CLASS 1
Managing Working Capital and Cash Flow
Corporate Finance and Valuation | Dr. Viktoria Dalko
1
HOW DO YOU MAKE SURE YOUR
COMPANY DOESN’T RUN OUT OF CASH?
2
Key Takeaways
What is the
appropriate amount
and mix of current
assets for the firm to
hold?
How should these
current assets be
financed?
3
What is the appropriate amount and mix
of current assets for the firm to hold?
4
Working Capital Basics
Apple Inc. Financial Statements, Fiscal Year
Ended September 24, 2016 ($ millions)
This exhibit shows the balance sheet and
income statement for Apple Inc. for the fiscal
year ended September 24, 2016. We use this
information in illustrating various elements of
working capital management.
Assets
Cash
Short-term investments
Accounts receivable
Inventory
Other current assets
Total current assets
Property, plant, and equipment
Less: Accum. depreciation
Net plant and equipment
Investments
Other noncurrent assets
Total Assets
$20,484
46,671
15,754
2,132
21,828
$106,869
61,245
34,235
27,010
170,430
17,377
$321,686
5
Working Capital Basics
Liabilities and equity
Accounts payable
$37,294
Deferred revenue
8,080
Accrued expenses
22,027
Other current liabilities
11,605
Total current liabilities
Balance Sheet as of September 24, 2016
$79,006
Long-term debt
75,427
Other noncurrent liabilities
39,004
Total liabilities
$193,437
Preferred stock
0
Common stock
31,251
Retained earnings
96,364
Other stockholder equity
Less: Treasury stock
634
0
Total common equity
$128,249
Total liabilities and stockholder’s equity
$321,686
6
Working Capital Basics
Income Statement for the fiscal year
ended September 24, 2016
7
Working Capital Basics:
Terms and Concepts
8
➢ Current assets are cash and other assets that the
firm expects convert into cash in a year or less
➢ Current liabilities (or short-term liabilities) are
obligations that the firm expects to pay off in a year
or less
➢ Working capital (also called gross working capital)
are the funds invested in a company’s cash account,
account receivables, inventory, and other current
assets
9
➢ Net working capital (NWC) refers to the difference
between current assets and current liabilities; it is
important because it is a measure of liquidity and
represents the net short-term investment the firm keeps in
the business
➢ Working capital management involves making decisions
regarding the use and sources of current assets
10
➢ Working capital efficiency refers to the length of time
between when a working capital asset is acquired and
when it is converted into cash
➢ Liquidity is the ability of a company to convert real or
financial assets into cash quickly and without loss of value
11
Working Capital Accounts and Trade-Offs
12
➢ Working capital accounts
➢ Cash includes cash and other highly liquid short-term
money market instruments, such as U.S. Treasury
securities
➢ Receivables represent the amount owed by customers
who have availed themselves of the firm’s trade credit
facility
➢ Firms maintain inventory of raw materials, work in
process, and finished goods
➢ Payables represent the amount owed to the firm’s
vendors and suppliers for materials purchased on credit
➢ Increasing working capital costs money, but should lead to
increased sales and better relationships with vendors,
suppliers, and employees
13
Strategies of Working Capital
Management:
Corporate Finance
14
➢ Financial managers use two types of strategies for
current assets: flexible and restrictive
➢ The flexible current asset management
strategy has a high percent of current assets to
sales, whereas a restrictive policy has a low
percent of current assets to sales
15
➢ Flexible current asset management strategy
➢ Calls for management to invest large amounts
in cash, marketable securities, and inventory
➢ Is considered low-risk and low-return
➢ The advantage of this strategy is large working
capital balances
➢ The downside of this strategy is the high
carrying cost associated with owning a high
level of inventory and providing liberal credit
terms to customers
16
➢ The restrictive current asset management
strategy is a high-risk high-return alternative to
the flexible strategy
➢ The high risk comes in the form of shortage
costs, both financial and operating
➢ Operating shortage costs result from lost
production and sales
➢ Financial shortage costs arise mainly from
illiquidity, shortage of cash, and a lack of
marketable securities to sell for cash
17
➢ The working capital trade-off: management will try to
find the level of current assets that minimizes the sum
of the carrying costs and shortage costs
➢ The optimal current assets investment strategy will
depend on the relative magnitudes of carrying
costs and shortage costs; this conflict is often
referred to as the working capital trade-off
➢ Financial managers need to balance shortage costs
against carrying costs to define an optimal strategy
➢ If carrying costs are larger than shortage costs,
then the firm will maximize value by adopting a
more restrictive strategy
➢ On the other hand, if shortage costs dominate
carrying costs, the firm will need to move towards
a more flexible policy
18
What are the decisions that define the
size of working capital?
