02/14
What is Finance?
● The science and art of managing money
○ Science - follows a scientific path to find and use financial data in a structured way
○ Art - involves skill in giving creative judgment
● The study of fund management and asset allocation over time
● At the personal level:
Concerned with individuals’ decisions about –
How much of their earnings they spend
How much they save
How they invest their savings
● In a business context:
Same types of decisions –
How firms raise money from investors
How firms invest money to earn a profit
How they decide whether:
To reinvest profits in the business; or
To distribute them back to investors
Two Main Drivers of Finance
● Time Value of Money
The passage of time affects the liquidity of money and its value.
● Risk
Financial plans are expected to happen in the future, so financial decisions are based on future
values. Always some uncertainty about the future.
Managerial Finance Function: Relationship to Economics
● Financial managers must understand economic framework and be alert to consequences of
varying levels of economic activity and changes in economic policy
● Must also be able to use economic theories as guidelines for efficient business operation
● Marginal cost–benefit analysis
Economic principle stating financial decisions should be made and actions taken only when
added benefits exceed the added costs
Managerial Finance Function: Relationship to Accounting
● Finance and accounting activities closely-related and generally overlap
● In small firms: accountants often carry out the finance function
● In large firms: financial analysts often help compile accounting information
● One major difference in perspective and emphasis between finance and accounting:
○ In accounting, use of accrual method
○ In finance, focus is on cash flows
●
●
●
Whether a firm earns profit or experiences loss, it must have sufficient flow of cash to meet its
obligations as they come due.
ILLUSTRATION:
The Clark Corporation experienced the following activity last year:
Sales
$100,000 (1 yacht sold, 100% still uncollected)
Costs
$80,000 (all paid in full under supplier terms
Comparison of performance under the accounting method vs. financial view:
Finance and accounting also differ with respect to decision-making:
Accountants: most of their attention in the collection and presentation of financial data
Financial managers: evaluate the accounting statements, develop additional data, and make
decisions on the basis of their assessment of the associated returns and risks
Area in Finance: Financial Services
● Area of finance concerned with the design and delivery of advice and financial products to
individuals, businesses, and governments.
● Career opportunities:banking, personal financial planning, investments, real estate, and
insurance.
Area in Finance: Managerial Finance
● Concerned with the duties of the financial manager working in a business
The Managerial Finance Function
● Size and importance of the managerial finance function depends on the size of the firm
○ In small firms, finance function generally performed by the accounting department
○ As firm grows, finance function typically evolves into a separate department linked
directly to the company president or CEO through the chief financial officer (CFO)
● Role of financial managers:
○ Administer the financial affairs of all types of businesses—private and public, large and
small, profit-seeking and not-for-profit.
○ Perform varied tasks:
■ develop financial plan or budget
■ extend credit to customers
■ evaluate proposed large expenditures
■ raise money to fund the firm’s operations.
● Importance and complexity of the financial manager’s duties increased due to:
○ Past global financial crisis and subsequent responses by governmental regulators
○
○
○
Increased global competition
Rapid technological change
Increasing globalization
■ increased demand for financial experts to manage cash flows indifferent
currencies, and protect against the risks that naturally arise from international
transactions
Primary Activities of the Financial Manager
Goal of Financial Management: Maximize Shareholder Wealth
● Decision rule for managers: only take actions that are expected to increase the share price.
Goal of Financial Management: Maximize Profit?
●
Profit maximization may not lead to the highest possible share price for at least three reasons:
1. Timing is important—the receipt of funds sooner rather than later is preferred (reinvest
returns to generate future earnings)
2. Profits do not necessarily result in cash flows available to stockholders (Preferred:
increased earnings + increased future cash flows)
3. Profit maximization fails to account for risk (chance that actual outcomes may differ
from those expected)–tradeoff bet. risk & return
Goal of Financial Management: What About Stakeholders?
● Stakeholders - groups such as employees, customers, suppliers, creditors, owners, and others
who have direct economic link to the firm
●
●
A firm with a stakeholder focus consciously avoids actions that would prove detrimental to
stakeholders.
