Chapter 09 {Final Energy Financial Management}.Doc

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Chapter - 9

Working capital management

9.1 IntroductionWorking capital management involves the relationship between a firm's short-term

assets and its short-term liabilities. The goal of working capital management is toensure that a firm is able to continue its operations and that it has sufficient abilityto satisfy both maturing short-term debt and upcoming operational expenses. Themanagement of working capital involves managing inventories, accounts receivableand payable, and cash.

Working capital is current assets (cash, receivables, inventory, etc.) minus currentliabilities (debt obligations due within one year). Working capital may also beviewed as the amount of a business's current assets provided (financed) by long-term debt and/or equity.

If, for example, a business has no current liabilities, working capital equals currentassets. In the situation just described, 100% of current assets are provided(financed) through long-term debt and/or equity. If, in contrast, a business hasexactly $0 working capital, current assets equals current liabilities. Or, in otherwords, 100% of current assets are provided (financed) with short- term debt(current liabilities).

A business that has no working capital or very little working capital will likely havedifficulty in paying short-term debt obligations from operational sources of cash insustained or sudden declines in sales. Therefore, the importance of maintaining anappropriate level of working capital and its contribution to business survival is a

concept that small business managers should understand. Managers should developa working capital philosophy that they can apply and monitor carefully.

Working capital (also known as net working capital) is a financial metric which

represents the amount of day-by-day operating liquidity available to a business.

Along with fixed assets such as plant and equipment, working capital is considered a

part of operating capital. It is calculated as current assets minus current liabilities.

A company can be endowed with assets and profitability, but short of liquidity, if

these assets cannot readily be converted into cash.

Current assets and current liabilities include three accounts which are of special

importance. These accounts represent the areas of the business where managers

have the most direct impact:

accounts receivable (current asset)

inventory (current assets), and


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accounts payable (current liability)

In a situation where a company carries more cash than the minimum amount

needed to maintain operations, the excess portion is usually excluded from working

capital.

In addition, the current (payable within 12 months) portion of debt is critical,

because it represents a short-term claim to current assets. Common types of short-

term debt are bank loans and lines of credit.

A positive change in working capital indicates that the business has either increased

current assets (that is received cash, or other current assets) or has decreased

current liabilities, for example has paid off some short-term creditors.

Implications on M&A: The common commercial definition of working capital for

the purpose of a working capital adjustment in an M&A transaction (ie for aworking capital adjustment mechanism in a sale and purchase agreement) is equal

to:

Current Assets - Current Liabilities excluding deferred tax assets/liabilities, excess

cash, surplus assets and/or deposit balances.

Cash balance items often attract a one-for-one purchase price adjustment.

9.2 Working capital management

Decisions relating to working capital and short term financing are referred to as

working capital management. These involve managing the relationship between a

firm's short-term assets and its short-term liabilities. The goal of Working capital

management is to ensure that the firm is able to continue its operations and that it

has sufficient cash flow to satisfy both maturing short-term debt and upcoming

operational expenses.

Decision criteria

By definition, Working capital management entails short term decisions - generally,relating to the next one year period - which are "reversible". These decisions are

therefore not taken on the same basis as Capital Investment Decisions (NPV or

related, as above) rather they will be based on cash flows and / or profitability.

One measure of cash flow is provided by the cash conversion cycle - the net number

of days from the outlay of cash for raw material to receiving payment from the


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customer. As a management tool, this metric makes explicit the inter-relatedness of

decisions relating to inventories, accounts receivable and payable, and cash. Because

this number effectively corresponds to the time that the firm's cash is tied up in

operations and unavailable for other activities, management generally aims at a low

net count.

In this context, the most useful measure of profitability is Return on capital (ROC).

The result is shown as a percentage, determined by dividing relevant income for the

12 months by capital employed; Return on equity (ROE) shows this result for the

firm's shareholders. Firm value is enhanced when, and if, the return on capital,

which results from working capital management, exceeds the cost of capital, which

results from capital investment decisions as above. ROC measures are therefore

useful as a management tool, in that they link short-term policy with long-term

decision making. See Economic value added (EVA).

