SHORT-TERM
FINANCIAL MANAGEMENT
Chapter 2 – Analysis of the Working Capital Cycle
Prepared by Patricia R. Robertson
Kennesaw State University
2
Chapter 2 Agenda
ANALYSIS OF THE WORKING CAPITAL CYCLE
Differentiate between solvency ratios and
the cash conversion period, distinguish
between solvency and liquidity, calculate
and interpret the cash conversion period,
and determine the change in shareholder
wealth attributable to changes in the cash
conversion period.
Cash Flow Timeline
3
The cash
conversion
period is the
time between
when cash is
received versus
paid.
The shorter
the cash
conversion
period, the
more efficient
the firm’s
working
capital.

The firm is a system of cash flows.

These cash flows are unsynchronized and uncertain.
Solvency v. Liquidity
4

A firm is solvent when its assets exceed its
liabilities.
 This
accounting measure is based on book, not market,
values.

A firm is liquid when it can pay its bills on time
without undue cost.
Solvency Measures
5

The following ratio measures are generally referred to
as liquidity measures but, in fact, measure solvency.

Net Working Capital

Net Liquid Balance

Working Capital Requirements

Working Capital Requirements / Sales

Current Ratio

Quick Ratio
Net Working Capital
6

Net Working Capital is a dollar-based solvency measure.





The larger the amount, the more solvent the firm.
It is an absolute, not relative measure, so it ignores scale and
trends.
Too much working capital is considered a drag on financial
performance.
Like the current ratio, it can be overstated based on uncollectible
receivables and obsolete inventory.
Some analysts exclude cash from the ratio to measure the amount
of cash tied up in the operating cycle.
Net Working Capital = Current Assets – Current Liabilities
WCR & NLB
7


Net Working Capital commingles operating and financial
accounts.
A variation separates Net Working Capital into two pieces:

Working Capital Requirements (WCR)


Operating CA – Operating CL
Net Liquid Balance (NLB)

Financial CA – Financial CL

Shows ability of stock resources to pay ‘arranged’ maturing debt which
is unaffected by the operating cycle.
Net Working Capital = WCR + NLB
WCR & NLB
8
Working Capital Requirements (WCR)
Net Working Capital
Current Assets
Minus
Current Liabilities
Current Assets
Minus
Current Liabilities
Cash
Accounts Payable
Cash
Accounts Payable
Marketable Securities
Notes Payable
Marketable Securities
Notes Payable
Accounts Receivable
CMLTD
Accounts Receivable
CMLTD
Inventory
Accruals and Other
Inventory
Accruals and Other
Prepaids and Other
Prepaids and Other
Net Working Capital = WCR + NLB


If positive, a portion of Current
Assets is financed with ‘permanent
funds’ (LT Liabilities and Equity).
If negative, a portion of Current
Liabilities are funding long-term.
Net Liquid Balance (NLB)
Current Assets
Minus
Current Liabilities
Cash
Accounts Payable
Marketable Securities
Notes Payable
Accounts Receivable
CMLTD
Inventory
Accruals and Other
Prepaids and Other
WCR & NLB / WCR/S
9

The level of WCR will change as sales expand and contract.


WCR/S = WCR in relative terms (% of sales)
During expansion, higher levels of WCR must be financed
by:

Drawing down NLB.


Appropriate for seasonal sales increases.
Adding to permanent working capital by acquiring new LTD,
equity, or both.

Appropriate for sustainable sales increases.
Current Ratio
10

The Current Ratio indicates the degree of coverage provided to
short-term (ST) creditors if ST assets were to be liquidated.



A ratio of 2.00 indicates the firm has $2.00 of Current Assets for $1.00
of Current Liabilities.
It does not consider the ‘going-concern’ aspect of the firm, which assumes
the firm would have to liquidate these assets to pay off the liabilities.
Plus, it is only a point in time, and not always representative.
Its use is limiting based on the components (firm might have a high ratio
due to large balance of uncollectible receivables and/or obsolete
inventory).
Quick Ratio
11

Also known as the Acid-Test Ratio, the Quick Ratio excludes
inventory in the numerator since inventory is the least liquid current
asset.
Quick Ratio =


Current Assets - Inventory
Current Liabilities
Inventory could be obsolete, stolen, worn (damaged), or non-saleable
(unless deeply discounted at a fire-sale price).
Prepaid Expenses are also commonly excluded.
What Is Liquidity?
12

Elements of liquidity include several dimensions:


Time

The amount of time to convert an asset to cash.