Goal: maximize shareholders value but preserve stakeholders' well-being
Such view considered as "socially responsible"
Managing for Stakeholders vs. Managing for Shareholders
● Primary stakeholders: Those whose continued association is absolutely necessary for a firm's
survival—employees, customers, suppliers, investors, shareholders, governments and
communities that provide infrastructure
● Secondary stakeholders: Those that do not typically engage in transactions with a company and
thus not essential for its survival—media, trade associations, special interest groups.
Growing Areas in Finance
● Microfinance - provision of financial services to small businesses and entrepreneurs
● Peer-to-peer (P2P) lending - online lending platform which matches borrowers with lenders
● Crowdfunding - involves a project initiator, supporters and an online platform that brings the
parties together; usually for charitable purposes
● Equity-based crowdfunding - supporters invest in shares sold by the project initiator and
receive shares of the profit. Targets MSMEs who need financial assistance to raise capital.
Careers in Finance
● Corporate Finance
● Commercial Banking
● Financial Planning
● Insurance
● Investment Banking
● Money Management
● Real Estate
Career Opportunities in Managerial Finance
● Financial analyst
● Capital expenditures manager
● Project finance manager
● Cash manager
● Credit analyst/manager
● Pension fund manager
● Foreign exchange manager
The Role of Business Ethics
● Business ethics - standards of conduct or moral judgment that apply to persons engaged in
business
●
●
●
●
Violations of these standards in finance involve a variety of actions: “creative accounting,”
earnings management, misleading financial forecasts, insider trading, fraud, excessive executive
compensation, options backdating, bribery, and kickbacks.
Negative publicity often leads to negative impacts on a firm
Investors, employees, customers, interest groups, the legal system, the community – often
determine whether a specific action is right/wrong, ethical/unethical
○ May not be necessarily “right”, but their judgments influence society’s
acceptance/rejection of a business and its activities
Simple Guides to Ethical Behavior
○ Golden Rule
○ Rotary International Four-Way Test
○ From a Stakeholder Approach
The Role of Business Ethics: Ethics and Share Price
● Ethics programs seek to:
○ reduce litigation and judgment costs
○ maintain a positive corporate image
○ build shareholder confidence
○ gain the loyalty and respect of all stakeholders
● Expected result of such programs is to positively affect the firm’s share price
Legal Forms of Business Organization
● Sole proprietorship
● Partnership
● Corporation
Sole Proprietorship
Strengths
●
●
●
●
●
●
Owner receives all
profits (and sustains all
losses)
Low organizational
costs
Income included and
taxed on proprietor’s
personal tax return
Independence
Secrecy
Ease of dissolution
Partnership
●
●
●
●
Can raise more
funds than sole
proprietorships
Borrowing power
enhanced by more
owners
More available
brain power and
managerial skill
Income included
and taxed on
partner’s personal
tax return
Corporation
●
●
●
Owners have
limited liability,
which
guarantees that
they cannot
lose more than
they invested
Can achieve
large size via
sale of
ownership
(stock)
Ownership
(stock) is
readily
●
●
●
Weaknesses
●
●
●
●
●
Owner has unlimited
liability–total wealth
can be taken to satisfy
debts
Limited fund-raising
power tends to inhibit
growth
Proprietor must be
jack-of-all-trades
Difficult to give
employees long-run
career opportunities
Lacks continuity when
proprietor dies
●
●
●
Owners have
unlimited liability
and may have to
cover debts of
other partners
Partnership is
dissolved when a
partner dies
Difficult to
liquidate or
transfer
partnership
●
●
●
●
transferable
Long life of firm
Can hire
professional
managers
Has better
access to
financing
Taxes generally
higher because
corporate
income is
taxed, and
dividends paid
to owners are
also taxed at a
maximum 15%
rate
More
expensive to
organize than
other business
forms
Subject to
greater
government
regulation
Lacks secrecy
because
regulations
require firms to
disclose
financial results
02/28
FINANCIAL TOOLS AND PLANNING
Financial Statements
- Prepared in accordance with GAAP
- Generally Accepted Accounting Principles (GAAP)
- The practice and procedure guidelines used to prepare and maintain financial
records and reports; authorized by the Financial Accounting Standards Board
(FASB)
- Currently, preparation of FS is in accordance with Philippine Financial Reporting Standards
(PFRS)/Philippine Accounting Standards (PAS)
- PFRS - Philippine version of the IFRS with minor modifications
- PFRS and PAS - new set of GAAP issued by the PFRS Council (formerly ASC) under BOA oversight
- Small entities - 3M below asset
- Small and Medium Enterprises - 3M to 100M assets
- PFRS - 100M above assets
- Kapag maliit na entities hindi need ng comprehensive financial standards
- IFRS goal - to provide a global framework for how public companies prepare and disclose their
FS.
