Chapter 1 - Controllership

8/10/2019 Chapter 1 - Controllership

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SHORT-TERMFINANCIALMANAGEMENT

Chapter 1 - The Role of Working Capital

Prepared by Patricia R. Robertson

Kennesaw State University


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Textbook Outline

Part I Introduction to Liquidity

Part II Management of Working Capital

Part III Corporate Cash Management

Part IV Forecasting & PlanningPart V Short-Term Investing &Financing

Part VI Special Topics

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Part I - Introduction to Liquidity

Chapters

Covered

Chapter 1

The Role of Working Capital

Chapter 2Analysis of the Working Capital Cycle

Chapter 3

Cash Holdings

3


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Identify the cash flows associated with short-term

financing decisions. understand how working capital flows anddepreciation charges create a disparity betweenprofit and operating cash flow.

identify the basic issues involved in managingworking capital.

After studying this chapter, you should beable to:

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THEROLEOFWORKINGCAPITAL

Chapter 1 Agenda5

Identify the cash flows associatedwith short-term financing decisions,understand how working capital flows

and depreciation charges create adisparity between profit andoperating cash flow, and identify thebasic issues involved in managingworking capital.


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Working Capital Management6

Short-Term Financial Management (aka Working

Capital Management) is the day-to-day managementof the operating needs of a firm through its current

assets and current liabilities. It involves managing cash, accounts receivable, inventory,

accounts payable, and accruals.

The goal is to ensure a firm has the ability to satisfyboth upcoming operational expenses and maturingshort-term debt.


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The Importance of Cash

Cash flow is the lifeblood of a firm.

The firm must design a cost structure to operate

profitably or it will fail. Similarly, profitable companies, if cash-strapped, can

also fail.

Profits and cash flow are highly correlated in short-

term decision-making.

Therefore, firms must manage cash flows andprofits.

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Financial Statements8

Financial statements report the performance of a firm, andinclude the: Balance sheet Income statement

Statement of retained earnings Statement of cash flows

These interrelated statements show where money came

from, where it went, and where it is now.

We need to understand if and where the firm generated cash,

and where it was used. While this course focuses on short-term financial management,

we will review long-term sources and uses of cash, too.

Understanding the sources and uses of cash historically allowsfor the accurate prediction of future cash flows.


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Financial Analysis9

Financial analysis is used to understand a firms historical

and present financial position, as well as its prospects.

The objective of financial statement analysis depends on the

perspective of the user: Management

Creditors

Investors

Suppliers

Analysts

Regulators


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The Balance Sheet10

The balance sheet is a snapshot of the financial accounts of afirm as of a particular date.


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Assets11

Assetsare categorized as current (CA) or fixed

(FA). Assets are listed on the balance

sheet in order of liquidity.

Frequently, more than one

timeframe is presented for

comparison.

Current assets are expected to be

converted to cash within a year.

Fixed assets have a relatively long

life, and can be tangible (e.g.

building) or intangible (e.g.

patent).


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The Current Accounts13

The relationship between current assets and current

liabilities is critical to the ongoing operations of the

firm.


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Current Assets14

Cash & equivalents

Cash and highly-liquid investments.

Short-term investments

Investments to be liquidated within the

year. Accounts receivable

Sales made to customers on credit.

Displayed net of doubtful accounts.

Inventory

Some combination of raw materials,W-I-P, and finished goods.

Affected by valuation method/inflation.

Other

Generally, Prepaid Expenses.

Cash Position refers to cash

on hand and in the bank, as

well as access to bank loans and

short-term investments.


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Current Liabilities15

Accounts payable

Amounts owed to suppliersfor purchases.

Accruals Expenses incurred but not

yet paid (e.g. salaries, rent,insurance, taxes, etc.).

Short-term debt

Short-term debt and/or theprincipal portion of long-term debt due within theyear.

The term of debt should

match the type of assetfinanced.