Management of working capital

Guided by the above criteria, management will use a combination of policies and

techniques for the management of working capital. These policies aim at managing

thecurrent assets (generally cash and cash equivalents, inventories and debtors) and

the short term financing, such that cash flows and returns are acceptable.

Cash management. Identify the cash balance which allows for the business to meet

day to day expenses, but reduces cash holding costs.

Inventory management. Identify the level of inventory which allows for

uninterrupted production but reduces the investment in raw materials - and

minimizes reordering costs - and hence increases cash flow; see Supply chain

management; Just In Time (JIT); Economic order quantity (EOQ); Economic

production quantity (EPQ).

Debtors management. Identify the appropriate credit policy, i.e. credit terms which

will attract customers, such that any impact on cash flows and the cash conversion

cycle will be offset by increased revenue and hence Return on Capital (or vice

versa); see Discounts and allowances.

Short term financing. Identify the appropriate source of financing, given the cash

conversion cycle: the inventory is ideally financed by credit granted by the supplier;


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however, it may be necessary to utilize a bank loan (or overdraft), or to "convert

debtors to cash" through "factoring".

Many organizations that are profitable on paper are forced to cease trading due toan inability to meet short-term debts when they fall due. In order to remain in

business it is essential that an organization successfully manages its working capital.Too often however, this is an area which is ignored. This article will look at theitems which comprise working capital, and using live examples will consider thelevel of working capital required by businesses operating in different industries. Wewill also look at the problems faced by small businesses before reviewing some of theways in which an organization can improve its management of working capital.

9.3 What is working capital?

The definition of working capital is fairly simple, it is the difference between anorganizations current assets and its current liabilities. Of more importance is itsfunction which is primarily to support the day-to-day financial operations of anorganization, including the purchase of stock, the payment of salaries, wages andother business expenses, and the financing of credit sales.

As the cycle indicates, working capital comprises a number of different items and itsmanagement is difficult since these are often linked. Hence altering one item mayimpact adversely upon other areas of the business. For example, a reduction in thelevel of stock will see a fall in storage costs and reduce the danger of goods becomingobsolete. It will also reduce the level of resources that an organization has tied up instock. However, such an action may damage an organizations relationship with itscustomers as they are forced to wait for new stock to be delivered, or worse still mayresult in lost sales as customers go elsewhere.

Extending the credit period might attract new customers and lead to an increase inturnover. However, in order to finance this new credit facility an organization mightrequire a bank overdraft. This might result in the profit arising from additionalsales actually being less than the cost of the overdraft.

Management must ensure that a business has sufficient working capital. Too littlewill result in cash flow problems highlighted by an organization exceeding its agreedoverdraft limit, failing to pay suppliers on time, and being unable to claim discountsfor prompt payment. In the long run, a business with insufficient working capital

will be unable to meet its current obligations and will be forced to cease tradingeven if it remains profitable on paper.

On the other hand, if an organization ties up too much of its resources in workingcapital it will earn a lower than expected rate of return on capital employed. Againthis is not a desirable situation.


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9.4 The working capital cycle

The working capital cycle starts when stock is purchased on credit from suppliersand is sold for cash and credit. When cash is received from debtors it is used to paysuppliers, wages and any other expenses. In general a business will want to minimize

the length of its working capital cycle thereby reducing its exposure to liquidityproblems. Obviously, the longer that a business holds its stock and the longer ittakes for cash to be collected from credit sales, the greater cash flow difficulties anorganization will face.

In managing its working capital a business must therefore consider the followingquestion. 'If goods are received into stock today, on average how long does it takebefore those goods are sold and the cash received and profit realized from that sale?'The answer will depend upon a number of factors that we will consider later in thisarticle. For now we will turn our attention to calculating the length of a business'sworking capital cycle.

Dublin Ltd has provided the following information based upon the year to 31January 1999.