- For example, yung company mo may parent company internationally, yung reporting
standards ng international, yun din yung reporting standards dito sa Pilipinas.
- Move to transition from US GAAP to international accounting standards - brought about by
SEC’s membership in International Organization of Securities Commissions, resolved to adopt
international accounting standards.
Users of the Financial Statements
● Owners/managers:
○ For making short-term and long-term financing and investing decisions
○ A source of historical data for planning purposes
● Others:
○ Prospective investors - for making investment decisions
○ Creditors - decisions for lending funds
■ Sino ba ang willing magpautang kung hindi ka sigurado na mayroon siyang
capacity to pay.
○ Government agencies - check accuracy of data filed by the firm
■ To determine magkano yung tax na iimpose sa business in accordance with their
income
○ Suppliers - assess credit worthiness of firm
○ Employees - basis of collective bargaining agreements
■ To determine if justifiable yung sweldo ng mga employees kung nag increase
man or decrease
4 Basic GAAP Principles for Preparing the Financial Statements
● Historical cost principle
○ Recording at acquisition cost rather than FMV of most assets
● Revenue recognition principle
○ Revenue is recorded when realized and earned
● Matching principle
○ Matching of expenses and revenues when work is performed or a product is produced
● Full disclosure principle
○ Reporting of all relevant and appropriate information (both financial and non-financial)
that could impact the decisions of users of financial statements. Usually reported in the
notes to the financial statements
○ For non-financial information, may Notes to Financial Statements
The Four Key Financial Statements: The Income Statement
● Financial summary of a company’s operating results during a period
Sa US GAAP, Income statement and tawag. Pero sa International Standards, statement of income.
● Dito makikita kung in terms of performance-wise, magaling yung company.
● Revenues and expenses
● Measures the performance of the company.
●
For the year ended - entire year period
The Four Key Financial Statements: The Balance Sheet
● Presents a summary of a firm’s financial position at a given point in time
US GAAP: Balance sheet; International Standards: Statement of Financial Position
● Balances the firm’s assets (what it owns)against its financing, which can either be debt (what it
owes) or equity (what was provided by owners)
The Four Key Financial Statements: Statement of Retained Earnings
● Reconciles net income earned during a given year, and any cash dividends paid, with the change
in retained earnings between the start and end of that year
The Four Key Financial Statements: Statement of Cash Flows
● Provides summary of the firm’s operating, investment, and financing cash flows and reconciles
them with changes in its cash and marketable securities during the period
● Provides not only insight into a company’s investment, financing and operating activities, but
also ties together the income statement and previous and current balance sheets
Statement of Cash Flows: Cash Flows from Firm’s Activities
● Summarizes the firm’s cash flow over a given period of time
○ Operating flows: cash flows directly related to sale and production of the firm’s products
and services
○ Investment flows: cash flows from purchase and sale of both fixed assets and equity
investments in other firms
○ Financing flows: cash flows from debt and equity financing transactions; acquisition and
repayment of debt, cash inflow from sale of stock, cash outflows to repurchase stock or
pay cash dividends
Non-cash Items added back in the Statement of Cash Flows
Kapag noncash item siya, hindi siya pumapasok sa cash flow.
● Depreciation of fixed assets (tangible assets)
○ Illustration: Assume the company purchased a $32,000 equipment with a useful life of
eight years. Installation cost is $4,000. Annual depreciation expense using the straightline method:
■ $32,000 cost + $4,000 installation cost / 8 years = $4,500
● Amortization of intangible assets
○ Illustration: Assume the company pays $300,000 for a patent that allows the firm
exclusive rights over the intellectual property for 30 years. Annual amortization expense
using the straight-line method:
■ $300,000 cost / 30 years = $10,000
** cash flow = inflow and outflow
** operating activity = performance = revenue (inflow) and expenses (outflow) > net income
** sa expenses baka may kasama na noncash items, depreciation and amortization for example. Expense
sila pero noncash sila kasi kapag nagrerecord, debit depreciation expense then credit accumulated
depreciation, debit amortization expense credit accumulate amortization. Walang lumabas na cash kaya
noncash sila. Kaya sa paggawa ng cash flow, binabalik tong mga noncash items na ito sa net income kasi
wala naman lumabas na pera.
