Week 2 Lecture FIN 429 PDF

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Role of Working Capital Management

1. Analyze the effect of working capital policies and its components on equity value within the scope of firm's daily operations 2. Assess corporate liquidity and solvency using cash based financial ratio and evaluate the impact of inventory management on the cash cycle 3. Prepare a liquidity analysis report of a company's financial position 4. Apply Net Present Value concepts to evaluate proposals that enhance shareholder value 5. Demonstrate the application of credit and payables management techniques in designing optimal working capital policies

Introduction to Working Capital Management The focus of this reading is on the short-term aspects of corporate finance activities collectively referred to as working capital management. 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, while at the same time making sure that the company’s assets are invested in the most productive way. Achieving this goal requires a balancing of concerns. Insufficient access to cash could ultimately lead to severe restructuring of a company by selling off assets, reorganization via bankruptcy proceedings, or final liquidation of the company. On the other hand, excessive investment in cash and liquid assets may not be the best use of company resources. Effective working capital management encompasses several aspects of short-term finance: maintaining adequate levels of cash, converting short-term assets (i.e., accounts receivable and inventory) into cash, and controlling outgoing payments to vendors, employees, and others. To do this successfully, companies invest short-term funds in working capital portfolios of shortdated, highly liquid securities, or they maintain credit reserves in the form of bank lines of credit or access to financing by issuing commercial paper or other money market instruments. Working capital management is a broad-based function. Effective execution requires managing and coordinating several tasks within the company, including managing short-term investments, granting credit to customers and collecting on this credit, managing inventory, and managing payables. Effective working capital management also requires reliable cash forecasts, as well as current and accurate information on transactions and bank balances.

Exhibit 1

Internal and External Factors That Affect Working Capital Needs Internal Factors Company size and growth

■ rates ■

External Factors ■Banking services ■ Interest rates

Organizational structure

■

Sophistication of working capital management

■

Borrowing and investing positions/ activities/capacities

■ New technologies and new products ■ The economy ■ Competitor

The scope of working capital management includes transactions, relations, analyses, and focus: ■

Transactions include payments for trade, financing, and investment.

■

Relations with financial institutions and trading partners must be maintained to ensure that the transactions work effectively.

■

Analyses of working capital management activities are required so that appropriate strategies can be formulated and implemented.

■

Focus requires that organizations of all sizes today must have a global viewpoint with strong emphasis on liquidity.

In this reading, we examine the different types of working capital and the management issues associated with each. We also look at methods of evaluating the effectiveness of working capital management.

1.

Assess corporate liquidity and solvency using cash based financial ratio and evaluate the impact of inventory management on the cash cycle Liquidity management refers to the ability of an organization to generate cash when and where it is needed. Liquidity refers to the resources available for an entity to tap into cash balances and to convert other assets or extend other liabilities into cash for use in keeping the entity solvent (i.e., being able to pay bills and continue in operation).For the most part, we associate liquidity with short-term assets and liabilities, yet longer-term assets can be converted into cash to provide liquidity. In addition, longer-term liabilities can also be renegotiated to reduce the drain on cash, thereby providing liquidity by preserving the limited supply of cash. Of course, the last two methods may come at a price as they tend to reduce the company’s overall financial strength. The challenges of managing liquidity include developing, implementing, and maintaining a liquidity policy. To do this effectively, a company must manage all of its key sources of liquidity efficiently. These key sources may vary from company to company, but they generally include the primary sources of liquidity, such as cash balances, and secondary sources of liquidity, such as selling assets.

Exhibit 2 Liquidity Analysis of Wal-Mart Stores

Panel A: Current and Quick Ratios, 1992–2005 Number of times 1.2 1.0 0.8 0.6 0.4 0.2

Current ratio Quick ratio

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

0.0

Panel B: Number of Days of Inventory and Number of Days of Payables Number of days of days of inventory Number of days of payables Number

70 40 30 20

2004

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

0

2003

10

Fiscal year

Sour c e :Wal-Mart Stores, Inc., 10-K filings, various years.

