Managing Corporate
Liquidity
Net Working Capital Components
CA
CA
CL
CL
Cash
Cash
Mkt. Sec
A/P
Mkt. Sec
A/P
A/R
N/P
A/R
N/P
Inventory
CMLTD
Inventory
CMLTD
Prepaid
Accruals
Prepaid
Accruals
NWC = CA - CL
WCR = A/R + INV + Pre – A/P - Accruals NLB = Cash + M/S – N/P - CMLTD
Net Working Capital = Working Capital Requirements + Net Liquid Balance
Legend:
CA = Current Assets
CL = Current Liabilities
Mkt. Sec. = Marketable Securities
A/R = Accounts Receivable
A/P = Accounts Payable
N/P = Notes Payable
CMLTD = Current Maturing Long Term Debt
NWC = Net Working Capital
WCR = Working Capital Requirements
Pre = Prepaid
NLB = Net Liquid Balance
Net Working Capital Requirements
 Index of working capital needs
 Spontaneous uses/sources of funds over operating
cycle
 Expands or contracts with sales
 If seasonal , working capital is financed with Net
Liquid Balance (NLB) or short term borrowings
Net Working Capital Requirements
 If permanent due to growth, finance with long term
capital
 Negative number means cash cycle is a source of
financing
Net Liquid Balance
 Measure of liquidity rather than solvency
 Current funds that are available to finance short term
needs
 Negative number indicates need for external financing
which means reduced financial flexibility
Cash Conversion Cycle
Dr. Pepper Manufacturing
Corp. is a diversified
manufacturing company.
Determine the company’s
2014 operating cycle and the
cash cycle after computing
the appropriate ratios for
inventory, receivables and
payables.
Cash Conversion Period
Inventory Stocked
Inventory Sold
Days Inventory Held
Cash Received
Days Sales Outstanding
Days Payable Outstanding
Cash Conversion Period
Cash Disbursed
Cash Conversion Period =
Days Inventory Held
+
Days Sales Outstanding
-
Days Payable Outstanding
Cash Conversion Cycle
Dr. Pepper Manufacturing Corporation Balance Sheet
2014
2013
Cash
$ 500,000
$ 500,000
Marketable Securities (at cost)
$ 500,000
$ 450,000
Accounts Receivable less allowance for bad debts
$ 2,000,000
$ 1,600,000
Inventories
$ 3,000,000
$ 2,000,000
$ 6,000,000
$ 4,550,000
Assets
Current Assets
Total current assets
Cash Conversion Cycle
Dr. Pepper Manufacturing Corporation Balance Sheet
2014
2013
Accounts payable
$ 1,000,000
$ 750,000
Notes payable
$ 1,500,000
$ 500,000
Accrued expenses payable
$ 250,000
$ 225,000
Taxes payable
$ 250,000
$ 225,000
$ 3,000,000
$ 1,700,000
Liabilities
Current Liabilities
Total current liabilities
Cash Conversion Cycle
Dr. Pepper Manufacturing Corporation Income Statement
2014
2013
$ 11,500,000
$ 10,700,000
$ 8,200,000
$ 7,684,000
$ 300,000
$ 275,000
$ 1,400,000
$ 1,325,000
$ 1,600,000
$ 1,416,000
Consolidated Income Statement
Net Sales
Cost of sales and operating expenses:
Cost of goods sold
Depreciation
Selling and administrative expenses
Operating profit
Cash Conversion Cycle
 Compute average inventory first
Ave. Inventory = $ 3 million + $ 2 million
2
= $ 2.5 million
Cash Conversion Cycle
Dr. Pepper Manufacturing Corporation Balance Sheet
2014
2013
Cash
$ 500,000
$ 500,000
Marketable Securities (at cost)
$ 500,000
$ 450,000
Accounts Receivable less allowance for bad debts
$ 2,000,000
$ 1,600,000
Inventories
$ 3,000,000
$ 2,000,000
$ 6,000,000
$ 4,550,000
Assets
Current Assets
Total current assets
Cash Conversion Cycle
 Compute Inventory Turnover Ratio
Inventory Turnover Ratio = Cost of Goods
