Chapter 2Analysis of Working Capital Cycle
Order Order Sale CashOrder Order Sale Cash
Placed Received ReceivedPlaced Received Received
Accounts Collection Accounts Collection
< Inventory > < Receivable > < Float > < Inventory > < Receivable > < Float >
Accounts Disbursement Time ==> Accounts Disbursement Time ==>
< Payable > < Float >< Payable > < Float >
Invoice Payment Cash Invoice Payment Cash
Received Sent Paid Received Sent Paid
Order Order Sale CashOrder Order Sale Cash
Placed Received ReceivedPlaced Received Received
Accounts Collection Accounts Collection
< Inventory > < Receivable > < Float > < Inventory > < Receivable > < Float >
Accounts Disbursement Time ==> Accounts Disbursement Time ==>
< Payable > < Float >< Payable > < Float >
Invoice Payment Cash Invoice Payment Cash
Received Sent Paid Received Sent Paid
Solvency Vs. Liquidity
Solvency concerns whether assetsexceed liabilities, whereas liquidityrefers to the firm’s ability to meetshort-term obligations with cash whileremaining a going-concernSolvency concerns whether assetsexceed liabilities, whereas liquidityrefers to the firm’s ability to meetshort-term obligations with cash whileremaining a going-concern
Solvency Measures
Current RatioCurrent Ratio
Quick RatioQuick Ratio
Net Working CapitalNet Working Capital
Working Capital RequirementsWorking Capital Requirements
Financial Statements - BasicSource 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 andless default riskLarger value- Adequate solvency andless default risk
For larger firms, the absolute value ofNWC will always be higher.For larger firms, the absolute value ofNWC will always be higher.
Standardization of NWC by eitherassets or revenueStandardization of NWC by eitherassets or revenue
The company increasingly fund theircurrent assets with their long-termfinancing
Traditional NWC figure includes accountsthat are not directly related to theoperating component of the workingcapital cycle.Traditional NWC figure includes accountsthat are not directly related to theoperating component of the workingcapital cycle.
Specifically, cash holdings and notespayable result from internal financialdecisions or policies enacted bymanagement.Specifically, cash holdings and notespayable result from internal financialdecisions or policies enacted bymanagement.
Decomposing the NWC into operating andfinancial components can be useful tomanagement when assessing workingcapital policies.Decomposing the NWC into operating andfinancial components can be useful tomanagement when assessing workingcapital policies.
NWC and its ComponentParts
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 CL CA CL CA CL CA CL
NWC = CA - CL WCR = A/R + INV +Pre NLB = Cash + M/S NWC = 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
CMLTDCMLTD
CMLTDCMLTD
AccrualsAccruals
AccrualsAccruals
AccrualsAccruals
- Accruals - Accruals
Working Capital Requirements
The working capital requirement(WCR) is the difference betweencurrent operating assets (i.e., noncashcurrent assets) and current operatingliabilities (e.g., accounts payable andoperating accruals).The working capital requirement(WCR) is the difference betweencurrent operating assets (i.e., noncashcurrent assets) and current operatingliabilities (e.g., accounts payable andoperating accruals).
These accounts represent spontaneoususes and sources of funds generatedover the working capital cycle.These accounts represent spontaneoususes and sources of funds generatedover the working capital cycle.
All other factors constant, anincreased WCR implies that theworking capital cycle requiresadditional financingAll other factors constant, anincreased WCR implies that theworking capital cycle requiresadditional financing
A negative WCR implies that theworking capital cycle providesfinancing for long-term assets,positively impacting solvency.A negative WCR implies that theworking capital cycle providesfinancing for long-term assets,positively impacting solvency.
Trend in the WCR indicates a substantial increase in net operatingworking capital.
For each year, the observed WCR shows that more funds are tied up inreceivables 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 tocover the gap in operating working capital.
Current ratio
Values exceeding 1 imply that current assetsexceed current liabilities.Values exceeding 1 imply that current assetsexceed current liabilities.
Relationship between the current ratio and NWC:Positive NWC means that the current ratioexceeds 1, and a negative NWC implies a currentratio of less than 1. The current ratio will equal 1only if NWC is $0.Relationship between the current ratio and NWC:Positive NWC means that the current ratioexceeds 1, and a negative NWC implies a currentratio of less than 1. The current ratio will equal 1only if NWC is $0.
Similar to the interpretation of the NWC,increased values for the current ratio traditionallyimply improved solvency and reduced default risk.Similar to the interpretation of the NWC,increased values for the current ratio traditionallyimply improved solvency and reduced default risk.
Despite this interpretation, keep in mind thathigher receivables and inventory, while increasingthe current ratio, also reduce operating cashflow.Despite this interpretation, keep in mind thathigher receivables and inventory, while increasingthe current ratio, also reduce operating cashflow.
