Working Capital Management. This is a long reading
in the curriculum. There is a tremendous amount
of detail. You can obviously do the reading if you
have time, but what I will do in this lecture is focus
on the 7 learning objectives and emphasize the most
testable points. As you've learned in earlier readings, working capital refers to a company's current assets
and current liabilities, which are used in the regular
operations of a business. The way this reading is
organized, there are a few high-level sections that give an
overview. Section 1 is an introduction, section 2
talks about how do you manage and measure liquidity.
This is perhaps one of the most important aspects
of this reading because it gives a lot of ratios for
measuring liquidity, managing liquidity over here
is referred to at a high level. Almost all the ratios
that you will see are ratios that you have covered
in earlier readings. So this is important. We didn't
get into the specific elements. If you look at these
items - cash, short-term funds, accounts receivables.
These all are current assets on the balance sheet.
So we will talk about how to deal with each of these
balance sheet elements. Inventory also is a current asset on
the balance sheet. Then section 7 and 8 move to the
right side of the balance sheet. We talk about
how to manage accounts payable and how to manage
short-term financing. The introduction in the
curriculum is extremely good. It's just over one
page and I would strongly encourage you to read the
introduction because it sets the context very well.
Here are the main points though. Working capital management
involves managing the relationship between a firm's
short-term assets and short-term liabilities.
The goal of effective working capital management
is to ensure that a company has adequate ready
access to the funds necessary for day-to-day operating
expenses. Another way of looking at this is that
a company will have short-term obligations such
as paying bills, paying salaries and so on, the short-term
assets and liabilities need to be managed in such
a way that the short-term obligations are easily
met. Different companies will have different working
capital needs and we need to understand the factors
that impact working capital needs. This slide presents
a list of internal factors and external factors.
Let's go over the specific items: company size and
growth rates, clearly companies that are large and companies
that are growing fast will have relatively high
working capital requirements. Organizational
structure. If you compare centralized companies
versus decentralized companies, decentralised
companies will have higher working capital requirements
because with decentralized companies each business
unit or division will try to manage its working capital
whereas with a centralized organizational structure
the cash management and receivables management
and other aspects of working capital will be managed
centrally which means that relative to a decentralized
company the working capital requirement would
be lower. Sophistication of working capital management.
A company that is using a sophisticated system
such SAP to manage working capital will be able
to do a better job of keeping working capital relatively
low while still meeting its short-term obligations.
Borrowing and investing positions, activities and
capacities. A company that can borrow relatively easily, invest relatively
easily, liquidate relatively easily will have relatively
lower working capital requirements, on the other hand
a company that cannot borrow easily will try to play it
a little safe and maintain relatively high working
capital. On the right we list the external factors. Banking services,
in an economy where banking services are very well
developed the working capital needs will be relatively
low because it would be easy for companies to raise
short-term funds. Interest rates, if interest rates
are relatively high then companies will maintain
high working capital because companies would not
want to borrow at high interest rates. New technologies
and new products, which make it easier to manage
working capital would result in relatively lower
working capital. The impact of the economy on working
capital depends on the industry and on the specific
element, for example, when the economy is not doing
well companies will cut down on inventory on the
other hand companies might maintain higher cash
balances because when the economy is not doing well,
then generally liquidity is impacted and it is harder
to raise money through banks and other non-bank
sources. In a highly competitive industry working
capital requirements might be relatively high.
Coming now to managing and measuring liquidity.
Liquidity is the extent to which a company is able
to meet its short-term obligations using assets
that can be readily transformed into cash. Liquidity
management refers to the ability of an organization
to generate cash when and where needed. We need to
understand the primary sources of liquidity and the
secondary sources, here are the primary sources:
cash balance. Obviously a company can use its cash
to pay off obligations. Trade credit, this refers
to accounts payable when a company purchases from
suppliers, if it is purchasing on credit that is
a source of liquidity. Short term investment portfolio,
companies invest their money in T-bills and other
short-term investments. If a company needs money,
it is easy to liquidate the short-term Investments
and generate cash. Secondary sources of liquidity.
These are sources of liquidity that companies generally
want to avoid. Negotiating debt contracts, a company
needs to make a large debt repayment, but is having
trouble generating sufficient cash. So the company
will try to renegotiate the debt contract. Liquidating
assets. Again, this is not a favorable position
to be in, if a company has to sell off its long-term
assets in order to pay off a loan that would be a negative
sign. Filing for bankruptcy protection obviously
is a last resort. Drags and pulls on liquidity. Cash
receipts and disbursements effect a company's
liquidity position. We need to at a high-level understand
these two terms. Drag on liquidity and pull on liquidity.