The quicker, the more liquid the firm.
Amount


Cost / Loss of Value


The firm’s capacity to meet its ST obligations.
Assets can be quickly converted to cash with little/no cost.
A liquid firm has enough financial resources to cover its
financial obligations in a timely manner with minimal cost.
Cash Conversion Period
13

We are concerned with the amount and timing of cash flows.



We have to build and sell products, then get paid before we generate cash
inflows.
In the meantime, we have cash outflows for supplies and labor.
This creates the Cash Conversion Period (CCP), the elapsed time
between payment to suppliers and receipt of customer payments.

CCP = Production Cycle + Collection Cycle – Payment Cycle
14
CCP and Activity Measures
15


Calculation of the Cash Conversion Period (CCP) relies on
three activity measures.
Activity measures indicate how efficiently the firm is using its
assets.

Days Inventory Held (DIH)


Days Sales Outstanding (DSO)


Inventory Turnover
Receivables Turnover
Days Payables Outstanding (DPO)

Payables Turnover
Cash Conversion Period (CCP)
16

Days Inventory Held (DIH) measures inventory management by
calculating the average length of time inventory is in stock before
being sold.
DIH
Note: Using
average inventory
is a more accurate
calculation.
DSO
DPO
Days Inventory
Held =
Inventory
Cost of Sales / 365
Cash Conversion Period (CCP)
17

Days Sales Outstanding (DSO) measures credit / collections
management by calculating the average time to collect from
customers.
Note: Using
DIH
average net
receivables is a
more accurate
calculation. Using
credit sales in the
denominator also
offers a superior
result (excludes
cash sales).
DSO
DPO
Days Sales
Outstanding =
Receivables
Sales / 365
Cash Conversion Period (CCP)
18

Days Payables Outstanding (DPO) measures payables management
by calculating the average time from inventory receipt to payment.
DIH
Note: Using
average
payables is a
more accurate
calculation.
DSO
DPO
Days Payables
Outstanding =
Payables
Cost of Sales / 365
Cash Conversion Period (Cycle)
19

Three Activity Measures explain the CCP:

Days Inventory Held (DIH)

Days Sales Outstanding (DSO)

Days Payables Outstanding (DPO)

CCP = [Production Cycle + Collection Cycle] – Payment Cycle

CCP = Operating Cycle – Payment Cycle


Operating Cycle = DIH + DSO

Payment Cycle = DPO
CCP = (DIH + DSO) – DPO
Cash Conversion Period (CCP)
20
The CCP is generally positive; the longer the CCP the more financing
is required for inventory and receivables. A lengthening cycle could
signal liquidity issues.
DIH
DPO
DSO
CCP Example
21

A firm has a CCP of 87 days. The CCP includes DIH
of 50 days. By changing inventory policies, it
believes it can reduce DIH by 5 days. How does
this change the firm’s investment in inventory,
assuming the firm has $500M in sales and CGS of
40%?
CCP Example
22

How does
reducing DIH
from 50 to 45
days change
the firm’s
inventory
investment.
Cost of Working Capital
23


Let’s first establish the cost of working capital.
Assume a firm offers standard 30-day credit terms (it gets
paid for sales 30-days after the sale is made). Assuming
average daily sales are $200,000 and the cost of capital
is 10%, what is the annual cost of extending trade credit?

30 × $200,000 × 10% = $600,000

The firm has permanently lost the use of $6,000,000 (it has
permanently committed this amount in capital to support A/R).

At a 10% cost of capital, the cost of extending credit is $600,000;
in other words, in the absence of offering trade credit, the
$6,000,000 could be otherwise used to generate $600,000 in
incremental firm value.
Valuation of ST Cash Flows
24

Each component of working capital (inventory,
receivables, payables, accruals) has two
dimensions…time and amount.

Cash flows can be converted to a value at a standard point
in time (usually t = 0) so they can be compared.

For example, to increase sales, a firm is considering
modifying its credit terms from net 30 to net 45 days.