Shortcomings of TraditionalWorking Capital Measures
First, although typically referred to as measures ofliquidity, the ratios presented earlier are moreproperly classified as solvency measures.First, although typically referred to as measures ofliquidity, the ratios presented earlier are moreproperly classified as solvency measures.
A second problem is the static nature of theaforementioned measures as the various balancesheet accounts are assumed to have equal “time-to-cash” conversion rates.A second problem is the static nature of theaforementioned measures as the various balancesheet accounts are assumed to have equal “time-to-cash” conversion rates.
A third shortcoming concerns interpretation of thecurrent and quick ratios, as can havecounterintuitive impacts depending on ratio’s initiallevel.A third shortcoming concerns interpretation of thecurrent and quick ratios, as can havecounterintuitive impacts depending on ratio’s initiallevel.
THE CASH CONVERSIONPERIOD
Represents the time needed to convert$1 of disbursements into $1 of cashreceipts.Represents the time needed to convert$1 of disbursements into $1 of cashreceipts.
Days Inventory Held (DIH)
Calculation of the CCP involves three measures,including days inventory held (DIH), days salesoutstanding (DSO), and days payables outstanding(DPO).Calculation of the CCP involves three measures,including days inventory held (DIH), days salesoutstanding (DSO), and days payables outstanding(DPO).
Conceptually, the DIH represents the averagenumber of days inventory sits idle. Also, given thatCOGS represents inventory production costs, theDIH can be interpreted as the number of days ofConceptually, the DIH represents the averagenumber of days inventory sits idle. Also, given thatCOGS represents inventory production costs, theDIH can be interpreted as the number of days of
inventory held on the balance sheet at a given point inventory held on the balance sheet at a given point
in time. in time.
Days Sales Outstanding (DSO)
DSO represents the average number of days it takesfor a supplier to collect on credit sales, whichreflects the efficiency of the credit and collectionsdepartment. DSO is also referred to as the averagecollection period and it is common to compare theDSO to the trade credit terms offered by suppliers.DSO represents the average number of days it takesfor a supplier to collect on credit sales, whichreflects the efficiency of the credit and collectionsdepartment. DSO is also referred to as the averagecollection period and it is common to compare theDSO to the trade credit terms offered by suppliers.
Days Payable Outstanding
DPO is the elapsed time betweenreceipt of inputs and when paymentsare made to suppliers.DPO is the elapsed time betweenreceipt of inputs and when paymentsare made to suppliers.
The CCP represents the length of time overwhich management must arrange fornonspontaneous financing. Longer CCPsrequire increased financial resources,reducing firm liquidityThe CCP represents the length of time overwhich management must arrange fornonspontaneous financing. Longer CCPsrequire increased financial resources,reducing firm liquidity
Implications of CCP
A positive CCP implies that additionalfinancing is needed to fund the cash cycle.A positive CCP implies that additionalfinancing is needed to fund the cash cycle.
A negative CCP occurs when the trade creditperiod received exceeds the operating cycle. Anegative CCP implies that suppliers providefinancing for the firm’s working capital cycleand for non-operating working capital assets.A negative CCP occurs when the trade creditperiod received exceeds the operating cycle. Anegative CCP implies that suppliers providefinancing for the firm’s working capital cycleand for non-operating working capital assets.
This desirable working capital position isattributable to the strong demand for bothfirms’ products (short inventory holdingperiods), quick repayment by customers (toretain a favorable relationship), and generoustrade credit terms received from suppliers.This desirable working capital position isattributable to the strong demand for bothfirms’ products (short inventory holdingperiods), quick repayment by customers (toretain a favorable relationship), and generoustrade credit terms received from suppliers.
Practice Math 1
Suppose that a firm currently has a CCPof 87 days and DIH equals 50 days.Management would like to reduce theCCP by 5 days through changes ininventory policy. That is, the extensionand use of trade credit policies willremain unchanged. With this goal inmind, and assuming that the firm hasannual revenues of $500M with COGSrepresenting 40% of revenues, thetreasury department wants to estimatethe implied reduction in inventory and thesubsequent increase in cash flow.Suppose that a firm currently has a CCPof 87 days and DIH equals 50 days.Management would like to reduce theCCP by 5 days through changes ininventory policy. That is, the extensionand use of trade credit policies willremain unchanged. With this goal inmind, and assuming that the firm hasannual revenues of $500M with COGSrepresenting 40% of revenues, thetreasury department wants to estimatethe implied reduction in inventory and thesubsequent increase in cash flow.
The Cash Conversion Period andFirm Value
The CCP directly impacts the value of the firm asthe gap between the operating cycle and the DPOcan be financed with either debt or equityThe CCP directly impacts the value of the firm asthe gap between the operating cycle and the DPOcan be financed with either debt or equity
An increased cash cycle implies increased interestexpense.An increased cash cycle implies increased interestexpense.
Practice Math 2