Comparing Wal-Mart with Target Inc. and Kohl’s in the 2005 fiscal year, as shown in Exhibit 3, we see differences among these three competitors. These differences may be explained, in part, by the different product mixes (e.g., Wal-Mart has more sales from grocery lines than the others), as well as different inventory management systems and different inventory suppliers. The different need for liquidity may also be explained, in part, by the different operating cycles of the companies.

2. Prepare a liquidity analysis report of a company's financial position Ratio

Solution:

Company

Industry

Company

Industry

Current ratio

1.9

2.5

1.1

2.3

Quick ratio

0.7

1.0

0.4

0.9

Number of days of

39.0

34.0

44.0

32.5

Number of days of inventory Number of days of payables

41.0

30.3

45.0

27.4

34.3

36.0

29.4

35.5

The ratios should be compared in two ways—over time (there would typically be more than two years’ worth of data) and against the industry averages. In all ratios shown here, the current year shows improvement over the previous year in terms of increased liquidity. In each case, however, the company remains behind the industry average in terms of liquidity. A brief snapshot such as this example could be the starting point to initiate or encourage more improvements with the goal of reaching or beating the industry standards. We can combine the number of days of inventory, number of days of receivables, and number of days of payables to get a sense of the company’s operating cycle and net operating cycle. The operating cycle is a measure of the time needed to convert raw materials into cash from a sale. It consists of the number of days of inventory and the number of days of receivables:

Operating cycle = Number of days + Number of days of inventory of receivables

The operating cycle does not take everything into account, however, because the available cash flow is increased by deferring payment to suppliers. This deferral is considered in the net operating cycle, also called the cash conversion cycle. The net operating cycle is a measure of the time from paying suppliers for materials to collecting cash from the subsequent sale of goods produced from these supplies. It consists of the operating cycle minus the number of days of payables: Net operating cycle = Number of days + Number of days − Number of days of inventory

of receivables

of payables

In general, the shorter these cycles the greater a company’s cash-generating ability and the less its need for liquid assets or outside finance. For many companies, the cash conversion cycle represents a period of time that requires financing- that is, the company offsets some of the financing need by deferring payments through payables terms, but the remainder must be financed.

Exercise 1.

RJ's has a fixed asset turnover rate of 1.26 and a total asset turnover rate of .97. Sam's has a fixed asset turnover rate of 1.31 and a total asset turnover rate of .94. Both companies have similar operations. Based on this information, RJ's must be doing which one of the following? A) B) C) D) E)

Utilizing its fixed assets more efficiently than Sam's Utilizing its total assets more efficiently than Sam's Generating $1 in sales for every $1.26 in net fixed assets Generating $1.26 in net income for every $1 in net fixed assets Maintaining the same level of current assets as Sam's

Answer: B 2. Al's has a price-earnings ratio of 18.5. Ben's also has a price-earnings ratio of 18.5. Which one of the following statements must be true if Al's has a higher PEG ratio than Ben's? A) B) C) D) E)

Al's has more net income than Ben's. Ben's is increasing its earnings at a faster rate than Al's. Al's has a higher market value per share than does Ben's. Ben's has a lower market-to-book ratio than Al's. Al's has a higher earnings growth rate than Ben's.

Answer: B 3. At the beginning of the year, Brick Makers had cash of $183, accounts receivable of $392, accounts payable of $463, and inventory of $714. At year end, cash was $167, accounts payables was $447, inventory was $682, and accounts receivable was $409. What is the amount of the net source or use of cash by working capital accounts for the year? A) B) C) D) E)

Net use of $16 cash Net use of $17 cash Net source of $17 cash Net source of $15 cash Net use of $15 cash

Answer: D Explanation: Change in NWC = ($167 + 409 + 682 − 447) − ($183 + 392 + 714 − 463) Change in NWC= −$15 A decrease in NWC is a source of cash. 4. During the year, Al's Tools decreased its accounts receivable by $160, increased its inventory by $115, and decreased its accounts payable by $70. How did these three accounts affect the sources of uses of cash by the firm? A) B) C) D) E)

Net source of cash of $120 Net source of cash of $205 Net source of cash of $45 Net use of cash of $115 Net use of cash of $25

