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
creditworthiness
the perception of a borrower’s ability to meet debt obligations, even under adverse circumstances
top 3 liquidity ratios
current ratio
quick ratio
cash ratio
current ratio
current assets / current liabilities
quick ratio
(cash + short term marketable securities + receivables) / current liabilities
cash ratio
(cash + short term marketable securities) / current liabilities
Permanent current assets
represent the base levels of cash, inventory, and receivables needed to maintain routine operations at any point throughout the year
Variable current assets
the incremental increases above the base levels to meet additional needs during periods of peak production and sales
Conservative Approach to Working Capital Management
A conservative approach is characterized by relatively large positions for current account items to minimize the risk of disruptions and increase the ability to respond to uncertainty
This approach relies on long-term debt and equity to fund all permanent (and some variable) current assets
advantages to the Conservative Approach to Working Capital Management
Relying on long-term sources of capital reduces rollover risk
Greater certainty over financing costs and cash flows
Lower risk of inventory shortages
Greater flexibility to adapt to adverse market conditions
Companies will tend to prefer the Conservative Approach to Working Capital Management if they:
Are in the early-stage of their development with limited access to access to short-term borrowing facilities;
Are more established with higher margins and greater ability to pass the higher borrowing costs onto their customers;
Expect interest rates to either remain stable or rise;
Have a preference for cash flow stability and want to avoid rollover risk, particularly during periods of market turmoil.
disadvantages to the Conservative Approach to Working Capital Management
Higher borrowing costs (if the yield curve is upward-sloping)
Higher cost of equity and shareholder dilution
Less flexibility to borrow on an as-needed basis
Issuing long-term debt and equity requires longer lead times
Long-term debt typically imposes more covenants
Increased risk of inventory obsolescence
Aggressive Approach to Working Capital Management
An aggressive approach to working capital management maintains relatively low levels of cash, inventory, etc., and relies on short-term funding sources to finance all variable (and some permanent) current assets
Taking an aggressive approach to working capital management increases the risk of running out of inventory or cash, so companies must be confident that their sales and production forecasts can be relied on to anticipate cash flow needs with a high degree of precision.
advantages of the Aggressive Approach to Working Capital Management
Lower financing costs under a normal upward-sloping yield curve
Greater flexibility to borrow only as needed
Short-term borrowing imposes fewer covenants and involves less rigorous credit analysis
Ability to reduce borrowing costs by refinancing on short notice if interest rates fall
Firms will tend to prefer the Aggressive Approach to Working Capital Management if they:
Are seeking a cost advantage relative to their competitors in a low-margin industry;
Are able to predict their future sales volumes and cash needs more accurately;
Expect interest rates to fall;
Want to shorten their cash conversion cycle;
Have inventories that can be liquidated quickly.
disadvantages of the Aggressive Approach to Working Capital Management
Risk of having to refinance at higher short-term rates
Potential difficulty rolling over short-term debt during periods of market turmoil
Possible need to rely on relatively expensive trade credit or sell receivables to raise cash if short-term debt cannot be rolled over
Sales may suffer if customer credit terms are tightened to reduce the cash conversion cycle
Moderate Approach to Working Capital Management
Companies may seek to strike a balance between these two extremes by taking a moderate approach characterized by funding permanent working capital requirements with long-term debt and equity and relying on short-term resources to fund variable working capital needs.
Because of this balance, it is known as a “matched” approach.
Major objectives when formulating a short-term borrowing strategy include:
Maintaining diversified sources of credit that are sufficient to meet ongoing cash needs. A firm should not be dependent on a single lender.
Ensuring sufficient capacity to meet variable cash needs that change due to seasonal demand or planned expansion.
Borrowing at cost-effective rates with terms that do not unduly impair the company’s operations and anticipate changing market conditions.
Determining an overall borrowing rate that accounts for both explicit funding costs as well as implicit costs (e.g., trade credit).
A company’s short-term borrowing strategy will be influenced by the following factors:
Size
Creditworthiness
Legal considerations
Regulatory considerations
Underlying assets
Which of the following is most likely a secondary source of liquidity?
A) Bank line of credit
B) Inventory liquidation
C) Trade credit
B) Inventory liquidation