What is the impact on the value of one day’s sales?
Firm’s Decision
25
Shown is how
the cash flows
compare.
Net 30:
0
Does this
decision
make sense?
Since the
amounts and
timing of the
cash flows are
different,
how can they
be compared?
30 Days
$550,000
Net 45:
0
45 Days
$600,000
Valuation of ST Cash Flows
26


It might seem that valuing intra-year year cash flows is not
meaningful.
However, financial policy decisions that are permanent are
meaningful.

ST financial decisions can impact firm value by:

Altering operating cash flows (amount).

Changing the length of the cash conversion cycle period (timing).

Changing the company’s risk posture.

Impacting interest income (or interest expense).
Valuation of ST Cash Flows
27

A widely-used valuation method is the Net Present Value
(NPV) approach.

This approach is preferred since it accounts for the timing and risk
of cash flows.

There are four steps:

Determine the relevant cash flows.

Determine the timing of the cash flows.

Determine the appropriate discount rate.

Discount the cash flows to compute NPV.

Choose the result that optimizes VALUE.
Valuation (NPV) Approach
28


Firm XYZ is considering modifying its credit terms from net 30 to net
60.

Relaxing the credit terms and giving customers more time to pay is
expected to increase sales.

What is the NPV of this decision?
First, let’s recall how to discount money (calculate the present value of
future cash flows).
Discounting ST Cash Flows
29


Other finance classes emphasize the importance of compounding in
financial analysis.
While this is meaningful for long-term (LT) decisions, simple interest
calculations are adequate for ST decisions.


While the timing of intra-year cash flows is significant, the effect of
compounding is not.
We will often use a daily interest rate since firms invest in overnight
investments or borrow money on credit lines daily.
Quick TVM Review
30

To calculate PV using simple interest, the formula is:


PV = FV / [1 + (i)(n)]

Where i = annual opportunity cost and n = # of years

i and n can be adjusted to reflect different periods
To modify the formula for a daily periodic interest rate:

PV = FV / [1 + [(i)(n/365)]]  Annual rate times portion of year
or…

PV = FV / [1 + [(i/365)(n)]]  Daily rate times # of days
Choosing the Discount Rate (i)
31

Throughout the course, we will refer to i as:

The annual interest rate

The discount rate

The opportunity cost of funds or capital

The required rate of return

The investment opportunity rate

The annual cost of capital
Choosing the Discount Rate (i)
32

i is the rate of return the firm should earn on its
assets
 It
is the Opportunity Cost; tying up funds in one or
more assets (like current assets) prevents the firm from
using those resources for the most valuable alternative,
which is usually reinvestment in the firm.
Simple vs. Compound Interest
33


Before we move on, let’s compare simple and compound interest to
ensure you agree the difference is not material intra-year…
Using the example from before….

Let’s assume a firm has standard 30-day credit terms, has average
daily sales of $200,000, and a cost of capital of 10%...
The Difference is Negligible
34
i = annual cost of capital
Simple Interest
PV =
PV =
PV =
PV =
FV
1 + (n x i )
FV
i
1 + (n х /365)
$200,000
1 + (30 х
0.10
/365)
$198,369.57
n = number of days
Compound Interest
PV =
PV =
PV =
PV =
FV
(1 + i )
n
FV
i
(1 + / 365 )
n
$200,000
(1 + 0.10/ 365 )30
$198,363.12
NPV With Daily Simple Interest
35

If this formula is true for a single cash flow:
FV
PV =
1 + (i х n )

This is the expanded formula for a series of cash flows:
i = annual rate
n = number of periods
CF1
CF2
NPV = CF0 +
+
+
1 + (i х n 1 ) 1 + (i х n 2 )
…
CFn
+
1 + (i х n n )
NPV Simplification
36

However, many ST financial decisions can be made based on a single
cash flow if it has multi-year effects.
FV
PV =
1 + (i х n )


So, one of the steps in the analysis is to determine if the cash flows are
constant and can be represented with a single sum.
If the change is permanent (a perpetuity), the aggregate impact can be
calculated since the benefit will continue indefinitely.
PV Perp

=
If not, it is an annuity.
CF
i
=
Cash Flow Per Period
Interest Rate Per Period
Valuation (NPV) Approach
37


Back to the decision…
Firm XYZ is considering modifying its credit terms from net 30 to net
60.

