Working Capital Management HAPP¥ N€W ¥€AR ! Working Capital Management Advanced Corporate Finance Spring 2014 Shanghai- week7 FINC 5880

Look at the past success of Dell BTO strategy..

WC Dell

Remember WC= current assets used for operations Net WC=current assets-current liabilities Net Operating WC=Cash + AR+ Inventory-AP-Accruals Current ratio Acid test ratio WC policy; target levels and finance WC Management: setting targets, organize, lead, monitor…day to day…

Reduced WC creates value FCF will increase since delta WC decreases over time EVA increases since the total operating capital decreases and thus WACC*TOC Remember EVA=NOPAT-WACC*TOC Also ROE increases since total assets reduces Remember ROE=ROS*Sales/Total Assets*Total Assets/Equity

Cash conversion cycle Cash Purchase inventory Process goods Sell goods on credit Collect AR

Conversion calculated Inventory Conversion: Inventory/Sales per day (say 72 days) Receivables Conversion: (also DSO) Receivables/Sales per day (say 24 days) Payables Conversion: Payables/Purchases per day (note at COGS) (say 30 days) Conversion cycle=72+24-30=66 days Shorter conversion cycles create value!

Companies that pursue WCM actively Boeing Guess PepsiCo Cisco Johnson Controls Mac Donald’s Eastman Kodak

WC score cards CFO magazine calculates WC performance for main industries Check their website at www.cfo.com

Barely Working: The 2003 Working Capital Survey Maybe they were preoccupied with governance issues. But whatever the reason, U.S. companies blew some good chances last year to generate extra cash via working capital improvements. That's the primary conclusion of CFO's annual CFO's annual working capital survey, conducted by REL Consultancy Group. The survey, which examines the 1,000 largest U.S. companies, showed the average company improved its days working capital (DWC) by a meager 2.1 percent. That's a poor showing compared with previous years — for 2001 the improvement was 9 percent. It's also just a fraction of the 7.6 percent improvement recorded by European companies

WC Performance… U.S. Versus Europe A comparison of the top 1,000 companies (by sales, in $billions, for all figures) here and in Europe show European firms narrowing the gap. Despite deterioration in DPO, they improved their average DWC by 7.6 percent. Their U.S. counterparts displayed an unimpressive 2.1 percent improvement in DWC in 2002.

Zero WC General Electric.. Inventory should be financed by suppliers So force payables to this level WC=AR+ Inventory-AP these three elements are intensively managed Companies carry on average 20 cts per USD in WC The WC is turned over 5 times per year!

Cash management Reasons for holding cash: Transaction balances for day to day payments Compensating balances allowing banks to provide for costs of loans Precaution Speculation

Advantage of holding cash Benefit the discounts for paying promptly Maintain good credit ratings Take advantage of special offers/discounts on opportunity buys Meet emergencies as strikes, fires, marketing campaigns of competition, and cyclical downturns

The cash budget Forecast of Cash in versus cash out Per month, week, day Based on past experience and updated with new knowledge Focusing on a Cash target level

Inventory Supplies Raw materials WIP Finished goods Inventories should be available at the right time Ordering and carrying costs of all inventory should be minimized

Inventory control The red line method Two bin method Computerized inventory control JIT Outsourcing

Accounts Receivable Quantity: DSO Quality: aging schedule Credit policy: Credit period Discounts for early payment Credit standards (credit worthiness of customers) Collection policy (how to approach slow payers)

EOQ (Economic Order Quantity) Order Cost= D/Q*Co Holding Cost= 1/2Q*Ch Total Cost= D/Q*Co+1/2Q*Ch d(Tc/Q)=0 Then Q= (2DCo/Ch)0.5

Assignment: Working Capital Analyze the WC of your company Determine the cash cycle time and compare it to it’s main competitors If you were in charge in this company what would you do to better manage WC What is the implied value impact of your actions on the company’s value?