CHAPTER 4: WORKING CAPITAL & LIQUIDITY Flashcards
Cash Conversion Cycle - Key Points
Business Operations Steps:
Acquiring raw materials
Producing inventory
Selling products to customers
Collecting cash
Operating Cycle:
Sequence of business activities
Can occur once or multiple times per year
Cash Flow Timing:
Cash outflows and inflows do not always match the timing of activities
Example: Raw materials bought on credit; payment to vendor later
Example: Finished goods sold; payment collected later
Financial Recording:
Future cash inflows: Short-term assets
Future cash outflows: Short-term liabilities
ST ASSETS & ST LIABILITIES
Short-Term ASSETS:
- Accounts Receivable: Amounts to be collected from customers for products/services sold
- Inventory: Cost of products produced or purchased for sale
Short-Term LIABILITIES:
Accounts Payable: Amounts owed to suppliers for products/services received
Recognition and Derecognition:
- Accounts Receivable:
Recognized when product/service is sold on credit
Derecognized when cash is received from customer - Inventory:
Recognized when issuer takes ownership of materials/goods/supplies
Derecognized when product is sold to customer - Accounts Payable:
Recognized when product/service is received and payment is deferred
Derecognized when cash is paid to supplier
Days Payable Outstanding (DPO):
Time taken to pay suppliers after receiving inventory
Represents cash outflow delay
Days of Inventory on Hand (DOH):
Time inventory is held before being sold
Represents the duration from receiving inventory to selling products
Days Sales Outstanding (DSO):
Time taken to collect cash from customers after selling inventory
Represents cash inflow delay
Cash Conversion Cycle (CCC):
Total time from paying suppliers to receiving cash from customers
Formula: CCC = DIO + DSO - DPO
DIO: Sell quicker
DSO: Collect faster
DPO: Negotiate longer
Indicates the efficiency of a company’s cash flow management
CCC Process Overview:
Receive Inventory from Suppliers
Cash Payment to Suppliers (after DPO period)
Inventory Sold to Customers (during DOH period)
Receive Cash from Customers (after DSO period)
CCC Visual Summary:
DPO: Time between receiving inventory and paying suppliers
DOH: Time inventory is held before sale
DSO: Time between selling inventory and receiving cash
CCC: DOH + DSO - DPO, indicating overall cash cycle duration
Cycle Duration:
Shorter cycle is better
Short cycle: Company converts inventory to cash quickly
Long cycle: Company converts inventory to cash slowly
Longer cycle increases working capital needs
Negative Cash Conversion Cycle:
Occurs when a company receives cash from customers before paying suppliers. DESIRABLE
This is based on Example 2 from the curriculum.
The following information is provided for five large US discount retailers Walmart Inc., Target
Corporation, Costco Wholesale Corporation, The TJX Companies, and Ross Stores for the 2021 calendar year.
Walmart: Target: Costco: TJX: Ross
DSO: 5:2:3:7:2
DIO: 48:68:29:63:61
DPO: 47:75:34:47:63
Which company has the shortest cash conversion cycle?
CCC= DIO+DSO-DPO
Walmart= (48+5)-47= 6
Target= (68+2)-75= -5
Costco= (29+3)-34= -2
TJX= (7+63)-47= 23
Ross= (2+61)-63= 0
Shortest= TARGET= -5
Reduce Days on Inventory on Hand:
Methods include discounting slow-moving products, implementing a ‘just in time’ inventory system, and using data analytics for better demand forecasting.
Reduce Days Sales Outstanding:
Offer prompt payment discounts to customers, apply late fees, and utilize third-party collection agencies to expedite payments.
Increase Days Payable Outstanding:
Negotiate longer payment terms with suppliers. Note that negotiation success depends on the company’s bargaining power relative to suppliers.
Supplier Discounts for Prompt Payments:
Suppliers typically offer discounts like “2/10 net 30,” meaning a 2% discount if paid within 10 days, otherwise full payment is due within 30 days.
