Lecture 6_Working Capital Managment(2)

nullSession 6: Working Capital Management (Chapter 23)Session 6: Working Capital Management (Chapter 23)JRE 300H1S – Foundations of Accounting and Finance Instructor: Fotini ToliasAnnouncementsAnnouncements*Mid Term Exam – Monday, Feb. 24 at 6pm – 8pm in HA – Room TBA by email Conflict session – Monday, Feb. 24 at 4pm to 6pm in HA316 Only students who emailed the instructor may write in the conflict session Exam for students who reported “double conflict” – TBA by email One Crib Sheet: 8.5x11 inches– 2 sides Calculator & your ID Please email conflicts to instructor if you have not done this already Subject line “JRE300 Mid Term exam conflict”  null “Cash is King”: Working Capital Management Read: Textbook Volume 2 – Finance Table of Contents – Chapter 11 (original Booth text – Ch. 23) *Working Capital Management Avoid Depleting Liquid Assets (Cash & Equivalents)Working Capital Management Avoid Depleting Liquid Assets (Cash & Equivalents)Objective: Maintain liquidity & avoid insolvency. Working capital = Current assets - Current liabilities Depleting liquid current assets leaves the firm unable to pay its obligations as they come due Result is technical insolvency - bankruptcy Companies can deplete liquid assets in many ways: Inability to collect cash payments from customers Rapid growth which depletes cash due to the need to hold higher inventories, A/R, and large fixed assets. Firm may be profitable in an accounting sense, but on the verge of bankruptcy as it pursues uncontrolled growth in sales.*Principles of Good Working Capital ManagementPrinciples of Good Working Capital ManagementWork to maintain optimal cash balances. Invest any excess cash in marketable securities to earn interest (more on this later...) Proper management of accounts receivable. Regular monitoring and collection. Set up an efficient inventory management system. Maintain an appropriate level of short-term financing, in the least expensive and most flexible manner possible. Cash flow from operations measures the cash-generating ability of the firm*Components of Corporate Financing:Components of Corporate Financing: Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity Current LiabilitiesLong-Term Debt What long-term investments should the firm make?1) The Capital Budgeting Decision*2) The Capital Structure Decision 2) The Capital Structure Decision How should the firm finance its investments? Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity Current LiabilitiesLong-Term Debt *3) Working Capital Decisions 3) Working Capital Decisions How much cash flow does the firm need to pay its bills? Net Working Capital Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity Current LiabilitiesLong-Term Debt *Net Working Capital = Current Assets – Current LiabilitiesNet Working Capital = Current Assets – Current LiabilitiesCurrent Assets are cash and other assets that will be converted to cash with the year. Cash Marketable securities Accounts receivable InventoryCurrent Liabilities are obligations that require cash payment within the year. Accounts payable Accrued wages Taxes *2 ratios measuring firm liquidity Working Capital Problem – An Example Working Capital Problem – An ExampleA company is growing rapidly: Increasing sales → Decreasing cash: WHY? Increased sales requires additional investment in inventory and Increases accounts receivable (AR) Solution: Conserve cash by: Speeding up collection of A/R Delaying payables The cash flow cycle helps managers visualize how different variables impact the cash account. *The Operating Cycle and the Cash CycleThe Operating Cycle and the Cash CycleTimeAccounts payable periodOperating cycleCash received Inventory soldFirm receives invoiceCash paid for materials*Example: Depletion of the Liquid Resources of a New FirmExample: Depletion of the Liquid Resources of a New Firm A simple example of a $1.0 million equity investment in a new business Levered with additional financial resources The need to finance growth quickly depletes cash.There are 7 steps to technical insolvency for an otherwise profitable firm.*This Example illustrates the Working Capital ProblemThis Example illustrates the Working Capital Problem It demonstrates: How cash is utilized over time. How investment in assets such as accounts receivable and inventory deplete cash resources. How the delays in receipt of cash from sales can leave a firm without cash, despite its overall profitability.