Working capital Dr Yifan Zhou Working Capital Working Capital Management Measuring Leverage Measuring Liquidity Working Capital Companies require sufficient resources to meet dayto-day obligations： ✓ paying suppliers and employees ✓ meeting lease terms ✓ other financial ✓ Commitments ✓ to continue operations Working Capital Companies typically determine their required working capital investment by 1. identifying optimal levels of inventory, receivables, and payables, as function of sales. 2. modeling those assumptions forward for the business. Working Capital Companies take different approaches to working capital management: 1. Conservative approach 2. Moderate approach 3. Aggressive approach Working Capital Conservative approach • hold a larger position in cash, receivables, and inventories, relative to sales. • has financial flexibility to respond to unforeseen events Working Capital Aggressive approach • has substantially less committed to current assets • less short-term financial flexibility Working Capital Moderate approach • hold a position somewhere between the conservative and aggressive approaches. Working Capital In 2023, Bed Bath & Beyond faced liquidity crisis due to sales decline (inventory Surge), negative cash cycle, and mounting debts, which led to stock price crash and bankruptcy filing. Working Capital In 2023, Bed Bath & Beyond faced liquidity crisis https://www.youtube.com/watch?v=KZUcQ-rF9qo&t=37s Working Capital Inventory Surge vs. Sales Decline Inventory levels ($1.73 billion) vs. sales decline (33%) shows how inventory became a liability rather than an asset. Debt Level Bed Bath & Beyond’s rising debt over five years, peaking at $5.2 billion in 2023. Cash Flow Operating cash flow turning negative in Q4 2022. Measuring Leverage ➢ Debt increases the returns to shareholders in good times and reduces them in bad times, it is said to create financial leverage. ➢ Leverage ratios measure how much financial leverage the firm has taken on. Measuring Leverage ➢ Financial leverage is measured by the ratio of long-term debt to total long-term capital. ➢ Long-term debt, should include not just bonds or other borrowing but also financing from long-term leases. Measuring Leverage • Measures of leverage ignore short-term debt. • Consider short-term debt is temporary or is matched by similar holdings of cash. Measuring Leverage • Widen the definition of debt to include all liabilities: if company is a regular short-term borrower. • Debt ratios make use of book (i.e., accounting) values rather than market values. Measuring Leverage Measuring Leverage ➢ Times-Interest-Earned Ratio: measure of financial leverage is the extent to which interest obligations are covered by earnings. ➢ Banks prefer to lend to firms whose earnings cover interest payments with room to spare. Measuring Leverage ➢ Interest coverage is measured by the ratio of earnings before interest and taxes (EBIT) to interest payments. Measuring Leverage ➢ Cash Coverage Ratio: add back depreciation to EBIT to calculate operating cash flow. Measuring Leverage ➢ There is no law stating how a ratio should be defined ➢ Do not use a ratio without understanding how it has been calculated. Measuring Liquidity • To extending credit to a customer or making a short-term bank loan? • How company can lay its hands on the cash to repayment. Measuring Liquidity • The credit analysts and bankers look at several measures of liquidity. • Liquid assets can be converted into cash cheaply. Measuring Liquidity ➢ Current assets include: • Cash • Marketable securities • Inventories • Accounts receivable ➢ Current assets are mostly liquid. Measuring Liquidity Firm owns assets with different degrees of liquidity: ➢ Accounts receivable and inventories of finished goods are generally quite liquid. • As inventories are sold off and customers pay their bills, money flows into firm. ➢ Real estate may be very illiquid. • hard to find a buyer, negotiate a fair price, and close a deal on short notice. Measuring Liquidity Current Ratio ➢ The current ratio is just the ratio of current assets to current liabilities Measuring Liquidity Current Ratio ➢ Changes in the current ratio can be misleading: ✓ Could be preferable to net short-term investments against short-term debt when calculating the current ratio. Measuring Liquidity • The credit assets that seem liquid sometimes could be illiquid. • During subprime mortgage crisis in 2007: • Some financial institutions had set up funds known as structured investment vehicles (SIVs) that issued short-term debt backed by residential mortgages. Measuring Liquidity • During subprime mortgage crisis in 2007: • As mortgage default rates increased, the market value declined • Investors who were forced to sell found that the prices that they received were less than half the debt’s estimated value. Measuring Liquidity Quick (Acid-Test) Ratio • If trouble comes, inventory may not sell at anything above fire-sale prices. • Firm can’t sell its inventory of finished products for more than production cost. Measuring Liquidity Quick (Acid-Test) Ratio ➢ Managers often exclude inventories and other less liquid components of current assets. ➢ Focus