Analyzing the Firm’s Cash Flow
● Cash flow (vs. accounting “profits”): primary ingredient in any financial valuation model
● From an accounting perspective: summarized in a firm’s statement of cash flows
● From a financial perspective: firms often focus on both
○ Operating cash flow (used in managerial decision making)
○ Free cash flow (closely monitored by participants in the capital market)
Operating Cash Flow (OCF)
● Cash flow a firm generates from normal operations—from the production and sale of its goods
and services.
● OCF may be calculated as follows:
NOPAT = EBIT (1 - T)
NOPAT is the Net Income After Tax
OCF = NOPAT + Depreciation
OCF = [EBIT (1 - T) + Depreciation
OCF = Net Income (less tax) + Depreciation
*Amortization expense is also added back.
Substituting for XYZ Company, we get:
OCF = [$370 (1-.40)] + $100 = $322
Conclusion: ABC’s operations generated positive operating cash flows
Free cash flow (FCF)
●
Amount of cash flow available to investors (creditors and owners) after firm has met all
operating needs and paid for investments in net fixed assets (NFAI) and net current assets
FCF = OCF - NFAI - NCAI
NFAI = Change in net fixed assets + Depreciation
NCAI = Change in CA - Change in CL
For XYZ Company, we get:
NFAI = [($1,200 - $1,000) + $100] = $300
NCAI = [($2,000 - 1,900) - ($800 - $700)] = 0
FCF = $322 - $300 - 0 = $22
Conclusion: Firm generated adequate cash flow to cover all operating costs and investments and
had free cash flow available to pay investors
Analyzing Financial Statements: Overview of Ratio Analysis
Using Financial Ratios: Interested Parties
● Ratio analysis: involves methods of calculating and interpreting financial ratios to analyze and
monitor firm’s performance
● Current and prospective shareholders: interested in firm’s current and future level of risk and
return, which directly affect share price
● Creditors: interested in company’s short-term liquidity and its ability to make interest and
principal payments
● Management: concerned with all aspects of firm’s financial situation, and attempts to produce
financial ratios considered favorable by both owners and creditors
Using Financial Ratios: Cautions about Using Ratio Analysis
1. Ratios revealing large deviations from norm mere indicate possibility of a problem
2. Single ratio generally not provide sufficient information to judge overall performance of the firm
3. Ratios being compared should be calculated using financial statements dated at the same point
in time during the year
4. Preferable to use audited financial statements
5. Financial data being compared should have been developed in some way
6. Results can be distorted by inflation
Five Basic Types of Ratios
● Profitability ratios
● Liquidity ratios
● Activity ratios
● Debt management ratios
● Market ratios
Profitability Ratios
● Gross profit margin
○ Measures the percentage of each sales dollar remaining after the firm has paid for its
goods.