Credit sales 1,200,000

Credit purchases 650,000

Average stock 80,000

Average debtors 200,000

Average creditors 54,000

With the help of a few simple ratios we can calculate the length of Dublin's workingcapital cycle as follows:

We can use the stock days ratio to calculate the average length of time that goodsremain in stock:

Average stock *365 days = 80,000*365 = 45 days

Credit purchases 650,000

The average time taken by Dublin Ltd to pay suppliers may be calculated asfollows:

Average creditors *365 days = 54,000*365 = 31 days


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William Miller has recently started a business producing pine dining furniture. Thefurniture is produced by himself and two employees and is then sold to a nationalchain of furniture retailers. The retail chain insists on a two month credit period.However, since the business is new, suppliers require immediate payment for rawmaterials. Wages and other expenses are paid as incurred. At the end of each

month, Miller has no stock remaining. The opening in cash balance in January was1,000.

Miller has provided the following forecast figures from which he would like you toconstruct a cash budget and profit and loss account.

Sales Purchases of Wages and

raw materials other expenses

Jan 10,000 5,000 3,000

Feb 10,000 5,000 3,000

Mar 20,000 10,000 4,500

Apr 30,000 15,000 6,000

Table 1 contains the forecast cash budget, profit and loss account and summary ofworking capital for the business and illustrates the problems faced by many smallbusinesses. The forecast profit and loss account shows that William Miller isrunning a profitable business (18,500 profit during the four months), with monthlysales increasing threefold during the period under review. However, due to thecredit terms offered to his customers, and the payment terms required by his

suppliers, Miller has severe cash flow problems highlighted by the cash deficit of30,500 at 30 April. Consequently the business has a weak working capital position,with net current liabilities of 18,500.

For small businesses that are starting up or expanding, the problems faced byWilliam Miller are not uncommon. As sales increase, businesses are required toacquire more raw materials to produce enough goods to meet the increase indemand, whilst workers are required to work longer hours necessitating thepayment of overtime wages. However, the cash from credit sales may not bereceived for several weeks, whilst suppliers and employees require immediatepayment. In this situation a business is heavily dependent upon its bank overdraft

and loans. In the long term, if the business survives, the problem will be reducedthrough negotiating better credit terms with customers and suppliers.

Table 1

Cash budget for the four months to 30 April

Jan Feb Mar Apr


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Opening cash balance 1,000 (7,000) (15,000) (19,500)

Cash receipts

Sales (2 month lag) 0 0 10,000 10,000

Cash paymentsPurchases of raw materials 5,000 5,000 10,000 15,000

Other expenses 3,000 3,000 4,500 6,000

Total8,000 8,000 14,500 21,000

Closing cash balance (7,000) (15,000) (19,500) (30,500)

Forecast profit and loss account forthe four months to 30 April

Sales 70,000

Less: cost of sales 35,000

Gross profit35,000

Less: other expenses 16,500

Net profit

18,500

Extract from balance sheet at 30 April

Current assets

Debtors (20,000 + 30,000) 50,000

Current liabilities

Bank overdraft 30,500

9.6 The optimum level of working capital

As a guide many text books suggest that to be safe an organisation requires a 2:1ratio of current assets to current liabilities. That is for every 1 of current liabilities,2 of current assets is required to ensure that the organisation does not run intocash flow problems. However, this is much too simplistic, and the required level ofworking capital will vary from industry to industry. We can illustrate this pointwith reference to Table 2 which shows a breakdown of the working capital for three


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public limited companies (plc) operating in different industrial sectors. The figuresare taken from recently published annual reports.

Table 2: Comparison of working capital by industry

Tesco

y/e

Airtours

y/e

Man Utd

y/e

28/2/98 30/9/98 31/7/97

m m 000s

Current assets

Stock 584 17.0 3,565

Debtors 133 413.8 10,731

Short terms investments 196 11.1 22,400

Cash at bank and in hand 29 364.2 23,244

942 806.1 59,940

Creditors: amounts falling due withinone year

2,712 802.0 29,468

Working capital1,770 4.1 30,472

Profit on ordinary activities beforetaxation

832 140.3 27,577

Current ratio 0.35 1.01 2.03

Acid test 0.13 0.98 1.91

Cash to current liabilities 0.01 0.45 0.79

Each of our plcs is profitable and is considered successful in its field. However, it isapparent from Table 2 that only Manchester United plc meets the 'suggested'

current ratio of 2:1. Indeed Tesco appears to be in real trouble with only 35 pence ofcurrent assets and 13 pence of 'quick' assets for every 1 of current liabilities.Worse still, if we consider the ratio of cash to current liabilities, Tesco has only onepence of cash coverage for every 1 of current liabilities suggesting severe liquidityproblems. Yet Tesco is the largest supermarket chain in the UK with over 600 storesand an annual profit on ordinary activities before taxation in excess of 800 million.