*Cash Flow Cycle StartCash Flow Cycle StartCash Account Balance = $0*Cash Flow Cycle 1) Initial Equity InvestmentCash Flow Cycle 1) Initial Equity InvestmentBalance Sheet Cash $1m Common Stock $1 m _____________________________________ T. Assets $1m T. Claims $1m*Cash Flow Cycle 2) Purchase $500,000 Fixed AssetsCash Flow Cycle 2) Purchase $500,000 Fixed AssetsBalance Sheet Cash $0.5 F. Assets 0.5 Common Stock $1 m ___________________________________ T. Assets $1m T. Claims $1m*Cash Flow Cycle 3) Buy $300,000 of inventory on trade creditCash Flow Cycle 3) Buy $300,000 of inventory on trade creditBalance Sheet Cash $0.5 A/P $0.3 Inventory 0.3 F. Assets 0.5 Common Stock $1 m _____________________________________ T. Assets $1.3m T. Claims $1.3m*Cash Flow Cycle 4) $400,000 added costs via Direct Labor and O/H, $300,000 is unpaid (includes $100,000 depreciation)Cash Flow Cycle 4) $400,000 added costs via Direct Labor and O/H, $300,000 is unpaid (includes $100,000 depreciation)Balance Sheet Cash $0.5 A/P $0.3 Inventory 0.7 Accruals 0.3 F. Assets 0.4 Common Stock $1 m _____________________________________ T. Assets $1.6m T. Claims $1.6m*Cash Flow Cycle 5) Payment of initial A/P ($300,000) and Accruals ($200,000)Cash Flow Cycle 5) Payment of initial A/P ($300,000) and Accruals ($200,000)Balance Sheet Cash $.0 A/P $0.0 Inventory 0.7 Accruals 0.1 F. Assets 0.4 Common Stock $1 m _____________________________________ T. Assets $1.1m T. Claims $1.1m*Cash Flow Cycle 6) Goods sold on A/R for a profitCash Flow Cycle 6) Goods sold on A/R for a profitBalance Sheet Cash $0.0 A/P $0.0 A/R 0.5 Inventory 0.3 Accruals 0.1 F. Assets 0.4 Common Stock $1 m R/E 0.1 ____________________________________ T. Assets $1.2m T. Claims $1.2m*Summary of the ExerciseSummary of the ExerciseThis firm is left at the stage where it is waiting to collect on accounts receivable, but should be ordering more inventory and converting it into saleable products. The firm could move forward if it had additional financing: Some options to solve the cash problem: Sale of additional shares to investors. Borrow funds. Delay payment of wages to employees until collection of accounts receivable. Collect on accounts receivable sooner.*null*Cash flow from operations is the correct measure of the cash-generating ability of the firm From the Balance Sheet of Rogers: Cash Budgeting & Forecasting Cash Budgeting & ForecastingThe cash flow cycle helps managers visualize how different variables impact the cash account: The cash budget is a planning tool used to forecast cash inflows and outflows (usually monthly). Essentially the cash budget is a cash flow statement for each month The cash budget’s purpose: Forecast the timing, magnitude and duration of cash surpluses and deficits Identify urgent financing needs which require action Net Working Capital Management NWC is one financial metric a business owner can use to manage cash and liquidity The monthly cash budget is the tool used to forecast the timing, magnitude and duration of both cash surpluses as well as deficits. *nullAssume the following for ABC Company: (example from the book, pages 917-918) Company forecasts a sales increase of $500 per month – begin with sales in month 1 of $1,000 Cost of Sales is 75%. (= cost of inventory to the company, therefore Sales = 1000, cost of inventory = 0.75*1000=$750) – in month 1, $750 of widgets was produced and sold Company keeps 1 month of inventory on hand (so 500 widgets at a cost of 0.75x500=$375 Company pays its bills immediately (i.e. no Accounts Payable) Takes one month to collect its receivables (i.e. 30 day credit policy). Maintains a cash balance equal to 20% of monthly sales for contingencies (i.e. emergencies)*ABC’s 12 month Cash BudgetABC’s 12 month Cash Budget*Forecast Cash Balances Timing, Magnitude & DurationForecast Cash Balances Timing, Magnitude & Duration*Analyzing Cash Inflows and Outflows Cash Changes and Sales GrowthIf we represent Company ABC’s sales, cost of sales and receivables policy by the following equation then the analysis of the impact of sales growth on the firm’s cash position can be done using the following equation: Where: St-1 = Last months sales (collected this month – 1 month lag in collection) and St = This months sales (collected next month) b = the cash production cost and (1 – b ) = unit contribution margin Analyzing Cash Inflows and Outflows Cash Changes and Sales GrowthFrom the cash budget for ABC: Change in cash=1000-(0.75)(1500)-(0.75)(500) = -$500 (in month 2) Cash went from $1,250 in month 1 to $750 in month 2*Last month’s salesCost of production this monthCost of producing goods for inventory this monthAnalyzing Cash Inflows and Outflows Cash Changes and Sales GrowthAnalyzing Cash Inflows and Outflows Cash Changes and Sales GrowthIf we define g as the monthly sales growth rate, so that St =St-1 x (1+g) and replace in the previous equation we get: where: g = monthly sales growth b = the cash production cost and (1 – b) = unit contribution margin St –1 = Sales in the previous time period We can conclude that the sensitivity of cash to sales growth is strongly related to the firm’s inventory and accounts receivable policies*Analyzing Cash Inflows and Outflows Credit, Inventory and Payables PoliciesAnalyzing Cash Inflows and Outflows Credit, Inventory and Payables PoliciesWe can create an expanded formula