4.4 working capital and liquidity Flashcards
Companies that produce physical goods go through a typical operating cycle:
- Raw materials are purchased from suppliers.
- The company converts raw materials into finished goods, which are held as inventory while waiting to be sold.
- Finished goods are sold to customers.
- The funds earned from selling inventory are used to purchase more raw materials.
The three main working capital accounts are:
accounts receivable
inventory
Accounts payable
activity ratios
Days of sales outstanding (DSO)
Days of inventory on hand (DOH)
Days of payables outstanding (DPO)
Days of sales outstanding (DSO)
The average number of days taken by customers to settle credit sales in cash.
Days of inventory on hand (DOH)
The average number of days inventory is held before being sold.
Days of payables outstanding (DPO)
The average number of days taken by the company to pay suppliers for credit sales.
cash conversion cycle
the average number of net days between when a company’s cash outflows and inflows.
DOH + DSO - DPO
All else equal, a company reduces its cash conversion cycle in the following ways:
Increase DPO
Reduce DOH
Reduce DSO
how to Increase DPO
A company can seek to obtain longer payment terms from its suppliers, but whether this can be achieved depends on the power dynamics of the relationship.
A supplier of critical inputs that sells to many other companies is unlikely to offer more generous payment terms.
A company is more likely to be successful if it commits to purchasing higher volumes from a particular supplier.
how to Reduce DOH
Discontinue products with niche demand.
Use data analytics to improve demand forecasts and adjust stock levels accordingly.
Switch to “just in time” inventory management with smaller, more frequent deliveries from suppliers.
how to Reduce DSO
Charge fees for late payments.
Tighten credit standards.
Require up-front deposits.
Accelerate installment payments. Contract with third-party collection agencies.
Offer a price reduction for cash settlement within a discount period.
total working capital
current assets minus current liabilities
adjusted net working capital
excludes cash and marketable securities from current assets and any interest-bearing debt from current liabilities.
Liquidity
refers to the ability to generate the cash required to meet short-term obligations
liquidity cost
the discount to market value that must be accepted to quickly convert it into cash
Primary sources of liquidity
Cash and marketable securities
Borrowings
Cash flow from the business
cash flow from operations (CFO) formula
CFO =
Cash received form customers
- Cash paid to employees
- Cash paid to suppliers
- Cash paid to government for tax obligations
- Cash paid to lenders for interest obligations
The amount of free cash flow available to a company’s shareholders is:
Free cash flow to equity
= CFO - Investments in long-term assets
Secondary Sources of Liquidity
Suspending or reducing dividend payments to shareholders.
Delaying or reducing capital expenditures, which helps meet short-term obligations but can lead to underperformance over the long-term.
Issuing new equity, which raises cash but dilutes the positions of existing shareholders.
Renegotiating the terms of contracts such as short-term and long-term debt, rental and lease agreements, and contracts with customers and suppliers.
Selling assets that can be liquidated relatively quickly without damaging the company’s long-term value.
Filing for bankruptcy protection and continuing to operate while the company is reorganized and debt obligations are renegotiated.
what do people interpret when using Secondary Sources of Liquidity?
often interpreted as a signal a company’s worsening financial health.
Companies prefer to avoid relying on these relatively costly sources because their existing current capital providers are disadvantaged and will expect higher rates of return
A drag on liquidity
a lag on cash inflows resulting in a shortage of available funds.
It occurs when funds are unavailable because assets are not being efficiently converted into cash.
Drags can be limited with stricter enforcement of credit and collection practices
Major drags on liquidity include:
Uncollectable receivables
Obsolete inventory
Tight credit (i.e., lenders are less willing to lend or charging higher interest rates).
A pull on liquidity
occurs when disbursements are made before cash can be generated from sales
Major pulls on payments (on liquidity) include:
Making payments early
Reduced credit limits from suppliers (i.e., suppliers tightening their credit terms)
Limits on short-term lines of credit from banks
Low liquidity positions