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from customers for holidays. Whilst creditors compromise amounts owing foraccommodation and advance payments made by customers.

We can see from Table 2 that like Tesco, Airtours can operate with a lower currentratio than the suggested 2:1, however due to the seasonal nature of its business,

sound budgeting and forecasting is essential to ensure that liabilities can be meteven during the close season.

Turning to Manchester United we can see little evidence of any working capitalproblems at 31 July 1997, with the company having a current ratio of 2:1. Inaddition the company has 79 pence of cash for every 1 of current liabilities. This isnot surprising if we consider the nature of Manchester United's business. During theperiod August to May cash flow is not likely to be a problem since almost everyweek over 50,000 fans will crowd into Old Trafford to watch their team play. Manyof these fans pay for their seats in advance, purchasing a season ticket before theseason commences. In addition the club will receive cash from sponsors, television

companies and the sale of merchandise. However, as with Airtours, business isseasonal and careful planning is necessary to ensure that all liabilities are met asthey fall due.

A review of the club's working capital at 31 July shows that stock and debtors arerelatively small, with the majority of working capital comprising short-terminvestments and cash, reflecting the cash received from season ticket sales.

From our review of Table 2 we can see that the optimum level of working capitalwill vary depending upon the industry in which an organization operates and thenature of its transactions.

9.7 Managing working capital

Having discussed what comprises working capital, let us now consider some of themethods that can be employed to assist in its management. We will review each ofthe key elements that comprise working capital in turn.

(a) Stock

The cost of holding stock is relatively easy to measure and will include:

storage; security; losses due to theft, obsolescence, and goods perishing.

For example, consider a retail outlet selling home computers. Three years ago itacquired fifty state of the art PCs at a cost of 1,000 each. At the time eachcomputer could be sold for 1,300 resulting in a profit of 300 per machine.Unfortunately today fifteen of these models remain in stock. Not only are they


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taking up valuable space, but due to rapid advances in technology they can only besold for 300 each. If this outdated stock is sold, the overall position on thistransaction is:

Sales of 35 computers at 1,300 each 45,500

Sale of 15 computers at 300 each 4,500

Total sales revenue50,000

Cost of sales (50 computers at 1,000 each) (50,000)

Profit'

-

When we take into account administration and storage costs this transaction willactually result in a loss to the organization.

We can therefore see the importance of not holding excessive levels of stock.

What is less easy to quantify is the cost of not holding sufficient levels of stock tomeet the demand from customers. For example, if an organization has insufficientstock to meet demand, it will initially result in lost sales. In the longer term it mayalso damage a business's goodwill, with long-standing customers turning to other,

more reliable suppliers.

For most organizations the difficulty is determining the optimum level of stock. Thiswill depend upon a number of factors including:

the average level of daily sales (adjusted for seasonal variations); the lead time between ordering goods and their delivery; the reliability of suppliers; the type of good and the danger of their perishing or becoming obsolete; the cost of re-ordering stock; storage and security costs;

other factors such as rumors of a shortage or an increase in price.

It is essential that systems are in place to ensure that stock levels are reviewedregularly and where necessary appropriate action taken.

(b) Debtors


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Too often, especially during their start-up period, businesses concentrate ongenerating sales and pay little attention to the collection of money from debtors. Asa result although sales exist on paper, the cash generated by these sales takes toolong to materialize and cash flow problems occur (as our William Miller exampleillustrates). Additionally, the longer a debt is outstanding the greater the likelihood

it will become bad.