Relaxing the credit terms and giving customers more time to pay is
expected to increase sales.

The Valuation Approach (NPV) compares the cash flows (amount and
timing) of a proposed policy change, including any funding costs, to the
cash flows from the existing policy.


There are rarely any fixed costs or fixed asset changes.
Consider only the relevant cash flows.
Firm XYZ’s Decision
PV =
FV
1 + (i х n )
38
First, let’s
observe the
timeline
based on the
current credit
policy.
Presented is
the cash flow
timeline at
net 30 and
the PV of
one day’s
sales using a
discount rate
of 10%.

Present sales data:



$36,500,000 annual sales
$36,500,000 / 365 = $100,000 / day
Cash Flow Timeline (net 30)
0
30
Days
$100,000
This is a DAILY
NPV…it recurs
every day.
PV =
$100,000
1 + (.10 х 30/365)
PV =
$99,184.78
Firm XYZ’s Decision
PV =
FV
1 + (i х n )
39
Now assume the
proposed net 60
is adopted.
Presented is the
cash flow
timeline at net
60 and the PV of
one day’s sales
using a discount
rate of 10%.
We didn’t
change the
amount of the
cash flows; but,
we did change
the TIMING,
lengthening the
Cash Conversion
Period.

Sales:



$36,500,000
$36,500,000 / 365 = $100,000 / day
Cash Flow Timeline (net 60)
0
PV =
PV =
30
60 Days
$0
$100,000
$100,000
1 + (.10 х 60/365)
$98,382.75
Without a corresponding increase
in sales, the policy change would
cost the firm $802.03/day, or
$292,741/year.
Firm XYZ’s Decision
PV =
FV
1 + (i х n )
40
Now assume
sales do
increase.
As sales
increase,
many costs
also change.
To make the
comparison,
we need to
FIRST look at
ALL relevant
present vs.
proposed
cash flows.



Remember, we are concerned with all relevant cash
flows.
Here, since the timing and/or amounts of cash
inflows AND cash outflows are impacted, all are
relevant.
NPV = PV of Inflows - PV of Outflows
Firm XYZ’s Decision
PV =
FV
1 + (i х n )
41
Now assume
sales do
increase.
As sales
increase,
many costs
also change.
To make the
comparison,
we need to
FIRST look at
ALL relevant
present vs.
proposed
cash flows.
Present Cash Flows:

Initial Investment

Sales Increase

CGS

Payment Terms
From Supplier

Inventory Conversion:


$0
+ 3% (even)
65% of Sales
Net 30 (DPO)
Inventory-to-Production Lag
Production-to-Sales Lag
30 Days
10 Days
40 Days DIH
Raw Materials
Purchased &
Received
Goods
Produced; Pay
For Materials
Product
Sold
Sales
Proceeds
Received
0
30
40
70 Days
$65,000
Inv.-toProd. Lag
Prod.to-Sales
Lag
$100,000
Payment
Terms
(DSO)
Firm XYZ’s Decision
PV =
FV
1 + (i х n )
42
The daily
NPV is the
difference
between the
PV of the
inflows and
outflows.
Raw Materials
Purchased &
Received
Goods
Produced; Pay
For Materials
Product
Sold
Sales
Proceeds
Received
0
30
40
70 Days
$65,000
$100,000
Inflows
PV =
PV =
Daily
NPV =
Outflows
$100,000
1 + (.10 х
70
/365)
$98,118.28
$98,118.28
-$64,470.11
$33,648.17
PV =
PV =
$65,000
1 + (.10 х
30
/365)
$64,470.11
Firm XYZ’s Decision
PV =
FV
1 + (i х n )
43