to explore the sensitivity of the firm’s cash position with respect to the firm’s credit, inventory and accounts receivable policies. Let: α = the firm’s credit policy as the percentage of sales collected this month 1 – α = the balance of sales collected in the month following sales β = the proportion of this month’s production costs paid in this month 1 - β= the proportion of production costs paid next month. γ = percentage of the firm’s monthly sales tied up in inventory 1/γ= monthly inventory turnover ratio *Analyzing Cash Inflows and Outflows Credit, Inventory and Payables PoliciesAnalyzing Cash Inflows and Outflows Credit, Inventory and Payables PoliciesThis model uses payments and receipts over 2 months (see text 23-2) Conclusion: The change in cash each month depends on: Credit policy – what % of revenue is collected in the month of sale Inventory management practices Trade credit – what % of current production is paid in the month of production$ collected on last month’s sales$ collected on this month’s salesCosts Paid: For this monthCosts Paid: For last monthInventory as % of sales*Analyzing Cash Inflows and Outflows Credit, Inventory and PayablesWe can simplify Equation 23-2 into the equation below by including the sales growth rate and removing the different sales levels: We can then solve for g, the growth rate... Analyzing Cash Inflows and Outflows Credit, Inventory and PayablesBreak-Even Sales Growth RateBreak-Even Sales Growth RateThe monthly sales growth rate at which the firm can grow without needing or generating cash: The firm can grow faster if: It has a higher gross margin (1 – b) Lower production costs (b) Collects is receivables more quickly (higher α) Pays its bills more slowly (lower β) Has less inventory (lower γ) *In practice, these models are available from many sources, including the banks Break-Even Sales Growth RateBreak-Even Sales Growth RateFor ABC Company: Note from the Cash Budget that ABC had ending cash of zero when sales went from 3000 to 3,500 in months 5 and 6 (3500 -3000/3000=16.67%) *Example – from bookExample – from bookα = the firm’s credit policy as the percentage of sales collected this month 1 – α = the balance of sales collected in the month following sales (one month lag) β = the proportion of this month’s production costs paid in this month 1 - β= the proportion of production costs paid next month. γ = percentage of the firm’s monthly sales tied up in inventory b = the cash production cost and (1 – b ) = unit contribution margin *Cash Budgets Dealing with Forecast SurplusesCash Budgets Dealing with Forecast SurplusesKnowing the timing, magnitude and duration of cash surpluses allows management to choose the most appropriate management response: Short period of time, small amount (ie. less than $100,000) Keep in current account. Short period of time, large amount Invest in money market securities (T-Bills) Long period of time, small amount Consider dispersing as a special dividend, potentially retire debt Long period of time, large surplus Consider dispersing excess funds as cash dividends Alternatively invest in longer-time, higher yielding investments*nullApple’s cash & equivalents: ($billions) = $10.7+$18.3 = $29.1 Add cash invested in long term marketable securities $92.1 Total = $121.2 billion in cash & near cashApple Consolidated Balance Sheet as of Sept. 29, 2012On April 23, 2013, Apple's Board of Directors approved a 15% increase in the Company’s quarterly dividend and has declared a cash dividend of $3.05 per share of the Company's common stock. The dividend is payable on May 16, 2013, to shareholders of record as of the close of business on May 13, 2013.Cash Budgets Dealing with Forecast DeficitsCash Budgets Dealing with Forecast DeficitsDealing with deficits: Short period of time, small deficit (i.e. less than $100,000) Delay purchases, speed collections and try to synchronize cash flows to eliminate/minimize, or Negotiate an operating line of credit with the financial institution Short period of time (30-90 days), large deficit (over $100,000) Open an operating line of credit, Recall: Rogers has up to $2.4 billion available under their operating lines of credit Seek longer term permanent capital solutions if large cash flow deficits are likely to reoccur.*Cash Budgets Dealing with Forecast DeficitsCash Budgets Dealing with Forecast DeficitsDealing with deficits: Long period of time, small deficit Explore more permanent solutions to the under-funding, change terms for A/R and inventory management. Long period of time, Large deficit Seek permanent capital increases in the form of debt, equity or combination.