Ave. Inventory
= $ 8.2 million
$ 2.5 million
= 3.3
This means an inventory cycle of 3.3 times per year
Cash Conversion Cycle
Dr. Pepper Manufacturing Corporation Income Statement
2014
2013
$ 11,500,000
$ 10,700,000
$ 8,200,000
$ 7,684,000
$ 300,000
$ 275,000
$ 1,400,000
$ 1,325,000
$ 1,600,000
$ 1,416,000
Consolidated Income Statement
Net Sales
Cost of sales and operating expenses:
Cost of goods sold
Depreciation
Selling and administrative expenses
Operating profit
Cash Conversion Cycle
 Compute for Days in Inventory
Days in Inventory =
365 days
Inventory Turnover Ratio
= 365 days
3.3
= 110.6 days
This means inventory cycle is around 110 days
Cash Conversion Cycle
 Compute for Average Accounts Receivable and Average
Receivable Turnover
Ave. Accounts Receivable = $ 2.0 million + $ 1.6 million
2
= $ 1.8 million
Ave. Receivable Turnover =
Credit Sales*
Ave. Accounts Receivable
= $ 11.5 million
$ 1.8 million
= 6.4
*Assumes company has no cash sales
Cash Conversion Cycle
Dr. Pepper Manufacturing Corporation Balance Sheet
2014
2013
Cash
$ 500,000
$ 500,000
Marketable Securities (at cost)
$ 500,000
$ 450,000
Accounts Receivable less allowance for bad debts
$ 2,000,000
$ 1,600,000
Inventories
$ 3,000,000
$ 2,000,000
$ 6,000,000
$ 4,550,000
Assets
Current Assets
Total current assets
Cash Conversion Cycle
Dr. Pepper Manufacturing Corporation Income Statement
2014
2013
$ 11,500,000
$ 10,700,000
$ 8,200,000
$ 7,684,000
$ 300,000
$ 275,000
$ 1,400,000
$ 1,325,000
$ 1,600,000
$ 1,416,000
Consolidated Income Statement
Net Sales
Cost of sales and operating expenses:
Cost of goods sold
Depreciation
Selling and administrative expenses
Operating profit
Cash Conversion Cycle
 Compute for Days in Receivable
Days in Receivables =
365 days
Ave. Receivable Turnover
= 365 days
6.4
= 57 days
Cash Conversion Cycle
 Compute for Average Payables
Ave. Payables = $ 1.0 million + $ 0.75 million
2
= $ 0.875 million
Accounts Payable Deferral Period = Cost of Goods Sold
Average Payables
= $ 8.2 million
$ 0.875 million
= 9.4
Cash Conversion Cycle
Dr. Pepper Manufacturing Corporation Income Statement
2014
2013
$ 11,500,000
$ 10,700,000
$ 8,200,000
$ 7,684,000
$ 300,000
$ 275,000
$ 1,400,000
$ 1,325,000
$ 1,600,000
$ 1,416,000
Consolidated Income Statement
Net Sales
Cost of sales and operating expenses:
Cost of goods sold
Depreciation
Selling and administrative expenses
Operating profit
Cash Conversion Cycle
Dr. Pepper Manufacturing Corporation Balance Sheet
2014
2013
Accounts payable
$ 1,000,000
$ 750,000
Notes payable
$ 1,500,000
$ 500,000
Accrued expenses payable
$ 250,000
$ 225,000
Taxes payable
$ 250,000
$ 225,000
$ 3,000,000
$ 1,700,000
Liabilities
Current Liabilities
Total current liabilities
Cash Conversion Cycle
 Compute for Days in Payables
Days in Payables =
365 Days
Accounts Payable Deferral
Period
= 365 Days
9.4
= 38.8 days
Cash Conversion Cycle
 Compute for Operating Cycle and Cash Cycle
Operating Cycle = Days in Inventory + Days in Receivable
= 110.6 days + 57 days
= 167.6 days
Cash Cycle = Operating Cycle – Days in Payables
= 167.6 days – 38.8 days
= 128.8 days
Current Liquidity Index
Current Liquidity Index
= Cash
Assets + Cash Flow From Operations
Notes Payable + Current Maturing Long Term Debt
Measuring Liquidity:
Alternative Liquidity Measures
 Comprehensive liquidity index (CLI)
 is an adjusted current ratio.
