Chapter 2
Analysis of Working Capital
Cycle
Order
Placed
Order
Received
< Inventory >
Sale
Cash
Received
Accounts
Collection
< Receivable > < Float >
Accounts
< Payable >
Invoice
Received
Disbursement
< Float
>
Payment
Sent
Time ==>
Cash
Paid
Solvency Vs. Liquidity

Solvency concerns whether assets
exceed liabilities, whereas liquidity
refers to the firm’s ability to meet
short-term obligations with cash while
remaining a going-concern
Solvency Measures

Current Ratio

Quick Ratio

Net Working Capital

Working Capital Requirements
Financial Statements - Basic
Source of Information

Balance Sheet

Income Statement

Statement of Cash Flows
Net Working Capital
Implication of positive NWC
 Implication of negative NWC
 Larger value- Adequate solvency and
less default risk
 For larger firms, the absolute value of
NWC will always be higher.
 Standardization of NWC by either
assets or revenue




Traditional NWC figure includes
accounts that are not directly
related to the operating component
of the working capital cycle.
Specifically, cash holdings and notes
payable result from internal
financial decisions or policies
enacted by management.
Decomposing the NWC into
operating and financial components
can be useful to management when
assessing working capital policies.
NWC and its Component
Parts
CA
CL
CA
CL
Cash
Cash
CA
CL
Cash
Mkt Sec
A/P
Mkt Sec
A/P
Mkt Sec
A/P
A/R
N/P
A/R
N/P
A/R
N/P
Inventory
CMLTD
Inventory
CMLTD
Inventory
CMLTD
Prepaid
Accruals
Prepaid
Accruals
Prepaid
Accruals
NWC = CA - CL
Net Working Capital
WCR = A/R + INV +Pre
- A/P - Accruals
NLB = Cash + M/S
- N/P - CMLTD
Working Capital Requirements
Net Liquid Balance
Working Capital Requirements
The working capital requirement
(WCR) is the difference between
current operating assets (i.e., noncash
current assets) and current operating
liabilities (e.g., accounts payable and
operating accruals).
 These accounts represent spontaneous
uses and sources of funds generated
over the working capital cycle.

All other factors constant, an
increased WCR implies that the
working capital cycle requires
additional financing
 A negative WCR implies that the
working capital cycle provides
financing for long-term assets,
positively impacting solvency.

Trend in the WCR indicates a substantial increase in net operating
working capital.
For each year, the observed WCR shows that more funds are tied up in
receivables 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 to
cover the gap in operating working capital.
Working Capital Requirements
($2,481+$273+$404) - ($2,397+$355+$943)
WCR/S = ----------------------------------------------------------$18,243
($537)
= ----------- = -0.029
$18,243
WCR/S
1995
.055
1996
.082
1997
-.030
1998
-.039
1999
-.029
Current Ratio
Current assets
Current ratio = ------------------------Current liabilities
$6,339
Current ratio = ----------- = 1.72
$3,695
Current ratio
1995
1.96
1996
2.08
1997
1.66
1998
1.45
1999
1.72





Values exceeding 1 imply that current assets
exceed current liabilities.
Relationship between the current ratio and NWC:
Positive NWC means that the current ratio
exceeds 1, and a negative NWC implies a current
ratio of less than 1. The current ratio will equal 1
only if NWC is $0.
Similar to the interpretation of the NWC,
increased values for the current ratio traditionally
imply improved solvency and reduced default risk.
Despite this interpretation, keep in mind that
higher receivables and inventory, while increasing
the current ratio, also reduce operating cash
flow.
Quick Ratio
Current assets - Inventories
Quick ratio = ------------------------------------Current liabilities
$6,339 - $273
Quick ratio = -------------------- =
$3,695
Quick ratio
1995
1.57
1996
1.63
1.64
1997
1.51
1998
1.36
1999
1.64
Shortcomings of Traditional
Working Capital Measures



First, although typically referred to as measures of
liquidity, the ratios presented earlier are more
properly classified as solvency measures.
A second problem is the static nature of the
aforementioned measures as the various balance
sheet accounts are assumed to have equal “time-tocash” conversion rates.
A third shortcoming concerns interpretation of the
current and quick ratios, as can have
counterintuitive impacts depending on ratio’s initial
level.
THE CASH CONVERSION
PERIOD

represents the time needed to convert
$1 of disbursements into $1 of cash
receipts.
Days Inventory Held (DIH)


Calculation of the CCP involves three measures,
including days inventory held (DIH), days sales
outstanding (DSO), and days payables outstanding
(DPO).
Conceptually, the DIH represents the average
number of days inventory sits idle. Also, given that
COGS represents inventory production costs, the
DIH can be interpreted as the number of days of
inventory held on the balance sheet at a given point
in time.

Days Sales Outstanding (DSO)

DSO represents the average number of days it takes
for a supplier to collect on credit sales, which
reflects the efficiency of the credit and collections
department. DSO is also referred to as the average
collection period and it is common to compare the
DSO to the trade credit terms offered by suppliers.
Days Payable Outstanding

DPO is the elapsed time between
receipt of inputs and when payments
are made to suppliers.

the CCP represents the length of time over
which management must arrange for
nonspontaneous financing. Longer CCPs
require increased financial resources,
reducing firm liquidity
Implications of CCP



A positive CCP implies that additional
financing is needed to fund the cash cycle.
A negative CCP occurs when the trade credit
period received exceeds the operating cycle. A
negative CCP implies that suppliers provide
financing for the firm’s working capital cycle
and for non-operating working capital assets.
This desirable working capital position is
attributable to the strong demand for both
firms’ products (short inventory holding
periods), quick repayment by customers (to
retain a favorable relationship), and generous
trade credit terms received from suppliers.
Practice Math 1

Suppose that a firm currently has a CCP
of 87 days and DIH equals 50 days.
Management would like to reduce the
CCP by 5 days through changes in
inventory policy. That is, the extension
and use of trade credit policies will
remain unchanged. With this goal in
mind, and assuming that the firm has
annual revenues of $500M with COGS
representing 40% of revenues, the
treasury department wants to estimate
the implied reduction in inventory and the
subsequent increase in cash flow.
The Cash Conversion Period and
Firm Value


The CCP directly impacts the value of the firm as
the gap between the operating cycle and the DPO
can be financed with either debt or equity
An increased cash cycle implies increased interest
expense.
Practice Math 2