*From Rogers’ 2010 Annual ReportThe Operating Cycle and the Cash CycleThe Operating Cycle and the Cash Cycle Two other measures are used to deal with the amount of time a firm must wait for cash to be generated from its sales and how much financing it will require: The Operating Cycle (OC) represents the average time required for a firm to acquire inventory, sell it and collect the sale proceeds The Cash Conversion Cycle (CCC) provides an estimate of the average time between when a firm pays cash for its inventory purchases and when it receives cash for its sales Inventory Conversion Period + AR Conversion Period *Overview of the Operating Cycle & the Cash CycleOverview of the Operating Cycle & the Cash CycleInventory periodInventory soldCash receivedAccounts receivable periodOperating cycle (OC)Cash CycleCash paid for inventoryAccounts payable periodTimeOrder PlacedStock ArrivesInventory purchasedFirm receives invoice*The Operating Cycle and the Cash Cycle: An Example – Apple 2012 annual reportThe Operating Cycle and the Cash Cycle: An Example – Apple 2012 annual reportShorter AR conversion period → Less sensitivity of cash to changes in salesIncrease Payables Deferral Period → Conserve Cash*The Operating Cycle and the Cash Cycle: Example: Apple Inc. 2012 annual reportThe Operating Cycle and the Cash Cycle: Example: Apple Inc. 2012 annual reportIn practice, the inventory period, the accounts receivable period, and the accounts payable period are measured by days in inventory, days in receivables, and days in payables.Shorter Inventory Conversion Period→ Less sensitivity of cash to changes in sales*Quote: “These numbers may indicate that Apple is improving its operations and getting more efficient with how it allocates capital, generates sales and manages inventory. If the trend of a company’s inventory turnover is up, that means the company is keeping products on the shelves for a shorter amount of time. Companies with perishable, fashion, or high-tech products don’t want their inventory sitting on the shelf for too long because it can deteriorate or become obsolete quickly.” The Operating Cycle and the Cash Cycle: An Example (continued)Summary of this Example: Operating cycle = Days in inventory + Days in receivables = 3.3 days + 25.5 days = 28.8 days. Cash cycle = Operating cycle – Days in payables = 28.8– 88 days = - 59.2 days The Operating Cycle and the Cash Cycle: An Example (continued)*Apple’s Other Cash Story - articleApple’s Other Cash Story - articleMar 13 2012, 13:06 by: Stephen Rosenman | about: AAPL, Apple (AAPL) has $97 billion in cash, piling up a whopping $93 billion in just 9 years as the company swaps iProducts for green backs. It practically prints the stuff. Apple's not quite as fast as the government: The U.S. Bureau of Engraving and Printing creates that much money in about 6 months. Still, Apple's a close second to Uncle Sam. (If you compare Apple's expected revenue for the upcoming year to U.S. printing presses, Apple might actually come in first.) In other words, Apple's a mean efficient cash machine. While Apple makes its money in the conventional way -- contracting with others to make its products, selling the goods, receiving cash and paying off its creditors -- the speed involved is anything but conventional. Apple literally makes money in "negative time." In retail, the cash cycle measures how efficiently companies manage their sales, inventories, and bills. Apple's handling of its cash cycle is remarkable: Cash is locked-up in inventory and receivables for less than half the time it takes to pay its creditors. When you figure the number of days Apple ties up its cash in inventory and sales minus the days it takes to pay its bills, the company actually has a -54 day cash cycle. In effect, Apple's cash sits in its inventory and outstanding sales for a shorter period than it takes to pay its creditors. Result: An efficiency unparalleled in retail. *null Working Capital Management: Current Assets and Current Liabilities*Cash and Marketable Securities Reasons for Holding Cash/How to hold cashCash and Marketable Securities Reasons for Holding Cash/How to hold cashMost firms retain some cash balances in their accounts despite earning low rates of return for their cash: To complete transactions To ensure emergency liquidity (precautionary) It is due to be paid out as dividends, investment capital, etc To be able to take advantage of unexpected bargains The optimal cash balance balances the risks of illiquidity against the sacrifice in expected return – holding too much cash Firms with predictable cash flows will have lower optimal cash balance requirement. Firms with excess borrowing capacity (unused line of credit for example) can hold less cash. Firms typically retain marketable securities (easily converted to cash) instead of sizable cash balances in order to afford themselves some return on their otherwise idle resources For example: Highly-rated money market securities such as T-Bills *The Credit Decision - Accounts ReceivableThe Credit Decision - Accounts ReceivableFirms often don’t have a choice regarding ‘extending credit’ to their customers If the availability of credit is an important fac