ABC Company’s gross profit margin for 2020 is:
●
Operating profit margin
○ Measures the percentage of each sales dollar remaining after all costs and expenses
other than interest, taxes, and preferred stock dividends are deducted
Operating profit margin = Operating profits / sales
ABC Company’s operating profit margin for 2020 is:
$418,000 / $3,074,000 = 13.6%
●
Net profit margin
○ Measures the percentage of each sales dollar remaining after all costs and expenses
including interest, taxes, and preferred stock dividends have been deducted
Net profit margin = earnings available for common stockholders / sales
*Net income after tax if there are no preferred stocks
ABC Company’s net profit margin for 2020 is:
$221,000 / $3,074,000 = 0.072 = 7.2%
●
Earnings per share represents the number of dollars earned during the period on the behalf of
each outstanding share of common stock
ABC Company’s EPS in 2020 is:
$221,000 / 76,262 = $2.90
●
Return on total assets
○
Measures the overall effectiveness of management in generating profits with its
available assets
ROA = Earnings available for common stockholders* / total assets
*Net income after tax if there are no preferred stocks
ABC Company’s ROA in 2020 is:
$221,000 / $3,597,000 = 0.061 = 6.1%
●
Basic earning power ratio
○ Determines how effectively a firm uses its assets to generate income
BEP = EBIT / total assets
ABC Company’s BEP for 2020 is:
$418,000 / $3,597,000 = 0.116 = 11.6%
●
Return on equity
○ Measures the return earned on common stockholders’ investment in the firm
ROE = Earnings available for common stockholders / Common stock equity
ABC Company’s ROE for 2020 is:
$221,000 / $1,754,000 = 0.126 = 12.6%
Activity Ratios
● Inventory turnover
○ Measures the activity, or liquidity, of a firm’s inventory; measures the number of times
inventory is sold
Inventory turnover = COGS / Average inventory
ABC Company’s inventory turnover in 2020 is:
$2,088,000 / [($300,000 + $289,000) / 2] = 7.09
●
Average age of inventory (average days to sell inventory)
○ The average number of days’ sales in inventory
Average Age of Inventory = 365 / Inventory turnover
ABC Company’s average age of inventory in 2020 is:
365 / 7.09 = 51.48 days
●
Accounts receivable turnover
○ Measures the liquidity of the firm’s accounts receivable
A/R turnover = net credit sales / ave. a/r
ABC Company’s accounts receivable turnover is
$3,074,000 / [($365,000 + $503,000) / 2] = 7.08
●
Average collection period (days sales outstanding)
○ The average amount of time needed to collect accounts receivable
ACP = Average A/R / Average Sales per day
ACP = Average A/R / (Annual sales / 365)
ACP = 365 / A/R Turnover
ABC Company’s average collection period is
$434,000 / ($3,074,000 / 365) = 51.53
365 / 7.08 = 51.53 days
●
Accounts payable turnover
○ Indicates how many times per period a firm pays its accounts payable
A/P turnover = net credit purchases / average A/P
Net credit purchase = COGS + Ending inventory - beginning inventory
ABC Company’s A/P turnover
Net credit purchases = $2,088,000 + $289,000 - $300,000 = $2,077,000
A/P turnover = $2,077,000 / [($270,000 + $382,000) / 2] = 6.37
●
Average payment period
○ The average amount of time needed to pay accounts payable
APP = Average A/P / Average Purchases per day
APP = Average A/P / (Annual purchases / 365 days)
APP = 365 / Accounts. Payable turnover
ABC Company’s 2020:
$326,000 / ($2,077,000 / 365) = 57.29
365 / 6.37 = 57.29 days
●
Fixed asset turnover
○ Indicates the efficiency with which the firm uses its fixed assets to generate sales
Fixed asset turnover = Net Sales / Average Net Fixed Assets
ABC Company’s fixed assets turnover is
$3,074,000 / [($2,266,000 + $2,374,000) / 2] = 1.325 = 1.33
●
Total asset turnover
○ Indicates the efficiency with which the firm uses its assets to generate sales
Total asset turnover = Net Sales / Average Total Assets
ABC Company’s total asset turnover is
$3,074,000 / [($3,270,000 + $3,597,000) / 2] = 0.895 = 0.90
Liquidity Ratios
● Current ratio
○ Measures the ability the ability of the firm to meet its short-term obligations
Current ratio = Current assets / Current liabilities
ABC Company’s current ratio is
$1,223,00 / $620,000 = 1.97
Matter of Fact
Determinants of Liquidity Needs
- Large enterprises generally have well established relationships with banks that can provide lines
of credit and other short-term loan products in the event that the firm has a need for liquidity
- Smaller firms may not have the same access to credit, and therefore they tend to operate with
more liquidity
●
Quick (acid-test) ratio
○ Excludes inventory, which is generally the least liquid current asset
The quick ratio for ABC Company in 2020 is:
Debt Management Ratios
● Debt ratio
○ Measures the proportion of total assets financed by the firm’s creditors
Debt ratio = Total liabilities / Total assets
ABC Company’s debt ratio is
$1,643,000 / $3,597,000 = 0.457 = 45.7%
●
●
Debt-to-equity ratio
○ Measures the relative proportion of total liabilities and common stock equity used to