With this in mind an effective credit control policy is necessary. This should includethe following:

Before allowing credit, an organization should check the credit rating ofpotential customers, where necessary seeking references from a third party.Often this will involve using the services of a credit agency such as Dunn andBradstreet.

Based upon the results of a credit check, credit limits can be set. Once thecredit limit is reached it cannot be exceeded without the authorization of

senior management. Credit customers should be informed in writing of the normal credit period

(for example 30 days after the invoice date). A small cash discount is often used as an incentive to encourage early

payment by debtors. For example, many firms offer a discount of 2.5% of theinvoice value for payment within seven working days of the invoice date.

It is essential that an organization maintains accurate records detailing alltransactions with customers and the amounts owing. An aged debtors' listdetailing the length of time that a debt has been owing is useful since ithighlights those debts which management needs to concentrate on.

An organization should issue regular statements (normally monthly), and

where necessary these should be followed up with reminders and phonecalls/letters.

Effective credit control will ensure that disputes are settled quickly withoutdamaging the relationship with a customer, whilst at the same time reducing theoccurrence of bad debts. However, such a system is often expensive and timeconsuming to set up, hence many organizations, especially those which have onlyrecently commenced trading, utilizes debt factoring.

Debt factoring involves an organization passing responsibility for the managementand collection of its trade debtors to a third party. The organization 'sells' itsinvoices to a factor company and in return the factor immediately advances cashequal to between 50 and 85% of the total invoice value. The balance of the invoicevalue, less a charge for the factoring service, is paid when the debts are collected. Inaddition the factor is responsible for the administration of an organizationsdebtors, and can offer protection against bad debts.

The advantage of factoring is that it enables an organization to concentrate upongenerating sales and leaves the collection of cash to a third party. Most importantly


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it reduces the cash flow problems often experienced by new businesses by givingaccess to cash immediately rather than having to wait 30 or more days. Again ourWilliam Miller example highlights the problems experienced by small businesses,factoring would immediately solve Miller's cash flow problem. However, factoring isexpensive and in the long term it may be cheaper for an organization to establish its

own debtor management systems.

Invoice discounting is becoming increasingly common. Like debt factoring thebusiness immediately receives cash representing a proportion of the total invoicevalue. Unlike debt factoring the business retains responsibility for the managementof its credit control system.

When deciding the credit period offered to customers an organization must considerseveral factors. A longer credit period (for example 45 days compared to 30 daysoffered by competitors) may generate additional sales; however these must becompared against the additional costs incurred by the business. These costs might

include an increase in bad debts, higher administration costs and bank overdraftcharges. If the profits arising from the additional credit period are less than thecosts incurred, the credit period should be reviewed.

(c) Trade creditors

The practice of businesses extending trade credit to one another is probably themost important source of short-term funding available to most organizations. Atfirst glance trade credit appears to represent a short-term interest free loan whichenables a higher level of trade than if everything was paid for immediately in cash.

However, if we take a closer look at trade credit we can see that there are costsassociated with it. Most suppliers offer customers a discount for early payment.Thus a supplier might allow 30 days credit on all sales. However, in order toencourage early settlement of debts, customers paying within seven days are offereda cash discount equating to 2.5% of the invoice total. On an invoice of 10,000(excluding VAT) this would equate to a saving of 250 (10,000*2.5%).

Even if an organization has an overdraft it may still be beneficial to take advantageof a cash discount. For example, Alanis purchases 5,000 of goods from Celine.Celine offers all customers the option of either 30 days' credit or a 1.5% discount ifcash is received within 5 days. If Alanis takes the cash discount she will incur anoverdraft on which interest is charged at 20% per annum. Is the cash discountbeneficial to Alanis?

If Alanis takes the cash discount she will save:

5,000*1.5% = 75

However, she will incur an overdraft for 25 days (30 ' 5 days) which will cost:


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5,000*[20%*25/365] = 68.49

In this example Alanis will benefit by 6.51 if she pays the invoice within five days.

Another cost of trade credit, which is often ignored, is its impact upon the

creditworthiness of a business. If a business consistently exceeds the credit periodimposed by suppliers, in the long term its credit rating will be damaged. In theworst case scenario, suppliers will be forced to take legal action and may evenwithdraw their credit facility, requiring cash on delivery.

