T. Claims $1.3m
Value is added to inventory through labour ($300,000) and equipment ($100,000). Further
Cash Flow Cycle

Work-in-process plus finished goods
Work-in-process inventory
Depreciation
Step 5
Finished goods inventory
Fixed Assets
Labour/utilities
Cash Account
Inventory
Balance = $500,000
Balance Sheet Cash $0.5 A/P $0.3 Inventory 0.7 Accruals 0.3 F. Assets 0.4 Common Stock $1 m _____________________________________ T. Assets $1.6m T. Claims $1.6m
Suppliers of initial inventory are paid ($0.3m). Labour costs ($0.2m in accruals) are paid resulting in a $0 cash balance.
Cash Flow Cycle

Payment of initial A/P and Accruals
Depreciation
Step 6
Fixed Assets
Labour/utilities
$200,000 paid Cash Account

Inventory
Balance = $0
$300,000 paid
Balance Sheet
Cash $0.0 A/P $0.0 Inventory 0.7 Accruals 0.1 F. Assets 0.4 Common Stock $1 m _____________________________________ T. Assets $1.0m T. Claims $1.1m
Sale of inventory occurs. Accounts receivable created. Cash = $0. There are 30 days till A/R collected.
Cash Flow Cycle

Goods sold on A/R for a profit
Depreciation
Step 7
Sold $400,000 of F.G. Inventory for $500,000
Fixed Assets
Labour/utilities
Cash Account
Inventory
Balance = $0
Balance Sheet Cash A/R Inventory F. Assets $0.0 0.5 0.3 0.4 A/P $0.0
Accruals 0.1 Common Stock $1 m R/E 0.1 ____________________________________ T. Assets $1.2m T. Claims $1.2m
Summary of the Exercise

This firm is left at the stage where it is waiting to collect on accounts receivable, but should be ordering more inventory and converting that inventory into saleable products. The firm could move forward if it had additional financing:
Sale of additional shares to investors Borrow funds Delay payment of wages to employees until collection of accounts receivable Collect on accounts receivable.
The Cash Budget

Working Capital Management - General Issues
The Cash Budget

Sample
Table 23-3 ABC's 12-Month Cash Budget $
Sales Cash inflow Cash outflow Current sales Inventory Operating cash Start cash End cash Required cash Surplus/deficit 750 0 250 1,000 1,250 200 1,050 1,125 375 -500 1,250 750 300 450 1,500 375 -375 750 375 400 -25 1,875 375 -250 375 125 500 -375 2,250 375 -125 125 0 600 -600 2,625 375 0 0 0 700 -700 3,000 375 0 0 0 700 -700 3,375 375 250 125 375 900 -525 3,750 375 375 375 750 1,000 -250 4,125 375 500 750 1,250 1,100 150 4,500 375 625 1,250 1,875 1,200 675 4,875 375 750 1,875 2,625 1,300 1,325
1
1,000 1,000
2
1,500 1,000
3
2,000 1,500
4
2,500 2,000
5
3,000 2,500
6
3,500 3,000
7
4,000 3,500
8
4,500 4,000
9
5,000 4,500
10
5,500 5,000
11
6,000 5,500
12
6,500 6,000
The Cash Budget

Purpose
The cash budget is a planning tool used to forecast cash inflows and outflows (usually each month) out into the future. The purpose of the cash budget is to forecast the timing, magnitude and duration of cash flow surpluses and deficits. The cumulative impact of the cash inflows/outflows will be forecast through the cash budget.
Forecast Cash Balances

Timing
Predicting when forecast deficits start and end allow the manager to communicate with the bank and eventually becomes a control-mechanism for the bank when monitoring the evolving financial condition of the firm.
$ Cash
Jan Feb Mar Apr May Jun Jul Aug

Magnitude
$ Cash
How much the firm is likely to need to borrow to cover a projected deficit.