19
Accounts Receivables
➢ Companies frequently make sales to customers on credit by delivering
goods in exchange for the promise of a future payment
➢ The promise is an account receivable from the firm’s point of view
➢ Offering credit to customers can help a firm attract customers by
differentiating the firm and its products from its competitors
20
Terms of Sale
➢ Whenever a firm sells a product, the seller spells out the terms and conditions of the
sale in a document called the terms of sale
➢ The agreement specifies when payment is due and the amount of any discount if
early payment is made
➢ The simplest offer is cash on delivery (C O D), with no credit offered
➢ When credit is part of the sale, the terms of sale spell out the credit agreement between
the buyer and seller
➢ Trade credit, which is short-term financing, is typically made with a discount for early
payment rather than an explicit interest charge
21
Terms of Sale
➢ Trade credit is a loan from the supplier and is usually a very costly form of credit
➢ We can find the effective annual rate (E A R) for trade credit using the following
formula:


Discount
EAR for accounts receivable = EARR = 1 +

Discounted
price


365
days credit
−1
22
Aging Accounts Receivables
➢ A common tool that credit managers use is called an aging schedule
➢ The aging schedule shows the breakdown of the firm’s accounts receivable by their
date of sale, how long the account has not been paid
➢ Its purpose is to identify and then track delinquent accounts and to see that they
are paid
➢ Aging schedules are also an important tool for analyzing the quality of a firm’s
receivables
➢ The aging schedule reveals patterns of delinquency and shows where collections
efforts should be concentrated
23
Inventory Management
➢ Inventory management is largely a function of operations management, not financial
management
➢ Manufacturing companies generally carry three types of inventory: raw materials,
work in process, and finished goods
➢ Investment in inventory is costly
➢ Capital invested in inventory provides no direct return, but running out of raw
materials can cause manufacturing to shut down at a greater cost to the firm
➢ A shortage of finished goods can mean lost sales
24
Cash Management and Budgeting
➢ There are three main reasons for holding a cash balance
➢
➢
➢
First, it facilitates transactions with suppliers, customers, and employees
Second, for precautionary or strategic reasons
The third reason for holding cash is simply that most banks require firms to hold
compensating balances, minimum cash balances in exchange for services
25
Example: Cash Flow Budget
for January through April
Assume beginning cash of $80,000.
Jan
Feb.
Mar
Apr
Beginning cash
$ 80,000
$ 64,000
$ 44,400
$ 22,080
Cash receipts
105,000
126,000
151,200
181,440
Cash disbursements
121,000
145,600
173,520
203,624
Net cash flow
(16,000)
(19,600)
(22,320)
(22,184)
Ending cash
Note ending cash for a month
becomes the beginning cash
for the following month.
$ 64,000
$ 44,400
$ 22,080
$
(104)
Note that even though growth in
sales lead to growth in net income,
the company runs out of cash
Cash Collections
➢ Collection time, or float, is the time between when a customer makes a
payment and when the cash become available to the firm
➢ Collection time can be broken down into three components:
➢ Delivery, or mailing, time: when a customer mails a payment it may take
several days before that payment arrives
➢ Processing delay: once the payment is received it must be opened, examined,
accounted for, and deposited at the firm’s bank
➢ Finally, there is a delay between the time of the deposit and the time the cash
is available for withdrawal
27
What is the best way to finance working
capital?
28
Financing Working Capital (1 of 4)
➢ The minimum level of working capital is viewed as permanent working capital
➢ Exhibit below shows the three basic strategies that a firm can follow to finance its working
capital and fixed assets
➢ Each of the three panels show:
➢ The total long-term financing needed, consisting of long-term and equity
➢ The seasonal needs for working capital that fluctuates with the level of sales
29
Financing Working Capital
(2 of 4)
Working Capital Financing Strategies
Three alternative strategies for financing working capital and
fixed assets are (1) a maturity matching strategy, which
matches the maturities of assets and the sources of funding;
(2) a long-term funding strategy, which relies on long-term
debt to finance both working capital and fixed assets; and (3)
a short-term funding strategy, which uses short-term debt to
finance all seasonal working capital needs and a portion of
permanent working capital and fixed assets.