Cost of Trade Credit Calculation:
Converting the discount to an annualized number
Cost of trade credit = (1 + discount / (1 - discount)) ^ n - 1
n= 365 / number of days beyond discount period
2/10 net 30
2/10: This means the buyer can take a 2% discount if they pay the invoice within 10 days of receiving it.
Net 30: If the discount isn’t taken, the full invoice amount is due within 30 days from the invoice date.
Example: Internal versus External Financing Decision. This is based on Example 1 from the curriculum.
A company is evaluating two options to fund its working capital needs:
Option1: Forgo the 2% discount offered by its supplier. The standard trade terms are 2/10 net 30.
Option 2: Borrow through its external line of credit. The effective annual rate for the line of credit is 7.7%
Which option should the company prefer?
Cost of Trade Credit= (1+ discount/1-discount)^n
n= 365/days beyond discount period
(1+(0.02/0.98)^365/20) - 1= 44.6%
n= 365/20 because net days= 30 & 2/10 structure
This is significantly higher than the 7.7% rate on the external credit line. Therefore, the company should prefer the credit line. It should borrow from the credit line and pay the supplier early to avail the discount
Apart from the cash conversion cycle, analysts also assess the amount of working
capital used by a company.
WORKING CAPITAL FORMULA
WORKING CAPITAL= Current Operating Assets - Current Operating Liabilities
COA (excluding cash & marketable securities)
COL (excluding ST & current debt)
COA: AR, inventory & prepaid expenses
COL: AP & accrued expenses
To compare across firms, total or net working capital is often expressed as a percentage of sales. The lower this ratio, the better.
Consider the following balance sheet for an issuer. Calculate the issuer’s net working capital.
Assets:
Cash: 100
Marketable securities: 20
Accounts receivable: 600
Inventory: 800
Prepaid expenses: 30
Property, plant, and equipment: 10,000
Intangibles: 500
Total Assets: 12,050
Liabilities and Equity:
Accounts payable: 980
Accrued expenses: 70
Short-term debt: 1,000
Long-term debt: 2,000
Shareholders’ equity: 8,000
Total Liabilities and Equity: 12,050
COA: AR, inventory & prepaid expenses
(investor’s money stuck up in the business)
COL: AP & accrued expenses: only non-interest bearing liabilities
(free money+pulling money from suppliers for your business)
COA: 600+800+30= 1430
COL: 980+70= 1050
WC: COA-COL= 1430-1050= 380
A company is evaluating two options to fund its working capital needs:
Option 1: Forgo the 2% discount offered by its supplier. The standard trade terms are 2/10 net 40.
Option 2: Borrow through its external line of credit. The effective annual rate for the line of credit is 11%.
The company would:
A prefer Option 1.
B prefer Option 2.
C would be indifferent between Options 1 and 2.
B is correct. The effective annual rate on the forgone trade credit can be calculated as:
[(1+(2/98))^(365/30)] – 1 = 27.86%
Take 2/98 first; then add one to it then ^365/30 then -1
This is significantly higher than the 11% rate on the external credit line.
Therefore, the company should prefer Option 2 i.e. the credit line.
All else equal, cash conversion cycle of a company will decrease if there is an increase in:
A Days of payables
B Days of inventory
C Days of receivables
A
A is correct. Cash conversion cycle is calculated using the following equation,
Cash conversion cycle = Days of inventory + Days of receivables – Days of payables
CCC= DIO+DSO-DPO
It will decrease if there is an increase in days of payables, all else equal.
A and B are not correct because an increase in days of inventory and days of receivables will result in an increase in cash conversion cycle.
- Liquidity
‘Liquidity’ is the extent to which a company is able to meet its short-term obligations using cash flows and those assets that can be readily transformed into cash. The liquidity of an asset can be evaluated along two dimensions:
The type of the asset
The speed at which the asset can be converted into cash (by sale or financing)
All other things constant, increase in days of payable:
A will increase the cash conversion cycle.
B has no effect on the cash conversion cycle.
C will reduce the cash conversion cycle
C.
C is correct.
Cash conversion cycle = Days of inventory + Days of receivables – Days of payables.
Hence, if all else is constant, increase in days of payable will shorten the cash conversion cycle.