Duration
$ Cash
The length of time that the projected cash deficit will last is useful in choosing the right financing solution, but is also an important control mechanism for monitoring after the fact.
The Cash Budget

Use
The Cash Budget:

Allows management to change plans before they are implemented to produce a more favourable cash result Allows management to choose the most correct investment option in the case of forecast surpluses Allows management to arrange the most appropriate financing solution in the case of forecast deficits.
Cash Budgets
Dealing with Forecast Surpluses Knowing the timing, magnitude and duration of cash surpluses allows management to choose the most appropriate management response:
Small Amount of Surplus available for a short period of time (ie. less than $100,000)
Keep in current account
Small Sum available for a long period time

Consider dispersing as cash dividends Potentially retire debt
Large Sum available for a short period of time 30 90 days (ie. greater than $100,00)
Invest in money market securities such as T-bills
Large Sum available for a long period time

Consider dispersing excess funds as cash dividends Alternatively invest in longer-time, higher yielding investments
Cash Budgets
Dealing with Forecast Deficits Knowing the timing, magnitude and duration of cash deficits allows management to choose the most appropriate management response:
Small deficit persisting for a short period of time (ie. less than $100,000)
Delay purchases, speed collections and try to synchronize cash flows to eliminate or minimize, or Negotiate an operating line of credit with the financial institution
Small deficit available for a long period time

Explore more permanent solutions to the under-funding
Large deficit forecast to last a short period of time 30 90 days (ie. greater than $100,00)
Operating line of credit, or Seek longer term permanent capital solutions if large cash flow deficits are likely to reoccur.
Large Sum available for a long period time

Seek permanent capital increases in the form of debt, equity or combination.
Useful Ratios in Working Capital Management
Use of Ratios in Working Capital Management

Ratios are commonly used to assess or to summarize a firms working capital management. The focus of such an assessment is:
Liquidity management The firms efficiency in asset utilization Current liability management

Liquidity Ratios
Ratios used to assess the firms liquidity include the current and quick ratios:
Current ratio Current assets (CA) Current liabilities (CL)
Quick ratio
Cash(C ) Marketablesec urities( MS) accounts receivable( AR) CL
Excessive liquidity will reduce ROI and ROE. It can also mean the firm is too lenient in terms of credit policy, or may have excessive inventories that may be subject to technological obsolescence.

Working Capital Ratios Changes in these ratios can indicate growing problems with credit policy and/or a need to improve collections efforts.
Sales AR
Receivables turnover(R T)
Average collection period(ACP)
AR 365 Average daily sales( ADS) RT
The shorter the collection period, the lower the cash sensitivity to changes in sales.

Working Capital Ratios
CGS is not likely to be comparable across different firms, so alternative is to use Sales in the numerator
Costof goods sold (CGS ) Inventory
InventoryTurnover(I T)
Sales Inventory
The higher the inventory turnover, the lower the sensitivity of cash to changes in sales.

Working Capital Ratios Dividing 364 days by inventory turnover (IT) gives ADSI:
Sales Inventory
Average days sales in inventory(ADSI)
Inventory 365 ADS IT
The higher IT the lower ADSI showing more efficient inventory management and a reduced sensitivity of cash to changes in sales.

Working Capital Ratios
On the liability side of the balance payable management ratios include:
Payables turnover( PT)
Sales Accounts payable
Average days of sales in payables(ADSP)
Accounts payable 365 ADS PT
PT shows how many times a year a firm pays off its suppliers on average. ADSP shows how long a firm defers payments to its suppliers.
Operating and Cash Conversion Cycles
Operating Cycle (OC)

Operating cycle is the time period between the acquisition of inventory and when cash is collected from receivables.

Operating and Cash Conversion Cycles Operating Cycle:
OC ADSI ACP
Operating cycle is a function of average days sales in inventory and the average collection period.
Cash Conversion Cycle (CCC)

Cash cycle is the time between cash disbursement and cash collection. An estimate of the average time between when a firm pays cash for its inventory purchases and when it receives cash for its sales; the average number of days of sales that firm must finance outside the use of trade credt.

Operating and Cash Conversion Cycles The Cash Conversion Cycle :
CCC OC - ADSP
The estimated time between when a firm pays cash for inventory purchases and when it receives cash from sales.
Cash Conversion Cycle (CCC)

Cash Conversion Cycle
= Inventory conversion period + Receivables conversion period Payables deferral period
Management of the cash cycle can make an important difference in the amount of financing required, assets employed to generate a given level of sales...and therefore, can affect ROA and ROE.
Cash Flow Time Line

Inventory sold Inventory purchased Inventory period Accounts payable period Cash paid for inventory Accounts receivable period
Cash received
Time
Operating cycle (OC) Cash Conversion Cycle (CCC)
Summary and Conclusions

In this chapter you have learned:
The importance of effective working capital management and the classic cash flow challenges faced by growing firms. That an integrative approach to working capital management reveals the relationships and interdependency among working capital accounts How to generate and use cash budgets How to use some common ratios to assess a firms overall approach to working capital management.

Working Capital Management

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Working Capital Management

In context with SSIs

An Integrated Approach to Net Working Capital Management