We say that a company has a drag on liquidity when
the receipts lag the disbursements. For example,
if a company is slow at collecting receivables,
whereas the company is making its payments on time
then this creates a drag on liquidity because the
company is not collecting cash at a fast enough rate
compared to paying bills. Obsolete inventory again
creates a drag because the company is not selling
its inventory, but the company is still making its
regular payments. There are other examples also
but what you need to remember is drag on liquidity
means receipts lag disbursements. A pull on liquidity represents the other
scenario where disbursements are paid too quickly or trade
credit is limited. If a company is paying its suppliers
very quickly relative to getting money from customers
then we have a pull on liquidity. Reduced credit
limits also creates a pull on liquidity. This could
refer to reduced credit limits from banks. It could
also refer to suppliers who are giving very tight
credit terms. Again, there are other examples but
it's important to understand these concepts from
a testability perspective. Coming now to measuring
liquidity. Liquidity contributes to a company's
credit worthiness; credit-worthiness is the perceived
ability of the borrower to pay what is owed in a timely
manner. High creditworthiness allows a company
to obtain lower borrowing costs, obtain better
terms for trade credit, have greater flexibility
and exploit profitable opportunities. These are
fairly self-evident, a company with a high level
of creditworthiness can borrow more easily at a
lower rate. A company with high working capital and
high creditworthiness can also exploit profitable
opportunities because this company can raise money
relatively quickly in order to take advantage of
opportunities. Liquidity ratios measure a company's
ability to meet short-term obligations. And before
you go to the next slide, I want you to write down all
the liquidity ratios that you remember from earlier
readings. So here are some ratios that you should
come up with, perhaps the most important one is the
current ratio which gives the current assets divided
by the current liabilities. If you recall from
FRA, we also have other issues such as the quick
ratio and the cash ratio. The quick ratio has the
same denominator, which is the current liabilities,
but in the numerator, we do not include inventory.
Because if for a given company the inventory is obsolete
or it is not very liquid then we want a ratio that
does not include inventory. In some textbooks you will
see the quick ratio return as current assets minus
inventory and as we've discussed in FRA there are
no strict rules or formulas for ratios, you just
need to understand what ratio is being used based
on the context. We also have other ratios such as
receivables turnover and payables turnover, inventory
turnover and so on. In FRA these were categorized as activity
ratios, but over here you need to recognize that
receivables turnover, inventory turnover also
measure liquidity. A company that has high receivables
turnover is collecting money from customers relatively
fast, which is a positive sign from a liquidity
perspective. As we've seen before the receivables
turnover is the credit sales divided by average
receivables. Sometimes you might see only sales
written over here. It depends on what data you have.
But the important thing is when you are comparing
the receivables turnover across different companies,
then you need to use the same formula. The number
of days of receivables is a measure of how many days
on average it is taking to collect receivables
and that is given by 365 divided by receivables turnover.
The way the formulas are given in corporate finance
is slightly different from the way the formulas
are given in FRA but just to help you remember this
better I am using the same format that we used in
FRA because the answer will be the same regardless
of whether you use the formulas shown here or the
formulas shown in this particular reading. Inventory
turnover is a measure of how quickly a company is
selling inventory. This is given by COGS divided
by average inventory, number of days of inventory
tells you on average how many days of inventory a
company has this is given by 365 / the inventory turnover.
Payables turnover is purchases divided by average trade payables, if purchases data is not
available then you can use COGS as an approximation
for purchases. And the number of days of payables
is 365 / the payables turnover ratio. When you are doing ratio analysis you need
to cover two dimensions. First, you need to look at
whether liquidity is improving for a given company
over time. That would be time series analysis. You
should also compare the liquidity ratios of companies
with other companies in the industry or we can call them peer-
group companies, you want to see whether these ratios
are above or below the average. This concept is covered
well in example one in the curriculum, so I would
encourage you to read and do this example. Net operating
cycle. Here you need to understand the difference between
the operating cycle and the net operating cycle
and we have seen those in FRA also. The operating
cycle refers to the days of inventory plus days of
receivables. The cash conversion cycle, which is
also the net operating cycle tells you how much time
it takes between when you pay cash to when you receive
cash and to calculate the net operating cycle, you
do the following: average days of receivables + average
days of inventory - average days of payables. Let us consider a simple example, say days of payables
for a given company equals 20, days of inventory is
30 and days of receivables is 15. If a company purchases
inventory on day zero, days of inventory equal to
30 means that it will sell the product after 30 days
or on day 30 and if days of receivables is 15 then the
company actually receives cash on day 45. From 0 to
45, which is the time between when inventory was
received and inventory sold that is 45 days. Days
of inventory: 30 + days of receivable: 15 is equal
to 45. This is the operating cycle. With the net operating
cycle, we are looking at the time between when cash
is paid to suppliers till the time when cash is received
from customers. So we take the overall operating
cycle of 45 days, which is days of receivables plus
average days of inventory and then we subtract the
days of payables. So 45 - 20 is equal to 25, that's this period
over here. This is the net operating cycle or the
cash conversion cycle. If you get a question in the
exam make sure you are careful about whether or not
the term net is being used. when you see net that means
you need to subtract the average days of payables.
If you don't see net then you are simply doing days
of inventory plus days of receivables. Managing
the cash position, now we will talk about specific
elements on the balance sheet. The purpose of managing
a firm's daily cash position is to make sure there
is sufficient cash, that sufficient amount of cash is
called the target balance. A company does not want
cash balances to become negative because it is expensive
to borrow cash on short notice. Companies also do
not want high cash balances because that would
be inefficient usage of funds. Companies should recognize
the major sources of cash inflows and outflows in
order to forecast and manage cash position. Clearly
a company needs to recognize how much cash is coming
in, how much gas is going out. Only if there is a view
on cash in and cash out will a company be able to effectively
manage... will a company be able to effectively manage
its cash position. The specific inflows and outflows
will vary from company to company but at a high-level
here are the typical inflows and here are the typical
outflows. As an analyst, you can figure out the inflows and outflows
by studying the cash flow statement of a company.