Liquidity management refers to the company’s ability to generate cash when needed, at the lowest possible cost.
Two sources of liquidity for a company are:
- Primary sources of liquidity, such as cash balances
- Secondary sources of liquidity, such as selling assets
The main difference between the two is that using primary sources has no effect on a company’s ongoing operations, whereas using secondary sources may have a negative impact on a company’s ongoing operations.
LIQUIDITY VS MARKETABILITY
LIQUIDITY: CONVERTING PROPERTY INTO CASH IMMEDIATELY & AT LOWEST POSSIBLE COST
MARKETABILITY: CONVERTING PROPERTY INTO CASH
Primary Liquidity Sources
They represent the most readily accessible resources available to the company. Primary sources include:
Free cash flow: The firm’s after-tax operating cash flow less planned short- and long-term investments.
Cash and marketable securities on hand: Cash available in bank accounts or held as marketable securities that can be sold quickly without loss of value.
Borrowings: From banks, bondholders, or supplier’s trade credit. This option settles the current obligation but creates a new obligation that has to be repaid in future.
Secondary Liquidity Sources
Secondary sources include:
- Suspending or reducing dividend payments.
- Delaying or reducing capital expenditures.
- Issuing additional equity.
- Renegotiating debt contracts.
- Selling assets.
- Filing for bankruptcy protection and reorganization.
3.4 Measuring and Evaluating Liquidity
Liquidity Ratios:
Measure company’s ability to meet short-term obligations.
Commonly Used Liquidity Ratios:
Current Ratio:
Formula: Current assets ÷ Current liabilities
Interpretation: Higher number = greater liquidity.
Quick Ratio:
= Cash + Marketable Secs + Receivables/CL
= CA-Inventory-PrepaidEx/CL
Formula: (Cash + Marketable securities + Receivables) ÷ Current liabilities
Interpretation: Higher number = greater liquidity. More conservative as inventory is excluded.
Cash Ratio:
Formula: (Cash + Marketable securities) ÷ Current liabilities
Interpretation: Most conservative liquidity ratio. Good measure of ability to handle a crisis situation.
Evaluating Liquidity:
Ratios and trends over time.
Comparisons with competitors or industry.
Used to judge a firm’s liquidity position.
Example: Estimating Costs of Liquidity
A company facing a liquidity crisis has the following options to raise funds. The estimated fair value and liquidation costs for each source of funds is listed below. Net of liquidation costs, how much liquidity can the company raise if all four sources of funds are used?
Sell short-term marketable securities: Fair Value = C$10 million, Liquidation Costs = 0%
Sell select inventories and receivables: Fair Value = C$20 million, Liquidation Costs = 10%
Sell excess real estate property: Fair Value = C$50 million, Liquidation Costs = 15%
Sell a subsidiary of the firm: Fair Value = C$30 million, Liquidation Costs = 20%
To calculate the net liquidity raised:
Sell short-term marketable securities:
Fair Value = C$10 million
Liquidation Costs = 0%
Net Proceeds = C$10 million (since there are no liquidation costs)
Sell select inventories and receivables:
Fair Value = C$20 million
Liquidation Costs = 10%
Liquidation Costs Amount = 10% of C$20 million = C$2 million
Net Proceeds = C$20 million - C$2 million = C$18 million
Sell excess real estate property:
Fair Value = C$50 million
Liquidation Costs = 15%
Liquidation Costs Amount = 15% of C$50 million = C$7.5 million
Net Proceeds = C$50 million - C$7.5 million = C$42.5 million
Sell a subsidiary of the firm:
Fair Value = C$30 million
Liquidation Costs = 20%
Liquidation Costs Amount = 20% of C$30 million = C$6 million
Net Proceeds = C$30 million - C$6 million = C$24 million
Adding up the net proceeds from all sources:
C$10 million + C$18 million + C$42.5 million + C$24 million = C$94.5 million
Therefore, the company can raise C$94.5 million net of liquidation costs.
3.3 Factors Affecting Liquidity: Drags and Pulls
A company’s liquidity position is affected by cash receipts and the amount of cash it has to pay.