Whilst trade credit is undoubtedly a useful facility, it is important that businesses donot become too dependent upon it.

(d) Cash and bank balances

Liquidity problems often arise because inflows and outflows of cash do not coincide.

For example, a small tour operator is likely to find itself awash with cash fromJanuary to June as customers book and pay for their summer holidays. Whilst fromJuly to December sales and hence cash balances will be lower. However, businessexpenses such as wages and salaries, heat and light, rent and rates, and loan interestwill remain more or less the same throughout the year. It is therefore essential thatbusinesses plan ahead to ensure that sufficient cash is available to meet expenses inthe off-peak period.

As demonstrated in Table 1, the preparation of a cash budget will indicate the flowof receipts and payments in and out of the business and will forecast periods ofsurplus and deficit cash balances thereby reducing the level of uncertainty. If a large

surplus is forecast, cash can be invested in an interest earning account until it isrequired. If a deficit is forecast, our business can arrange a bank overdraft or loan.However, wherever possible overdrafts and loans should be avoided due to theirhigh cost

During the course of this article we have looked at the items which make upworking capital and considered how organisations can improve their managementof working capital. We have seen that the ideal level of working capital is difficult tocalculate and will vary from one organisation to another depending upon theindustry in which they operate. What is essential is that a business avoids both thesituation of too little or too much working capital.

Too little working capital is known as over-trading, and is common when a businessis starting up or is experiencing a period of rapid growth. As we saw in our WillamMiller example, the level of sales might grow very quickly, but inadequate workingcapital is available to support this growth. The situation will then arise whereby abusiness may be profitable on paper but has insufficient funds available to pay debtsas they become due. In the short term this situation can be solved through acombination of measures including:


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obtaining an increased overdraft facility; negotiating a longer credit period with suppliers; Encouraging debtors to pay faster.

However, in the long term a business is unlikely to survive without a combination

of:

new capital from shareholders/proprietor; better control of working capital; the building up of an adequate capital base through retained profits.

Almost as bad is too much working capital or over-capitalization. Poor managementof working capital will result in excessive amounts tied up in current assets. Such ascenario will lead to a business earning a lower than expected return.

It must be remembered that the shorter an organizations working capital cycle, the

faster cash, and hence profits, from credit sales will be realized. In order to achievethis an organization must regularly review its working capital, taking action wherenecessary.

9.8 How Do You Calculate A Company's "Incremental Net WorkingCapital" Needs?

Incremental investment in net working capital is another important value driver ina calculation of shareholder value. This session focuses on where to find the data,how to calculate historical working capital trends and how to project futureworking capital needs. As with previous sessions, we will use Gateway, Inc., as of

April 21, 2000, as a case study. What Does "Net Working Capital" Mean?

To understand what we mean by "net working capital," let's break this phrasedown into its component parts:

Net. This means we look at cash tied up in short term operating assets suchas accounts receivable and inventory, offset by non-interest bearing currentliabilities such as accounts payable.

Working. This means that we want to focus on cash tied up in short termoperating assets. Thus, working capital excludes long term capital requiredfor, say, investment in Plant, Property and Equipment (PP&E).

Capital. This means that we want to calculate the amount of cash that acompany has to tie up in working capital in order to run its business.

More specifically, for industrial companies, "net working capital" equals cash tied up by a company's short term operating assets, netted against short term operating

liabilities.


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For any year, then, we add and subtract the following to calculate a company's networking capital:

1. Required cash. We usually assume that a company needs to have some cashon hand to run its business. We can estimate that sum as a fixed amount of

cash, or an amount as a percentage of sales. Thus, we add required cash tocalculate working capital.2. Accounts receivable (A/R). Accounts Receivable equals money owed to a

company for goods or services purchased on credit. As A/R grow, then, acompany needs to tie up cash in its business as it effectively lends this moneyout. Thus, weadd accounts receivable to calculate working capital.