The calculated daily NPV is converted to the aggregate NPV since it is
assumed that the daily NPV would persist indefinitely (here, use i in the
denominator).
Inflows
PV =
PV =
Daily
NPV =
Outflows
$100,000
1 + (.10 х
70
/365)
$98,118.28
$98,118.28
-$64,470.11
$33,648.17
PV =
PV =
$65,000
1 + (.10 х
30
PVPerp =
CF
i
PVPerp =
$33,648.17
(.10/365)
PVPerp =
$33,648.17
0.000273973
PVPerp =
$122,815,820.50
/365)
$64,470.11
Firm XYZ’s Decision
PV =
FV
1 + (i х n )
44
Net 30:
We now
compare the
previous
results to the
proposed
change to net
60.
Shown is how
the cash flows
compare.
THE
AMOUNT
AND TIMING
OF CASH
FLOWS
CHANGES.
Raw Materials
Purchased &
Received
0
Goods
Produced; Pay
For Materials Product
Sold
30
40
$65,000
Net 60:
Raw Materials
Purchased &
Received
0
$66,950
$103,000 х 65%
70 Days
$100,000
Goods
Produced; Pay
For Materials Product
Sold
30
Payment
Terms
(DSO)
Sales
Proceeds
Received
40
Payment
Terms
(DSO)
Sales
Proceeds
Received
100 Days
$103,000
$100,000 х 1.03
Firm XYZ’s Decision
PV =
FV
1 + (i х n )
45
We now
compute the
cash flow
effect from
the proposed
change to net
60.
Raw Materials
Purchased &
Received
Goods
Produced; Pay
For Materials
Product
Sold
0
30
40
Sales
Proceeds
Received
100 Days
$66,950
$103,000
Inflows
PV =
PV =
Daily
NPV =
Outflows
$103,000
1 + (.10 х
100
/365)
$100,253.33
$100,253.33
-$66,404.21
$33,849.12
PV =
PV =
$66,950
1 + (.10 х
30
/365)
$66,404.21
Firm XYZ’s Decision
PV =
FV
1 + (i х n )
46

Again, the calculated daily NPV is converted to the aggregate NPV since it
is assumed that the daily NPV would persist indefinitely.
Inflows
PV =
PV =
Daily
NPV =
Outflows
$103,000
1 + (.10 х
100
/365)
$100,253.33
$100,253.33
-$66,404.21
$33,849.12
PV =
PV =
PVPerp =
CF
i
PVPerp =
$33,849.12
(.10/365)
PVPerp =
$33,849.12
0.000273973
PVPerp =
$123,549,288.00
$66,950
1 + (.10 х
30
/365)
$66,404.21
Firm XYZ’s Decision
47
Evaluate the
results and
make a
decision.

Choose the project with the highest NPV:

$123,549,288 > $122,815,821

$123,549,288 - $122,815,821 > 0
Changing the terms [permanently] increases
CASH and the VALUE of this transaction.
 The delay in receiving the cash is more than offset
by the value of the increased sales.
 So, change the terms to net 60.

Note: If there is reason to believe that the cash
flow effect will only last several years, modify the
analysis to an annuity versus a perpetuity.
A Word of Caution…
48

Regarding the formula…
[1 + (i)(n/365)] ≠ [1 + (i)](n/365)
A Word of Caution…
49

Discounting the cash flows is the step that considers the timing of the cash
flows.

Typically, you use a daily periodic rate.
FV
PV =
1 + (i х n )

Once you have the PV (and assuming you consider it a perpetuity), the
denominator in the following formula is based on the frequency of the
occurrence of the cash flows, not the change in the cash conversion cycle.
PV Perp
=
CF
i
=
Cash Flow Per Period
Interest Rate Per Period
Use appropriate
periodic rate
that matches the
frequency of the
cash flows.
A Word of Caution…
50

For example, if you have a daily NPV of $75,000 and the cost of
funds is 10%, the perpetuity (aggregate) value of the transaction is:


$75,000 / (.10 / 365) = $273,750,000
If the $75,000 occurred monthly:

$75,000 / (.10 / 12) = $9,000,000

This is the same thing as annualizing the benefit and then dividing it by the
annual rate:

($75,000 x 365) / .10 = $273,750,000

($75,000 x 12) / .10 = $9,000,000
Another Word of Caution…
51

When evaluating the result of a NPV calculation, remember
if it is an inflow or an outflow:

If you are evaluating accounts receivables (an inflow), you want
the higher NPV.

If you are evaluating inventory costs and/or paying for that
inventory (accounts payables, which is an outflow), you want the
lower NPV.

If you are evaluating a situation that includes both inflows and
outflows, you want the higher NPV.
The Importance of Cash
52

Why is more cash sooner a good thing?

Firms can reinvest cash in the firm (new equipment, more
inventory, more warehouse space, etc.).


It can finance operations and sales growth internally without
having to rely on external financing.
Firms can borrow less or invest more.