Working Capital

Learning outcomes Concept of working capital management Evaluating techniques for working capital Operating cycle and cash conversion cycle

Working capital Introduction Working capital management is the management of the short-term investment and financing of a company. Definition: Basic metrics used to evaluate the company's efficiency and its short-term financial health Describe primary sources of liquidity and factors that influence a company’s liquidity position. Introduction Working capital management is the management of the short-term investment and financing of a company. Cash and cash equivalents, inventory, accounts receivable, accounts payable, short-term loans, etc. The goals: Adequate cash flow for operations and the most productive use of resources. Note: Too much cash may result in the company putting too much investment in low and nonearning assets. Copyright © 2013 CFA Institute

Working capital= current asset – current liabilities Formula Working capital= current asset – current liabilities WC = CA – CL Goals Adequate cash flow for operations Most productive use of resources

Working capital Current Assets Cash Account receivable Prepaid expense Merchandise Inventory Marketable securities Current Liabilities Accounts payable Accrued expenses

Current Assets/Current Liabilities Working Capital Ratio Formula Current Assets/Current Liabilities Anything below 1 indicates negative W/C (working capital). While anything over 2 means that the company is not investing excess assets. Most believe that a ratio between 1.2 and 2.0 is sufficient

Operating Cycle Is used to measure the efficiency of working capital The operating cycle is the length of time it takes a company’s investment in inventory to be collected in cash from customers. Acquire Inventory for Cash Sell Inventory for Credit Collect on Accounts Receivable

Cash Conversion Cycle The net operating cycle (or the cash conversion cycle) is the length of time it takes for a company’s investment in inventory to generate cash, considering that some or all of the inventory is purchased using credit. Acquire Inventory for Credit Sell Inventory for Credit Collect on Accounts Receivable Pay Suppliers Evaluate working capital effectiveness of a company based on its operating and cash conversion cycles, and compare the company’s effectiveness with that of peer companies. Operating and Cash Conversion Cycles The cycle indicates the length of time that cash is invested in current assets (other than cash). The cash conversion cycle is useful when the company acquires inventory using trade credit. The length of time associated with a segment in the cycle varies among companies and industries. Copyright © 2013 CFA Institute

Cash Conversion Cycle Formula

Cash Conversion Cycle 1. Days Inventory outstanding (DIO): is the average number of days a company hold their inventory before sell Formula: DIO= 365/ inventory turnover* *inventory turnover= COGS/average inventory** **Avg. inventory= (beg.+ ending inventory)/2

Cash Conversion Cycle 2. Day sales outstanding (DSO): is the average number of days a company takes to collect revenue after sales has been made. Formula: DSO= 365/ Account receivable turnover* *A/R turnover= Sales/average A/R ** **Avg. A/R= (beg.+ ending A/R)/2

Cash Conversion Cycle 3. Days payable outstanding (DPO): is the average number of days a company takes to pay its suppliers. Formula: DPO= 365/ Account payable turnover* *A/P turnover= COGS/average A/P ** **Avg. A/P= (beg.+ ending A/P)/2

Case:

Case:

Case:

Competitor’s Scenario Item 1/31/2004 1/31/2003 Revenue 6000 COGS 7000 Inventory 1000 2000 A/R 500 400 A/P 800 900 Average inventory (1000+2000)/2 = 1500 Average A/R (400+500)/2= 450 Average A/P (800+900)/2 = 850

Competitor’s Scenario DIO = $1,500 / ($7,000/ 365) = 78.2 days DSO = $450 / ($6,000 / 365 days) = 27.3days DPO = $850 / ($7,000/ 365) = 44.3 days CCC = 78.2+27.3- 44.3= 61.26 days

Competitive Analysis Items Kohler’s company X company DIO 85 days DSO 38 days 27 days DPO 31 days 44 days CCC 92 days 61 days