Answer: E Explanation: Sources(uses) of cash = $160 − 115 − 70 5. Lani's generated net income of $911, depreciation expense was $47, and dividends paid were $25. Accounts payables increased by $15, accounts receivables increased by $28, inventory decreased by $14, and net fixed assets decreased by $8. There was no interest expense. What

was the net cash flow from operating activity? A) $776 B) $865 C) $959 D) $922 E) $985 Answer: C Explanation: Net cash from operating activities = $911 + 47 + 15 − 28 + 14 Net cash from operating activities = $959 6. The Floor Store had interest expense of $38,400, depreciation of $28,100, and taxes of $19,600 for the year. At the start of the year, the firm had total assets of $879,400 and current assets of $289,600. By year's end total assets had increased to $911,900 while current assets decreased to $279,300. What is the amount of the cash flow from investment activity for the year? A) B) C) D) E)

−$51,150 $21,850 $29,300 −$70,900 −$89,400

Answer: D Explanation: Cash flow from investment activity = ($879,400 − 289,600) − 28,100 − ($911,900 − 279,300) Cash flow from investment activity = −$70,900 7. Williamsburg Market is an all-equity firm that has net income of $96,200, depreciation expense of $6,300, and an increase in net working capital of $2,800. What is the amount of the net cash from operating activity? A) B) C) D) E)

$91,300 $99,700 $93,400 $105,300 $113,700

Answer: B Explanation: Net cash from operating activity = $96,200 + 6,300 − 2,800 Net cash from operating activity = $99,700 8. The accounts payable of a company changed from $136,100 to $104,300 over the course of a year. This change represents a :

A) B) C) D) E)

use of $31,800 of cash as investment activity. source of $31,800 of cash as an operating activity. source of $31,800 of cash as a financing activity. source of $31,800 of cash as an investment activity. use of $31,800 of cash as an operating activity.

Answer: E Explanation: Change in accounts payable = $104,300 − 136,100 Change in accounts payable = −$31,800 A decrease in accounts payable is a use of cash as an operating activity. 9. Uptown Men's Wear has accounts payable of $2,214, inventory of $7,950, cash of $1,263, fixed assets of $8,400, accounts receivable of $3,907, and long-term debt of $4,200. What is the value of the net working capital to total assets ratio? A) B) C) D) E)

.31 .42 .47 .51 .56

Answer: D Explanation: NWC to total assets = ($1,263 + 3,907 + 7,950 − 2,214)/($1,263 + 3,907 + 7,950 + 8,400) NWC to total assets = .51 10. The Up-Towner has sales of $913,400, costs of goods sold of $579,300, inventory of $123,900, and accounts receivable of $78,900. How many days, on average, does it take the firm to sell its inventory assuming that all sales are on credit? A) B) C) D) E)

74.19 days 84.69 days 78.07 days 96.46 days 71.01 days

Answer: C Explanation: Days' sales in inventory = 365/($579,300/$123,900) Days' sales in inventory = 78.07 days 11. Lawn Care, Inc., has sales of $367,400, costs of $183,600, depreciation of $48,600, interest of

$39,200, and a tax rate of 25 percent. The firm has total assets of $422,100, long-term debt of $102,000, net fixed assets of $264,500, and net working capital of $22,300. What is the return on equity? A) B) C) D) E)

24.26 percent 15.38 percent 38.96 percent 29.96 percent 17.06 percent

Answer: C Explanation: Net income = ($367,400 − 183,600 − 48,600 − 39,200) (1 − .25) Net income = $72,000 Current liabilities = $422,100 − 264,500 − 22,300 Current liabilities = $135,300 Total equity = $422,100 − 135,300 − 102,000 Total equity = $184,800 ROE = $72,000/$184,800 ROE = .3896, or 38.96% 12. The Green Fiddle has current liabilities of $28,000, sales of $156,900, and cost of goods sold of $62,400. The current ratio is 1.22 and the quick ratio is .71. How many days on average does it take to sell the inventory? A) B) C) D) E)

128.13 days 74.42 days 199.81 days 147.46 days 83.53 days

Answer: E Explanation: Inventory = $28,000 (1.22 − .71) Inventory = $14,280 Days' sales in inventory = 365/($62,400/$14,280) Days' sales in inventory = 83.53 days...