30
Financing Working Capital (3 of 4)
➢ Strategies for financing working capital
➢ The maturity matching strategy is one of the most basic techniques used by
financial managers to reduce risk when financing assets
➢ All seasonal working capital is funded with short-term borrowing and, as the
level of sales varies seasonally, short-term borrowing fluctuates between
some minimum and maximum level
31
Financing Working Capital (4 of 4)
➢ Strategies for financing working capital
➢ The long-term funding strategy is shown in Panel B
➢ All permanent working capital and fixed assets are funded with long-term
financing
➢ This strategy relies on long-term debt to finance both capital assets and
working capital
➢ The short-term funding strategy is shown in Panel C
➢ This strategy relies on short-term debt to finance all seasonal working
capital, a portion of the permanent working capital and fixed assets
32
Financing Working Capital in Practice
➢ Matching Maturities
➢ Nearly all financial managers try to match the maturities of assets and
liabilities when funding the firm
➢ Short-term assets are funded with short-term financing and long-term assets
are funded with long-term financing
➢ Permanent Working Capital
➢ Most financial managers like to fund some of their current assets with longterm debt as shown in Panel B
➢ Some large firms with the highest credit standing prefer to fund some of their
long-term fixed assets with short-term debt sold in the commercial paper
market
33
Sources of Short-Term Financing (1 of 4)
➢ Accounts Payable
➢
➢
Accounts payable (trade credit), bank loans, and commercial paper are
common sources of short-term financing
The buyer decides whether to take advantage of the cash discount or
wait and pay in full when the account is due
34
Sources of Short-Term Financing (2 of 4)
➢ Short-term Bank Loans
➢ If the firm backs the loan with an asset the loan is defined as secured,
otherwise the loan is unsecured
➢ Secured loans should allow the borrower to borrow at a lower interest rate
➢ An informal line of credit is a verbal agreement between the firm and the
bank, allowing the firm to borrow up to an agreed-upon upper limit
➢ In exchange for providing the line of credit, a bank may require that the
firm hold a compensating balance with them
➢ A formal line of credit is also known as revolving credit
➢ Under this type of agreement, the bank has a legal obligation to lend an
amount of money up to a pre-set limit; the firm pays a yearly fee in
addition to the interest expense on the amount they borrow
35
Sources of Short-Term Financing (3 of 4)
➢ Commercial Paper
➢
➢
➢
Commercial paper is a promissory note issued by large financially secure
firms that have high credit ratings
Commercial paper is not secured (the issuer is not pledging any assets to
the lender in the event of default), but most commercial paper is backed
by a credit line from a commercial bank
The default rate on commercial paper is very low, resulting in an interest
rate that is usually lower than what a bank would charge on a direct loan
36
Sources of Short-Term Financing (4 of 4)
➢ Accounts Receivable Financing
➢
➢
➢
A company can secure a bank loan by pledging the firm’s accounts
receivable as security
Accounts receivable financing is an important source of funds for
medium-size and small businesses
A second way for a business to finance itself with accounts receivables,
called factoring, is to sell the receivables to a factor at a discount; the
firm that sells the receivables has no further legal obligation to the factor
37
Any
questions?
https://mashable.com/article/comedy-wildlife-photography38
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Practice Q1
Trend Foods distributes its products to more than 100 restaurants and delis. The company's
collection period is 32 days, and it keeps its inventory for 10 days. What is Trend's operating
cycle?
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Practice Q2
Senter Corp. sells its goods with terms of 2/10 EOM, net 30. What is the implicit cost of the
trade credit? Round your final percentage answer to 2 decimal places. Do not round your
intermediate calculations.
40
Practice Q3
Which of the following statements about maturity matching strategy is true?
A) All seasonal working capital needs are funded with short-term borrowing.
B) As the level of sales varies seasonally, short-term borrowing fluctuates with the level of seasonal working
capital.
C) All fixed assets are funded with long-term financing.
D) All of the above
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Breakout session: Take a screen shot of the
questions or keep this ppt open
During Breakout Session, share a Microsoft
Excel file, or share a google sheet.
Type your actual current team members’
name on first worksheet who are
participating in this activity with you.
Record a single joint answer of the team on
the second worksheet and upload it in
Dropbox.
Be ready to present it in class.
42
Breakout session Q1
Stamp, Inc. has an operating cycle of 81 days and takes 47 days to collect on its receivables. What is
its level of inventory if the firm's cost of goods sold is $312,455? Round your final answer to the
nearest dollar.
43
Breakout session Q2
Kearns, Inc. sells its goods with terms of 3/15 EOM, net 60. What is the implicit cost of the trade
credit? Do not round your intermediate calculations, and round your final answer to the nearest
whole percent.