instead on cash, marketable securities, and bills that customers have not yet paid. Measuring Liquidity Net-Working-Capital-to-Total-Assets Ratio ➢ Net working capital: difference between current assets and current liabilities. ➢ Net working capital is generally positive: as current assets usually exceed current liabilities. Measuring Liquidity Net-Working-Capital-to-Total-Assets Ratio Measuring Liquidity Cash Ratio • Why analysts also look at the cash ratio? • A company’s most liquid assets are its holdings of cash and marketable securities. Measuring Liquidity Cash Ratio Measuring Liquidity More liquidity is not always a good thing: ✓ Efficient firms do not leave excess cash in their bank accounts ✓ Firms don’t allow customers to postpone paying their bills Measuring Liquidity More liquidity is not always a good thing: ➢ High levels of liquidity may indicate sloppy use of capital. ➢ It not good to keep more liquid assets than firms really need. Measuring Liquidity The Cash Cycle The regular financing that firm needs in order to maintain regular operations. The firm conducts a very simple business: • Buys raw materials for cash • Processes them into finished goods • Sells these goods on credit Measuring Liquidity Inventory period: delay between firm’s initial investment in inventories and the final sale date. Accounts receivable period: delay between the time that the goods are sold and when the customers finally pay their bills The total length of time from the purchase of raw materials until the final payment by the customer is termed the operating cycle: Operating cycle = inventory period + accounts receivable period Measuring Liquidity The Cash Cycle The regular financing that firm needs to maintain regular operations. The whole cycle of operations looks like this: Measuring Liquidity Current Ratio Changes in the current ratio can be misleading: ➢ For example, company borrows a large sum from the bank and invests it in marketable securities. ➢ Current liabilities/ current assets rise. ➢ So net working capital is unaffected but the current ratio changes. Measuring Liquidity The interval between firm’s payment for its raw materials and collection of payment from customer cash cycle or cash conversion period: Cash cycle = operating cycle − accounts payable period = (inventory period + accounts receivable period) − accounts payable period Measuring Liquidity Operating and cash cycles: Measuring Liquidity For example, firm A purchases materials on day 0 but does not pay for them until day 24 (payable period = 24 days). By day 29 it has converted the raw materials into finished mattresses, which are then sold (inventory period = 29). 21 days later on day 50, Dynamic’s customers pay for their purchases (receivables period = 21). Cash cycle (days) = inventory period + accounts receivable period − accounts payable period 26 = 29 + 21 − 24 Working Capital Working capital requirements are often a function of firm’s particular business model. Retail businesses ✓ significant inventory ✓ operating more heavily on credit ➢ Require substantially more working capital to fund operations. Working Capital Working capital requirements are often a function of firm’s particular business model. Technology businesses (software companies) ✓ large amounts of intangible assets ✓ few physical assets ➢ far lower working capital needs Measuring Liquidity: Industry Aspect Walmart (Retail Industry) Business Model Requires large inventory and acc Primarily delivers software and ounts receivable to support opera cloud services, requiring minim tions. al physical inventory. Inventory Needs High – Inventory is critical to me Low – Digital products and ser et customer demands in stores. vices do not require physical in ventory. Working Capital Requirement High – Inventory and receivables Low – Digital nature of service heavily impact cash flow. s reduces dependency on worki ng capital. Liquidity Indicators - Current Ratio: 0.85 - Current Ratio: 1.30 - Quick Ratio: 0.20 - Quick Ratio: 1.06 - Net Margin: 2.78% - Net Margin: 37.61% - Gross Margin: 24.91% - Gross Margin: 69.35% Profitability Microsoft (Technology Indust ry) Measuring Liquidity: Industry Aspect Walmart (Retail Industry) Microsoft (Technology Industry) Inventory Needs High – Inventory is critical to me Low – Digital products and et customer demands in stores. services do not require physical inventory. Working Capital Requirement High – Inventory and receivables Low – Digital nature of service heavily impact cash flow. s reduces dependency on worki ng capital. Liquidity Indicators - Current Ratio: 0.85 - Current Ratio: 1.30 - Quick Ratio: 0.20 - Quick Ratio: 1.06 Challenges - Low liquidity ratios may - Minimal dependency on create pressure in meeting inventory, enabling more short-term obligations. cash flow flexibility. - Requires effective inventory - Focus on scaling intangible management. assets. Strengths - Strong supply chain and invent - High profitability and robust ory management systems to cash flow due to subscriptionoptimize working capital. based revenue and low inventor y needs. Working Capital Working Capital Management Measuring Leverage Measuring Liquidity