finance the firm’s total assets
Debt to equity = total liabilities / common stock equity
ABC Company’s debt-to-equity ratio is
$1,643,000 / $1,754,000 = 0.937 = 93.7%
Times interest earned ratio (interest coverage ratio)
○ Measure the firm’s ability to make contractual interest payments
Time interest earned ratio = Operating profits / interest expense
ABC Company’s times interest earned ratio
$418,000 / $93,000 = 4.49
Market Ratios
● Price/earnings (P/E) ratio
○
○
○
●
Measures the amount that investors are willing to pay for each dollar of a firm’s earning
Used to assess the owner’s appraisal of the value of the firm’s earnings
Indicates the degree of confidence that investors have in the firm’s future
P/E ratio = market price per share of common stock / earnings per share
If ABC Company’s common stock at the end of 2020 was selling at $32.25, using the EPS
of $2.90, the P/E Ratio At Year-end 2020 is:
$32.25 / $2.90 = 11.12
Market/book (M/B) ratio
○ Compares firm’s current market price to its book value; provides an assessment of how
investors view the firm’s performance
ABC Company’s M/B ratio
DuPont System of Analysis
● Used to dissect the firm’s financial statements to assess its financial condition
● Merges the income state and balance sheet into two summary measures of profitability
●
●
Brings together net profit margin (measures the firm’s profitability on sales) with its total asset
turnover (indicates how efficiently firm used its assets to generate sales) to get
ROA = Net profit margin x Total asset turnover
Then with the financial leverage (ratio of total assets to total equity - measures the amount of
debt utilized by the firm) to get ROE (Return on equity) = ROA x FLMultiplier
DuPont Equation:
03/07
Using Financial Ratios for Analysis
● Ratio analysis relies on the reported financial statements
● Reformulated financial statements
○ Usually the income statement with reported items classified into recurring and
nonrecurring or special items
● Non-recurring items
○ Not expected during regular business operations
● Normal or recurring earnings
○ Considered permanent and more relevant for prediction and valuation
Non-recurring Items in the Income Statements
● Discontinued operations
○ Ex. gains or losses from discontinued significant business segment
● Extraordinary items
○ Unusual in nature, infrequent in occurrence, material in amount.
■ Ex. effect of government expropriations of property, unexpected earthquake,
eruption, typhoon (not included in IFRS)
● Change in accounting principle
○ Ex. Effect of change in inventory method
Using Financial Ratios for Analysis
● Cross-sectional analysis
○ For industry comparisons - benchmarking within the same industry and using industry
average
○ For comparison with peer companies
● Tren (time-series) analysis
○ Comparing company performance over time
Limitations of Ratio Analysis
● Accounting limitation
○ May include errors and may distort data used to calculate financial ratios; audited F/S
are recommended
● Ratios may not prove to drive stock prices as compared with investors’ behavior
● Ratio analysis does not take into account important drivers of firm’s success, e.g. brand,
relationships, skills, culture
Role of Financial Forecasting in Planning
● Strategic planning
○ Firm’s process of defining strategy and making decisions about allocating resources to
implement its strategy
●
Financial forecast
○ Key input to strategic planning; an estimate of company’s future financial outcomes;
uses historical data, external market and economic indicators
Strategic Planning, Forecasting, Budgeting
● Strategic planning
○ Provides a framework for firm’s financial objectives typically for next 3 to 5 years
● Budgeting
○ Details how the plan will be carried out month to month for the next year; compares
budgets with actual performance to determine variances
● Forecasting
○ Makes predictions based on historical data and current market conditions as to how
much revenue to generate over the next months or years; forecasts usually adjusted as
new information becomes available
Forecasting Financial Statements
● Comprises realistic estimation of several values such as sales, costs, expected interest rates
○ Cash flow forecast - shows sources and application of funds (Ex. forecast sufficient cash
to meet regular costs and expenses)
○ Profit forecast - consists of matching forecast revenues with associated costs to
generate the revenues
○ Balance sheet forecast - determines soundness of firm’s financial position; cash flow and
profit forecasts are reconciled with this forecast
Sample Application of Forecasting
● Used in supply chain management
○ Assures right products at the right place at the right time
○ Helps reduce excess inventory
○ Helps meet consumer demand
MODULE 2 PROBLEM SET
03/14
WORKING CAPITAL MANAGEMENT
Working capital
● Represents the operating liquidity available to an organization, whether established for profit or
not.