‘Drags on liquidity’ reduce cash inflows. For example, uncollected receivables, obsolete inventory, tight credit etc.
‘Pulls on liquidity’ accelerate cash outflows. For example, earlier payment of vendor dues, reduced credit limits (by suppliers), limits on short-term lines of credit (by banks) etc.
CURRENT RATIO
QUICK RATIO
CASH RATIO
CuR= CA/CL
QR= CA-INV/CL= CA-Inv-PrepaidEx/CL
CaR= CA-AR-Inv/CL
QR= gets rid of inventory
CaR= gets ride of AR & inventory
Working Capital Management
Determining Working Capital:
- Identify optimal levels of inventory, receivables, and payables based on sales.
- Project these assumptions into the future.
Financing Working Capital:
Determine the optimal mix of short-term and long-term financing.
Approaches to Working Capital Management:
CONSERVATIVE APPROACH
Conservative Approach:
Holds a larger position in current assets (cash, receivables, inventories).
Provides financial flexibility but results in lower return on equity.
Finances most current assets (permanent and variable) with long-term debt or equity
Approaches to Working Capital Management:
MODERATE APPROACH
Moderate Approach:
Holds a position in current assets between conservative and aggressive.
Matches duration of current assets with liabilities.
Finances permanent current assets with long-term debt and equity; finances variable current assets with short-term debt and payables.
Approaches to Working Capital Management:
AGGRESSIVE APPROACH
Aggressive Approach:
Holds a smaller position in current assets.
Reduces financial flexibility but results in higher return on equity.
Finances most current assets (permanent and variable) with short-term debt or payables.
Permanent & Variable CAs
Permanent Current Assets: Constant throughout the year.
Variable Current Assets: Vary based on business seasonality, increasing during peak production periods.
Conservative Approach: Pros & Cons
Pros:
Stable, permanent financing avoids rollover risk.
Financing costs are known upfront.
Certainty of working capital for inventory purchases.
Extended payment terms reduce short-term cash needs.
Higher flexibility during market disruptions.
Cons:
Long-term debt typically has a higher interest rate.
High cost of equity.
Permanent financing increases ongoing financing costs.
Longer lead time to establish financing.
Long-term debt may require restrictive covenants.
Moderate Approach: Pros & Cons
Pros:
Lower financing cost versus conservative approach; lower risk than aggressive approach.
Flexibility to increase financing for seasonal spikes while maintaining a base level.
Diversifies funding sources and promotes disciplined balance sheet management.
Cons:
Access to short-term capital may be limited for seasonal or growth needs.
Uncertain cost of short-term debt during market disruptions.
May need to rely on costly trade credit if unable to refinance at favorable terms.
Aggressive Approach: Pros & Cons
Pros:
Higher return on equity due to lower current asset holdings.
Short-term financing generally has lower interest rates.
Greater leverage can amplify profits during favorable conditions.
Cons:
Reduced financial flexibility due to smaller current asset holdings.
Higher risk of liquidity issues.
Increased dependence on short-term debt can lead to rollover risk and higher refinancing costs.
Greater exposure to interest rate fluctuations.
Liquidity and Short-Term Funding:
Objectives of Short-Term Financing:
- Ensure capacity to handle peak cash needs.
- Maintain diversified and sufficient credit sources.
- Achieve cost-effective financing rates.
- Consider both implicit and explicit funding costs.
Factors Influencing Short-Term Borrowing Strategies:
- Size: Larger companies have more and cheaper borrowing options compared to smaller ones.
- Creditworthiness: Determines access to and cost of borrowing.
- Legal and Regulatory Considerations: Industry-specific constraints on borrowing terms.
- Underlying Assets: Some companies can leverage attractive assets as collateral for secured loans.
LO. Explain the cash conversion cycle and compare issuers’ cash conversion cycles
A company’s cash conversion cycle is the amount of time between an issuer paying its suppliers and
receiving cash from customers.
Cash conversion cycle = Days of inventory on hand + Days sales outstanding - Days payable outstanding.
Companies can shorten their cash conversion cycle in several ways:
- Reduce days on inventory on hand by discounting products with low demand, using a ‘just in time’ inventory system, using data analytics to improve demand forecasts.