3. Inventory. Any company selling a physical product will have to tie up cash inraw materials, work-in-progress and finished goods inventory. Thus, we addinventory to calculate working capital.

4. Other current assets. A company may have to tie up cash in other currentassets, such as insurance pre-payments. Thus, we add other current assets to

calculate working capital.5. Accounts payable. Accounts Payable equal bills from suppliers for goods orservices purchased on credit. A company benefits from accounts payable justlike consumers benefit from a charge card: you enjoy the merchandise now,and pay later. Thus, we subtract accounts payable to calculate workingcapital.

6. Deferred or Unearned Revenue. Some companies get paid in cash by theircustomers before those companies deliver a promised product or service. Asan example, you may have purchased a warranty for a product, whereby yougave a company cash in advance for a promised service: the ability to havethat product replaced or fixed in the event it became defective. Until thewarranty ends, the company has the obligation to provide this service to you,so it must recognize this cash received as a liability. Thus, we subtractdeferred revenue to calculate working capital.

7. Other non-interest bearing current liabilities. Various companies may haveassorted non-interest bearing current liabilities such as accrued wages,accrued expenses, accrued royalties, or "other accrued liabilities." Thesenon-interest bearing current liabilities generate cash as they increase. Thus,we subtract other non-interest bearing current liabilities to calculate workingcapital.

Case Study: Gateway, Inc., as of April 21, 2000

To calculate Gateway's net working capital, we first need to obtain the seven datapoints described above from the company's historical SEC filings.


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Required cash

(2% of sales) 74 101 126 149 173

A/R 405 450 511 559 646

Inventory 225 278 249 168 192

Other current

assets 67 74 153 173 522

Current operating

assets 770 903 1038 1049 1533

Accounts

payable 235 412 489 718 898

Accrued

expenses 109 191 271 415 609

Accrued

royalties 123 125 159 168 154

Other accruedliabilities 44 57 71 117 143

Current

operating

liabilities 512 785 990 1418 1804

Net working

capital 259 118 48 -369 -271

The last step of the analysis calculates how much cash Gateway typically ties up inworking capital to generate a dollar of new sales.

1994 1995 1996 1997 1998 1999

Net working

capital 119 259 118 48 (369) (271)

Incremental

working

capital (33) 139 (141) (70) (418) 98

Sales 2,701 3,676 5,035 6,294 7,468 8,646

Incremental

sales 970 975 1,359 1,259 1,174 1,178Incremental

working

capital (% of

sales) -3.4% 14.3% -10.3% -5.5% -35.6% 8.3%


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Incremental

working

capital over

last 5 years

(%) -6.6%

Here, we see that--unlike most companies--Gateway's net working capital tends togenerate cash from year to year. Over the five year period, we see that Gateway'snet working capital has fallen from $119 million to negative $271 million--a fall of$336 million--while sales have increased from $2.7 billion to $8.6 billion--an increaseof $5.9 billion. Over this period, then, Gateway's "incremental working capital as apercentage of sales" equals negative $336 million divided by $5.9 billion, or (6.6)%.

How Do You Project Future "Incremental Working Capital (%)"?

In Gateway's case, the company's historically tight working capital managementleads us to anticipate little future variability. We project incremental workingcapital as a percentage of incremental sales to be approximately (5.0)%, similar tothe company's historical average.

Sidebar: Cash Conversion Cycle

In cases where working capital tends to be more volatile or trend in a particulardirection, "cash conversion cycle" analysis offers an intuitive way of thinking about,and projecting, working capital. The cash conversion cycle quantifies the timebetween cash payment to suppliers and cash receipt from customers.

The three components of the cash conversion cycle are as follows:

1.Days sales outstanding (DSO). The number of days between the sale of a productand the receipt of a cash payment. The formula is: DSO = Days in year (360) / (Sales/ Average accounts receivable).

2.Days in inventory (DII). The number of days it takes for a company to convert itsraw material, work-in-progress and finished goods inventory into product sales. Theformula is: DII = Days in year (360) / (Cost of goods sold / Average inventory).