● Formula: WC = Current assets - Current liabilities
● Controlling Working (WC) Components
○ Current assets (CA)
■ Increase in CA > Increase in WC
■ Decrease in CA > Decrease in WC
○ Current liabilities (CL)
■ Increase in CL > Decrease in WC
■ Decrease in CL > Increase in WC
Working Capital Management: Four Main Areas
● Cash management
○ Identify cash balance needed to meet firm’s daily expenses, but reduce cash holding
costs
● Inventory management
○ identify inventory level to allow for uninterrupted production but reduces carrying costs
and reordering costs; hence increases cash flow.
● Accounts receivable management
○ Identify appropriate credit policy (e.g. credit terms) to attract customers, where any
impact on cash flows and cash conversion cycle (CCC)* will be offset by increased
revenue and hence return on capital (or vice versa)
○ CCC = Ave. Age of Inventory + Ave. Collection Period - Ave. Payment Period
Importance of Working Capital
● As a measure of liquidity, serves as a measure of firm’s future credit-worthiness
● For small businesses and start-ups which can’t access ready financing sources: the amount of
money needed to stay in operation
However:
● Too much WC means some assets not being invested for the long-term, thus not being put to
good use for company’s growth
● WC: not the only measure of liquidity, not a guarantee of a firm's ability to pay. (Ex: positive WC
but not enough cash to pay for expenses; negative WC but may adjust some debt to long-term
to reduce CL)
● WC: not the only metric of firm’s financial health
Working Capital Management
● Working capital
○ Considered a part of operating capital along with fixed assets
● Sufficient WC: required to ensure a firm’s continuity of operations – to satisfy both maturing
short-term and long-term debt, pay for upcoming operational expenses
● WC needs vary depending on type of business and its operational requirements
● WC management involves managing inventories, accounts receivable, accounts payable, and
cash
Primary Objectives of Working Capital
● Profitability
○ Effective utilization of working capital for both the firm’s short-term and long-term
objectives
● Liquidity (solvency)
Goal of Working Capital Management
● To achieve a balance between profitability and risk (risk of insolvency, thus being liquid) that
contributes positively to the firm’s value
Firm’s concern
● Reduce financing costs or increase funds available for expansion by minimizing the amount of
funds tied up in working capital
Trade-off between Profitability and Risk
● Profitability - the relationship between revenues and costs generated by using the firm’s current
and fixed assets in productive activities
- A firm can increase its profits by (1) increasing revenues or (2) decreasing costs
● Risk (of insolvency) - the probability that a firm is unable to pay its bills as they come due
General assumption:
The greater the firm’s working capital, the lower its risk.
Thus, the more working capital:
The more liquid the firm
The lower its risk of being insolvent
Effects of Changing Ratios on Profit and Risk
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Current assets - less profitable than fixed assets
Fixed assets - add more value to the product or service; are used in production
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Increase in current assets = increase in net working capital, reducing insolvency risk
The nearer an asset is to cash, the less risky it is.