- Reduce days sales outstanding by offering prompt payment discounts to customers, imposing late fees, working with third party collection agencies.
- Increase days payable outstanding by negotiating longer payment terms with suppliers
LO. Explain liquidity and compare issuers’ liquidity levels
‘Liquidity’ is the extent to which a company is able to meet its short term obligations using cash flows and those assets that can be readily transformed into cash.
The three commonly used liquidity ratios are:
- CURRENT RATIO: Current Assets/Current Liabilites: A higher number implies greater liquidity.
- QUICK RATIO: Cash + Marketable Secs + Receivables/Current Liabilities: A higher number implies greater liquidity. More conservative than current ratio as inventory is excluded.
- CASH RATIO: Cash + Marketable Secs/Current Liabilities: This is the most conservative liquidity ratio and a good measure of a company’s ability to handle a crisis situation.
LO. Describe issuers’ objectives and compare methods for managing working capital and liquidity
Issuers can take a conservative, moderate, or aggressive approach to working capital management. These approaches differ in the amount of working capital held on the balance sheet, their reliance on external financing, and the composition of short and long term financing.
Companies seek to implement a short term financing strategy that will help achieve the following objectives:
- Ensure sufficient capacity to handle peak cash needs.
- Maintain sufficient and diversified sources of credit.
- Ensure rates are cost effective.
- Ensure both implicit and explicit funding costs are considered.
Which of the following working capital management approaches requires the company to hold a larger position in cash, receivables, and inventories relative to sales?
A Aggressive approach
B Moderate approach
C Conservative approach
C is correct. In a conservative approach, the firm holds a larger position in current assets (cash, receivables, and inventories).
In an aggressive approach, the firm holds a substantially smaller position in current assets.
In a moderate approach, the firm holds a position in current assets that is somewhere between the two above mentioned approaches.
Which of the following is an example of secondary source of liquidity?
A trade credit
B lines of credit from banks
C negotiating debt agreements
C is correct.
A and B are primary sources of liquidity. Two sources of liquidity for a company are:
- Primary sources: Cash sources used in day-to-day operations. For example, cash balances, trade credit, lines of credit from banks, etc.
- Secondary sources: For example, liquidating assets, filing for bankruptcy, negotiating debt agreements, etc.
The main difference between the two is that using primary sources has no effect on the operations of a company while using secondary sources may negatively impact a company’s financial position.
Which of the following is most likely a drag on liquidity?
A Obsolete inventory
B Earlier payment of vendor dues
C Reduced credit
A is correct. A drag on liquidity is when cash inflows lag, resulting in pressure from the decreased available funds. Bad debts and uncollected receivables are other examples of drags on liquidity.
B and C are incorrect because they are pulls on liquidity. A pull on liquidity is when cash outflows are accelerated because disbursements are paid too quickly or trade credit availability is limited.
The Neon has accounts payable of €1.5 million with terms of 2/10, net 40. Accounts receivable stands at €2 million.
The company also has €3 million in marketable securities. Neon has a short-term need of €300,000 to meet working capital requirements.
Which of the following options appears to be most suitable for raising the €300,000?
A The company should delay paying accounts payable and forgo the 2% discount.
B The company should sell some of its marketable securities at a 0.5% brokerage cost.
C The company should sell some of its accounts receivable to a factor at a 10% discount.
1+(d/1-d)^n - 1
1+(0.02/0.98)^365/30 - 1
1.0204^12.16 -1
1.2783-1= 27.83%
B is correct. The options available for raising €300,000 are summarised below:
- AP: 2/10, net 40: Delay payment of 300,000 & forego 2% discount: liquidation cost: 2% i.e. 6000
- Marketable Secs: Sell 300,000 in value; liquidation cost: 0.5% i.e. 1500
- AR: Sell 333,333 in value at 10% discount to raise 300,000; liquidation cost: 10% i.e. 333,333
Sale of marketable secs is the LEAST COSTLY option for meeting the working capital requirements of 300,000.
Marketable secs are liquid instruments & can be easily sold for market value less than the brokerage cost.