 Liquidity weighted version of the current ratio.
 Traditional current ratio treats all assets and liabilities as
being of equal degree of liquidity.
 CLI avoids this by weighing each current asset or current
liability based on its turnover or nearness to cash
 The accounts receivable, inventory, accounts payable
and accrued expenses are adjusted by a turnover factor.
Measuring Liquidity:
Alternative Liquidity Measures
 Comprehensive liquidity index
 Each current asset or liability is multiplied by one,
minus the inverse of the of the asset’s or liability’s
turnover ratio.
Accounts receivable x [ 1 – ( 1/arto)]
 In cases of more than one turnover required to generate
cash from the asset, the inverse of each of these ratios is
subtracted.
Inventory x [1 – (1/arto) – (1/invto)]
Comprehensive Liquidity Index
Comprehensive Liquidity Index = Adjusted Current Asset
Adjusted Current Liability
 Comprehensive liquidity index considers the
degree of liquidity of current assets and time to
repay current liabilities
Comprehensive Liquidity Index
 Specific weight is assigned
to each current asset
considering their liquidity
degree and their adjusted
amount is calculated
 A coefficient of one is
assigned to cash and short
term investments due to
their high liquidity quality
and their weight does not
need to be adjusted
Comprehensive Liquidity Index
 Accounts receivable is adjusted
Adjusted Accounts Receivable = Average Accounts Receivable * [1 – (1 /Accounts Receivable
Turnover)]
Comprehensive Liquidity Index
 Compute for Average Accounts Receivable and Average
Receivable Turnover
Ave. Accounts Receivable = $ 2.0 million + $ 1.6 million
2
= $ 1.8 million
Ave. Receivable Turnover =
Credit Sales*
Ave. Accounts Receivable
= $ 11.5 million
$ 1.8 million
= 6.4
*Assumes company has no cash sales
Comprehensive Liquidity Index
Dr. Pepper Manufacturing Corporation Balance Sheet
2014
2013
Cash
$ 500,000
$ 500,000
Marketable Securities (at cost)
$ 500,000
$ 450,000
Accounts Receivable less allowance for bad debts
$ 2,000,000
$ 1,600,000
Inventories
$ 3,000,000
$ 2,000,000
$ 6,000,000
$ 4,550,000
Assets
Current Assets
Total current assets
Comprehensive Liquidity Index
 Inventory is adjusted
AINV = INV * [1 – (1/ARTO) – (1/INVT)]
Adjusted Inventory = Average Inventory * [1 – (1 /Accounts Receivable Turnover) – (1/Inventory Turnover Ratio)]
AINV = Adjusted Inventory
INV = Average Inventory
ARTO = Accounts Receivable Turnover Ratio
INVT = Inventory Turnover Ratio
Comprehensive Liquidity Index
 Compute for Average Accounts Receivable and Average
Receivable Turnover
Ave. Accounts Receivable = $ 2.0 million + $ 1.6 million
2
= $ 1.8 million
Ave. Receivable Turnover =
Credit Sales*
Ave. Accounts Receivable
= $ 11.5 million
$ 1.8 million
= 6.4
*Assumes company has no cash sales
Comprehensive Liquidity Index
Dr. Pepper Manufacturing Corporation Balance Sheet
2014
2013
Cash
$ 500,000
$ 500,000
Marketable Securities (at cost)
$ 500,000
$ 450,000
$ 2,000,000
$ 1,600,000
$ 3,000,000
$ 2,000,000
$ 6,000,000
$ 4,550,000
Assets
Current Assets
Accounts Receivable less allowance for bad debts
Inventories
Total current assets
Comprehensive Liquidity Index
 Compute average inventory first
Ave. Inventory = $ 3 million + $ 2 million
2
= $ 2.5 million
Comprehensive Liquidity Index
Dr. Pepper Manufacturing Corporation Balance Sheet
2014
2013
Cash
$ 500,000
$ 500,000
Marketable Securities (at cost)
$ 500,000
$ 450,000
Accounts Receivable less allowance for bad debts
$ 2,000,000
$ 1,600,000
Inventories
$ 3,000,000
$ 2,000,000
$ 6,000,000
$ 4,550,000
Assets
Current Assets
Total current assets
Comprehensive Liquidity Index
 Compute Inventory Turnover Ratio
Inventory Turnover Ratio = Cost of Goods
Ave. Inventory
= $ 8.2 million
$ 2.5 million
= 3.3
This means an inventory cycle of 3.3 times per year
Comprehensive Liquidity Index
Dr. Pepper Manufacturing Corporation Balance Sheet
2012
Amount
Adjusted
Weight
Adjusted
Amount
Cash
$ 500,000
100 %
$ 500,000
Marketable Securities (at cost)
$ 500,000
100 %
$ 500,000
Average Accounts Receivable (AR) less allowance for
bad debts
($ 2,000,000 +
$ 1,600,000)/2
= $ 1,800,000
Adj. AR = Ave.