44
Breakout session Q3
What are some strategies that financial managers can follow in managing their working capital
accounts?
45
Key Takeaways
What is the
appropriate amount
and mix of current
assets for the firm to
hold?
How should these
current assets be
financed?
46
Appendix:
Operating and Cash Conversion Cycles:
Accounting Review
47
➢ The cash conversion cycle is the length of time from the
point at which a company pays for raw materials until the
point at which it receives cash from the sale of finished
goods made from those materials
➢ Sequence of events in the cash conversion cycle:
➢ The firm uses cash to pay for the cost of raw materials
and the costs of conversion
➢ Finished goods are held in finished goods inventory
until they are sold
➢ Finished goods are sold on credit to the firm’s
customers
➢ Customers repay the credit the firm has extended to
them; and the firm receives the cash
48
➢ A typical cash conversion cycle begins with
cash outflows for raw materials and
conversion costs and goes through several
stages before these resources are turned
back into cash. The cash conversion cycle
reflects the average time from the point that
cash is used to pay for raw materials until
cash is collected on the account receivable
associated with the product produced with
those raw materials. One of the main goals of
a financial manager is to optimize the time
between the cash outflows and the cash
inflows.
49
➢ Minimal working capital is obtained is the financial
managers in managing the cycle:
➢ To delay paying accounts as long as possible
without suffering any penalties
➢ To maintain minimal raw material inventories
without causing manufacturing delays
➢ To use as little labor as possible to manufacture
the product while maintaining quality
➢ To maintain minimal finished good inventories
without losing sales
➢ To offer customers the most attractive credit
terms possible on trade credit to maximize sales
while minimizing the risk of non-payment
➢ To collect cash payments on accounts receivable
as fast as possible to close the loop
50
Operating and Cash Conversion Cycles
➢ Time Line for Operating and Cash Conversion Cycles for Apple Inc. in 2016
➢ The exhibit shows the cash inflows and outflows and other key events in a firm’s
operating cycle and cash conversion cycle, along with computed values for Apple. Both
of these cycles are used for measuring working capital efficiency.
51
Operating and Cash Conversion Cycles
Inventory-on-hand period
+
Receivable collection period
=
Operating Cycle
–
Day’s payable period
Additional working capital financing period - called Cash
Conversion Cycle
52
DSI
➢ The operating cycle begins when the firm uses its cash to purchase raw materials and
ends when the firm collects cash payments on its credit sales
➢ Days sales in inventory (D S I) shows to the daily cost of good sold how long the firm
keeps its inventory before selling it, the ratio of the inventory balance to the daily cost
of good sold
365 days
365 days
DSI =
=
Inventory turnover COGS / Inventory
53
DSO
Days sales outstanding (DSO)
estimates how long it takes on
average for the firm to collect its
outstanding accounts receivable
balances; also called the Average
Collection Period (A C P)
DSO =
=
365 days
Accounts receivable turnover
365 days
Net sales
Accounts receivable
54
Operating Cycle = DSI + DSO
55
DPO
➢ The cash conversion cycle does not start until the firm actually pays for its inventory
➢ It represents the length of time between the cash outflow for materials and the cash
inflow from sales
➢ Days payables outstanding (DPO) tells how long a firm takes to pay off its suppliers
for the cost of inventory
DPO =
365 days
365 days
=
Accounts payable turnover COGS / Accounts payable
56
Cash Conversion Cycle
➢ We can now calculate the cash conversion cycle using one of two methods:
Cash Conversion Cycle = DSI + DSO − DPO
Cash Conversion Cycle = Operating Cycle − DPO
57
Selected Financial Ratios for Apple Inc. and the
Computer Industry in 2016
When we compare working capital ratios for Apple with
average ratios for the computer industry, we see that
Apple is outperforming its peers on all metrics. Apple
holds less inventory, collects on its outstanding balances
more quickly than competitors, and is able to defer its
cash payments to suppliers longer than competitors.
These three facts combined ensure that Apple’s operating
and cash conversion cycles are significantly shorter than is
the norm in the computer industry. Note that a negative
cash conversion cycle of −71.11 days means that Apple
collects cash from its customers before it has to pay its
suppliers. Thus, Apple’s suppliers are financing all of
Apple’s working capital and then some
Financial Ratio
Apple
Computer
Industry
Days’ sales in inventory
(D S I)
5.92
54.25
Days’ sales outstanding
(D S O)
26.66
58.10
103.69
72.41
Operating cycle (days)
32.58
112.35
Cash conversion cycle
(days)
−71.11
39.93
Days’ payables
outstanding (D P O)
58