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Probability effect: Current liabilities are less expensive; only notes payable have a cost (interest)
Risk effect: Increase in current liabilities decreases net working capital
Cash Conversion Cycle (CCC)
● Length of time required for a company to convert cash invested in its operations to cash
received as a result of its operations
● OC - APP or AAI + ACP - PPP
Calculating the CCC
● Operating Cycle (OC)
○ The time from the beginning of the production process to collection of cash from the
sale of the finished product
○ Measured in elapsed time by summing average age of inventory (AAI) and average
collection period (ACP)
○ OC = AAI + ACP
○ Increasing speed lowers working capital
■ A firm can lower its working capital if it can speed up its operating cycle
Strategies for Managing the Cash Conversion Cycle
● Goal: Minimize the length of the cash conversion cycle to minimize negotiated liabilities through
the following strategies:
1. Turn over inventory as quickly as possible without stockouts that result in lost sales
2. Collect accounts receivable as quickly as possible without losing sales from highpressure collection techniques
3. Manage mail, processing, and clearance float to reduce them when collecting from
customers and to increase them when paying suppliers
4. Pay accounts payable as slowly as possible without damaging the firm’s credit rating
Common Techniques for Managing Inventory
● ABC Technique - divides inventory into three groups — A, B, and C, in descending order of
importance and level of monitoring, on the basis of investment in each
● Economic Order Quantity (EOQ) Model - used to determine an item’s optimal order size: the size
that minimizes total order costs and carrying costs
- An appropriate model for the management of A and B group items
● Assumption in EOQ: Relevant costs of inventory can be divided into order costs
and carrying costs
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Order costs - the fixed clerical costs of placing and receiving an inventory order
Carrying costs - the variable costs per unit of holding an item in inventory for a
specific period of time
● EOQ analyzes tradeoff between order costs and carrying costs to determine
order quantity that minimizes the inventory cost
Carrying cost: cost of carrying a unit of inventory per period multiplied by the firm’s average
inventory
Average inventory: order quantity divided by 2 (Q/2); inventory assumed to be depleted at a
constant rate
Carrying cost = C x Q/2
Total cost of inventory: sum of order cost and carrying cost
Total cost = (O x S/Q) + (C x Q/2)
To determine EOQ for a given inventory item, where
S = usage in units per period
O = order cost per order
C = carrying cost per unit per periods
Q = order quantity in units
Order cost: cost per order x number of orders
Number of orders: usage during the period (S) divided by the order quantity (Q)
EOQ is the point where: Order Cost = Carrying Cost
[O x (S/Q)] = [C x (Q/2)]
2 x O x S = C x Q^2
Q^2 = (2 x O x S) / C
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When should the firm order its inventory?
● Reorder point - point at which to reorder inventory, expressed as days of lead time x daily usage
● Lead times and usage rates not precise, so most firm hold safety stock – extra inventory held to
prevent stockouts of important items.
Lead time - period between placing and receiving order
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Just-in-time (JIT) system - inventory management technique that minimizes inventory
investment by having materials arrive exactly at the time needed for production
○ Objective is to minimize inventory investment, so system uses no (or very little)
safety stock
○ Extensive coordination among firm’s employees, suppliers, and shipping
companies must exist to ensure material inputs arrive on time
○ Failure of materials to arrive on time results in shutdown of production line until
the materials arrive
○ Requires high-quality parts from suppliers
Materials requirement planning (MRP) system - inventory management technique that
applies EOQ concepts using a computer to determine how much to order; simulates a
product’s bill of materials
○ Objective: lower investment in inventory without impairing production
Manufacturing resource planning II (MRP II0 - extension of MRP; integrates data from
areas in the organization (e.g. finance, accounting, marketing, engineering,
manufacturing)
○ Generate production plans, financial and management reports
○ Models the firm’s processes so effects of changes (e.g. increase in labor costs) in
different areas (e.g. on production and marketing) can be assessed and
monitored
Enterprise resource planning (ERP) - integrates external information about the firm’s
suppliers and customers with the firm’s departmental data
○ So info on all available resources–human and material–can be instantly ibtaines
to eliminate production delays, thereby control costs
Aging of Inventories
● Determines the storage duration of an inventory item
● Main purpose: to find out which items stay in inventory for a long time or are perhaps becoming
obsolete
Balancing Competing Requirements to Determine Optimal Inventory Levels
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Competing Requirements
○ Carrying costs of inventory
○ Inventory demand forecasting
○ Inventory valuation
○ Future inventory price forecasting
○ Available physical space for inventory
○ Quality management
○ Replenishment and ordering costs
○ Returns and defective goods
○ Inventory levels, seasonality considered
Differing Viewpoints about Inventory Levels among a Firm’s Managers
● Financial manager: Keep them low to ensure firm’s money is not unwisely invested in excess
resources
● Marketing manager: have large inventories of the firm’s finished products to avoid stockouts
● Manufacturing manager: keep high levels of inventories to avoid production delayed
● Purchasing manager: Should have on hand correct quantities of raw materials, at favorable
prices and at desired time needed by production. May uncontrollably purchase large quantities
to avail of discounts or in anticipation of rising prices or shortages