AR x [( 1 –
1/ARTO)]
$ 1,800,000 x
[( 1 –
1/ARTO)]
Average Inventories (INV)
($ 3,000,000 +
$ 2,000,000)/2
= $ 2,500,000
Adj. INV = Ave.
INV x [( 1 –
1/ARTO) –
(1/INVT)]
$ 2,50,000 x
[( 1 – 1/ARTO)
– (1/INVT)]
Assets
Current Assets
Total current assets
Note:
Adj. AR = Adjusted Accounts Receivable
Ave. AR = Average Accounts Receivable
ARTO = Accounts Receivable Turnover Ratio
Adj. INV = Adjusted Inventory
Ave. INV = Average Inventory
INVT = Inventory Turnover Ratio
$ xxxxxxxx.00
Comprehensive Liquidity Index
 Specific weight is assigned
to each current liabilities
considering their timing of
repayment and their
adjusted amount is
calculated
Comprehensive Liquidity Index
 Accounts Payable is adjusted
AAP = AP * [1 – (1/APT)]
APT = PUR/AP
Adjusted Inventory = Average Inventory * [1 – (1 /Accounts Receivable Turnover) – (1/Inventory Turnover Ratio)]
AAP = Adjusted Accounts Payable
AP = Average Accounts Payable
APT = Accounts Payable Turnover Ratio
PUR = Total purchases
Comprehensive Liquidity Index
 Compute for Average Payables
Ave. Payables = $ 1.0 million + $ 0.75 million
2
= $ 0.875 million
Accounts Payable Deferral Period
= Cost of Goods Sold
also called Accounts Payable Turnover Average Payables
= Total Purchases
Average Accounts Payables
= $ 8.2 million
$ 0.875 million
= 9.4
Comprehensive Liquidity Index
Dr. Pepper Manufacturing Corporation Income Statement
2014
2013
$ 11,500,000
$ 10,700,000
$ 8,200,000
$ 7,684,000
$ 300,000
$ 275,000
$ 1,400,000
$ 1,325,000
$ 1,600,000
$ 1,416,000
Consolidated Income Statement
Net Sales
Cost of sales and operating expenses:
Cost of goods sold
Depreciation
Selling and administrative expenses
Operating profit
Comprehensive Liquidity Index
Dr. Pepper Manufacturing Corporation Balance Sheet
2014
2013
Accounts payable
$ 1,000,000
$ 750,000
Notes payable
$ 1,500,000
$ 500,000
Accrued expenses payable
$ 250,000
$ 225,000
Taxes payable
$ 250,000
$ 225,000
$ 3,000,000
$ 1,700,000
Liabilities
Current Liabilities
Total current liabilities
Comprehensive Liquidity Index
 Other components of liabilities can be adjusted by the
same method
Comprehensive Liquidity Index
Dr. Pepper Manufacturing Corporation Balance Sheet
2013
Amount
Adjusted Weight
Adjusted Amount
Average Accounts Payable
($ 1,000,000 +
$ 750,000)/2
= $ 875,000
Adj. AP = Ave. AP x [1 –
(1/APT)]
$ 875,000 x [( 1 – 1/APT)]
Average Notes Payable
($ 1,500,000 +
+ $ 500,000)/2
= $ 1,000,000
Adj. NP =
Ave. NP x [ 1 – (1/NPT)]
$ 1,000,000 x
[ 1 – (1/APT) – (1/NPT)]
Average Accrued Expenses
payable
($ 250,000 +
$ 225,000)/2
= $ 237.50
Adj. AEP =
Ave. AEP x [ 1 – (1/AEPT)]
$ 237,500
x [ 1 – (1/APT) – (1/AEPT)]
Taxes Payable
($ 250,000 +
$ 225,000)/2
= $ 237.50
Adj. TP = Ave. TP x [ 1 –
(1/TPT)]
$ 237,500 x
[ 1 – (1/APT) – (1/TPT)]
Liabilities
Current Liabilities
Total current liabilities
Note:
Adj. AP = Adjusted Accounts Payable = Ave. AP x [1 – (1/APT)]
Ave. AP = Average Accounts Payable
APT = Accounts Payable Turnover Ratio = Total Purchases/ Ave. Accounts Payable
ANP = Adjusted Notes Payable = Ave. Notes Payable x [1 – (1/NPT)]
NPT = Notes Payable Turnover
AAEP = Adjusted Accrued Expenses Payable = Ave. Accrued Expenses Payable x [ 1 – (1/AEPT)]
AEPT = Accrued Expenses Payable Turnover