3.Days payables outstanding (DPO). The number of days between the purchase of aninput from a vendor and cash payment to that vendor. The formula is: DPO = Daysin year (360) / (Cost of goods sold / Average accounts payable)

9.9 Operating Cycle


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Operating Cycle can be defined as the average time between purchasing oracquiring inventory and receiving cash proceeds from its sale.

The operating cycle is the number of days from cash to inventory to accountsreceivable to cash.

Theoperating cycle reveals how long cash is tied up in receivables and inventory.A long operating cycle means that less cash is available to meet short termobligations.

The phrase operating cycle refers to the period of time that a companys cash is tied

up in inventory and/or receivables before recovering the initial investment or

realizing a profit or ROI .

A short operating cycle is one in which the time between purchasing inventory and

recovering the investment is brief. The company recovers its investment and/or

realizes profits quickly.

With a long operating cycle, cash may be tied up in inventory and/or receivables for

an extended period of time before the business is able to recover its initial

investment. Investments with a long operating cycle can be sound, as long as the

organization has sufficient access to capital to meet its short-term obligations.

An operating cycle should not be confused with a Fiscal Year. The amount of time

an operating cycle entails has nothing to do with a standard fiscal period.

To repeat, the operating cycle measure the number of days it takes for money youhave in cash to work its way through the business and return to cash. Calculatingthe operating cycle helps you understand why businesses that are growing quicklyoften have cash flow problems.

In this appendix, we will use more precise definitions than the earlier cash flowsection. We also will show you how to calculate the operating cycle in terms of thenumber of days.

The operating cycle summarizes four parts of your business:

1. Cash is the money that you have on hand to pay your bills. Since cash is boththe starting and ending point of the operating cycle, it is omitted from thecalculation.

2. Accounts Payable is the money you owe to suppliers when you buymerchandise or have expenses. It is measured here by the number of days ofcredit you have before you need to repay your suppliers.

3. Inventory Replacement is the value of new products you order for yourinventory on a regular basis. It is measured here by the number of days youtake between placing your orders.. If you use many different suppliers, you


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should look at the time between orders of the two or three largest companiesand take an average.

4. Accounts Receivable is the money people owe you from purchasing yourgoods and services. It is measured here by the number of days of credit yougive to your customers.

The operating cycle is calculated by estimating the number of days of credit in thethree accounts (exclude cash), and then adding them together.

Operating cycle = + accounts payable (in days)

- inventory replacement (in days)

- accounts receivable (in days)

Example 1:

You get 14 days of credit from your suppliers. It takes 21 days to sell yourmerchandise. You have an all cash business. How long is your operating cycle?

Operating cycle = + 14 (accounts payable in days)

- 21 (inventory replacement in days)

- 0 (accounts receivable in days)

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Operating cycle - 7 days

A negative operating cycle means you need to pay your bills before you get paid byyour customers. As your sales volume increases, you will need more cash to keep upwith your bills. Unless you are able to invest more cash, you limit your businesssability to grow. Most businesses have negative operating cycle.

Example 2

You get 14 days of credit from your suppliers and it takes 21 days to sell yourmerchandise. To attract new customers, you give 30 days of credit. How long is youroperating cycle?

Operating cycle = + 14 (accounts payable in days)- 21 (inventory replacement in days)


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Operating cycle - 37 days


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Extending credit may improve sales but it lengthens your operating cycle (makescash flow more negative). You need to borrow additional cash for 30 days to operateyour business. As sales increase, you will need even more cash to continueexpanding.

Example 3:

You get 30 days of credit from you suppliers. It takes only 14 days to sell yourmerchandise. You give 14 days of credit. How long is you operating cycle?

Operating cycle = + 30 (accounts payable in days)

- 14 (inventory replacement in days)


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Operating cycle + 2 days

A positive operating cycle means that you can increase sales without needingadditional cash. Be aware, however, that your suppliers can disrupt your businessby changing their credit policy.

In summary, you maximize your cash flow by getting credit from your suppliers,reducing inventory costs, and limiting the amount of credit you give to yourcustomers. You should push to get as much credit as you can. However, make surethat you are not overpaying for merchandise and that you order only what youneed.

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