ATP = Adjusted Taxes Payable = Ave. Taxes Payable x [1 – (1/TPT)]
TPT = Taxes Payable Turnover
$ xxxxxxx.00
Comprehensive
Liquidity
Index
Mc. Ilhenny Co. has the following short term balance sheet
below:
Assets
Current Assets
Cash
$ 15,000,000
Average Accounts Receivables
$ 50,000,000
Average Inventories
$ 75,000,000
Total current assets
$ 140,000,000
Its account receivable turnover ratio is 20, while its
inventory turnover ratio is 12.
Comprehensive Liquidity Index
Mc. Ilhenny Co. has the following short term balance sheet
below:
Liabilities
Current Liabilities
Average Accounts Payable
$ 110,000,000
Average Wages Payable
$ 60,000,000
Total current liabilities
$ 170,000,000
Its accounts payable turnover ratio is 3.64, while its wages
payable turnover ratio is 8.33.
What is it’s comprehensive liquidity index and its
current ratio?
Comprehensive Liquidity Index
Amount
Adjusted Weight
Adjusted Amount
Cash
$ 15,000,000
100 %
$ 15,000,000
Average Accounts Receivables (AR)
$ 50,000,000
Adj. AR = Ave. AR x [( 1
– 1/ARTO)]
$ 50,000,000 x [( 1 –
1/20)]
= $ 47,500,000
Average Inventories (INV)
$ 75,000,000
Adj. INV = Ave. INV x [(
1 – 1/ARTO) –
(1/INVT)]
$ 75,00,000 x ( 1 – 1/20)
– (1/12)]
= $ 65,000,000
Assets
Current Assets
Total adjusted current assets
Note:
Adj. AR = Adjusted Accounts Receivable
Ave. AR = Average Accounts Receivable
ARTO = Accounts Receivable Turnover Ratio
Adj. INV = Adjusted Inventory
Ave. INV = Average Inventory
INVT = Inventory Turnover Ratio
$ 127,500,000
Comprehensive Liquidity Index
2013
Amount
Adjusted Weight
Adjusted Amount
Average Accounts Payable
$ 110,000,000
Adj. AP = Ave. AP x [1 –
(1/APT)]
$ 110,000,000 x [( 1 – 1/3.64)]
= $ 79,750,000
Average Wages Payable
$ 60,000,000
Adj. NP =
Ave. NP x [ 1 – (1/NPT)]
$ 60,000,000 x
[ 1 – (1/3.64) – (1/8.33)]
= $ 52,800,000
Liabilities
Current Liabilities
Total current liabilities
$ 132,550,000
Comprehensive Liquidity Index
Comprehensive Liquidity Index = Adjusted Current Asset
Adjusted Current Liability
= $ 127,500,000
$ 132,550,000
= 0.96
Current Ratio = ( $ 15,000,000 + $ 50,000,000 + $ 75,000,000)
($ 110,000,000 + $ 60,000)
= 0.82
Measuring Liquidity:
Alternative Liquidity Measures
Lambda = Liquid resources + Expected cash flow
Uncertainty of cash flow during analysis horizon
= Cash Flow at beginning of month + Cash Flow during the month
+ Unused Short Term Borrowing Facility
Standard deviation or Cumulative degree of fluctuation from
beginning of the year up to that point
Lambda
Lambda
= Initial Liquid Reserve + Total Anticipated Net Cash Flow During Analysis
Horizon
Uncertainty of net cash flow during analysis horizon
Initial Liquid Reserve = Cash Balances + Marketable Securities/Short
Term Investments + Available Unused Credit Lines but not
inventory and receivables
Expected Cash Flow = Net Cash Flow Expected to be received or paid during
the analysis period (the difference between cash receipts and
disbursements)
Net Cash Flow = balance of cash receipts – cash outlays
Uncertainty of net cash flow during analysis horizon = standard deviation of
the net cash flow expectation
Measuring Liquidity:
Alternative Liquidity Measures
 Lambda Index
 Liquid resources include cash, marketable securities,
and unused credit lines.
 Expected cash flow includes any expected planned
financing and investment as well as net cash from
operation from operations for the time period of the
analysis.
 This term can be either positive or negative.
Lambda Index
 Helps a company
forecasts where it will
have adequate cash and
credit to survive or not
enough, and will become
insolvent and go
bankrupt
Lambda Index
 Measures the
uncertainty about the
company’s future cash
flows using standard
deviation of those cash
flows
 Ideal is maintaining a
Lambda Index of 3
Lambda Index
 The numerator of the
Lambda Index measures
total cash available over
time, while the
denominator measures
expected volatility of cash
Lambda Index
 The higher the Lambda
value obtained, the
smaller the chance that
the company's cash
requirements will
exceed its cash on hand
Lambda Index
 Lambda Index model
has proven itself
statistically superior to
both bond rating
models and Altman's
Z- score bankruptcy
model in various
studies of its predictive
accuracy
Lambda Index
 The Lambda Index can be
used to estimate the
probability of default since it
measures the viability of the
current liquidity reserve of a
company
Lambda Index
 A Lambda index of 15 is
considered safe, while index
below 2 means the company is
in serious trouble
 A Lambda index of 1.64 means
there is a chance of one in 20
that cash requirements will
exceed cash on hand
Lambda Index
 A Lambda index of 3.00 means
there is a chance of one in
1,000 that cash requirements
will exceed cash on hand
 A Lambda index of 3.29 means
there is a chance of one in
2,000 that cash requirements
will exceed cash on hand
Lambda Index
 A Lambda index of 3.90 means
there is a chance of one in
20,000 that cash requirements
will exceed cash on hand
Lambda Index
 A worksheet can be prepared to contain 12 line items
in the following order from top to bottom:
Short term line of credit
Beginning liquid assets
Adjustments
Initial liquid reserve
Total sources of funds
Total uses of funds
Ending liquid assets
Ending liquid reserve
Standard deviation
The Lambda Index
Additional cash to maintain a Lambda of 3
Lambda Index
 Short term line of credit may not change during the
course of the forecast of 1 year
 Liquid assets include marketable securities and cash
at the start of the forecast summary
 By having the an adjustment line item, the result can
been by decreasing or increasing the cash level
 Initial liquid reserve is the total short term line of
credit with any adjustments
Lambda Index
 The total sources and uses of funds are forecasts by
company management that result in a positive or
negative net cash flow
 The Lambda value should rise if a company’s short
term line of credit does not change and it has positive
net cash flow
 Ending liquid assets is the sum of beginning liquid
assets, adjustments, and net cash flow
 Ending liquid reserve is the sum of short term line of
credit and liquid assets
Lambda Index
 The standard deviation is derived from the net cash
flows from period to period
 The Lambda Index is computed by dividing the
ending liquid reserve by the standard deviation
 In the additional cash needed to hold a Lambda of 3, a
negative number indicates a Lambda value of greater
than 3 , thus a safer company financially
 A high negative number may mean that those funds
could be better utilized elsewhere