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Working Capital16

(Net) working capital = current assets current liabilities

Working capital is the operating liquidity available to a companyand is positive in a healthy firm and varies by industry.

If a firm has negative working capital, it might have to sell assets at

fire sale prices to raise cash.


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Long-Term Assets & Liabilities17

Long-term assets represent the investments made by thefirm.

Long-term liabilities (LTD) represent the long-term financingsources for those investments.


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The residual interest in assets after deducting

liabilities.

Includes Common Stock (at par), Additional Paid-In-

Capital, Retained Earnings, and Treasury Stock.

Retained Earnings is not idle cash; rather reinvestedearnings.

Stockholders Equity18


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Sources & Uses of Cash

Buy inventory on credit Sell inventory for cash

Collect receivables

Borrow short-term debt

Borrow long-term debt Sell fixed assets

Sell common stock

Liquidate investments

Buy inventory with cash Make sales on credit

Pay suppliers (A/P)

Repay short-term loan

Retire long-term debt Buy fixed assets

Repurchase stock

Pay dividends / taxes

Make new investments

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Sources (Inflows) Uses (Outflows)

On the balance sheet, there are both short and long-term sourcesand uses of cash; they are the opposite of each other.


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The Income Statement20

The income statement measures financial performance overa period of time.

Income,

earnings, and

profit are used

interchangeably.


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The Income Statement21

Revenue is recognized when

earned, not collected

(accrual accounting).

Expenses are booked to

match the timing of

revenue recognition.

The income statement does

not reflect cash flows.

We are concerned with cash

flows.


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Earnings Quality22

Earnings quality is

affected by:

Accounting choices,

methods, and

assumptions.

Discretionary

expenditures.

Non-recurring

transactions.

Non-operating gains and

losses.


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Profits vs. Cash

Net income is not the same

as cash flow (economic

earnings).

The firm earned $5,642million, yet cash decreased

by $65 million.

We look to the balance

sheet to reconcilechanges in cash.

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Cash Flow Timeline Example24

A brand new

firm is

created.

The ownerputs in half

the money

and borrows

the other

half.

Cash 1,000$ Debt 500$

Stock 500$

Total 1,000$ Total 1,000$

Balance Sheet - Day 1

Assets Liabilities & Net Worth


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The next day,

the firm buys

a building and

an initial

supply of

inventory.

They pay cash

for the

building and

the inventory

is bought on

45-day credit

from the

firms

suppliers.

Cash 1,000$ Debt 500$

Stock 500$


Cash 400$ Accounts Payable 300$

Inventory 300$ Debt 500$

Fixed Assets 600$ Stock 500$







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Buying the

inventory on

credit creates

the liability,

accounts

payable.

The size of

the firm

increases by

300.

Cash 1,000$ Debt 500$

Stock 500$



Inventory 300$ Debt 500$








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Heres where

we are at

month-end.

The firm

offers credit

sales to

customers,

creating a

receivable

and depleting

inventory.


Accounts Receivable 700$ Accruals 200$

Inventory -$ Debt 500$


(Accumulated Depreciation) (100)$ Retained Earnings 25$



Balance Sheet - End of Month

Sales 700$

Cost of Goods Sold 300$

Gross Profit 400$

Operating Expenses

Salaries, Advertising, Etc. 200$

Depreciation 100$

Operating Profit 100$

Interest 50$

Taxes 25$

Net Profit 25$

Income Statement - End of Month


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As the firm

operates, it

incurs

expenses

(salaries,

utilities, rent,

etc.), which

are accrued

until paid.









Sales 700$


Gross Profit 400$

Operating Expenses


Depreciation 100$


Interest 50$

Taxes 25$

Net Profit 25$



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Depreciation,

a non-cash

charge, is

expensed.









Sales 700$


Gross Profit 400$

Operating Expenses


Depreciation 100$


Interest 50$

Taxes 25$

Net Profit 25$



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Cash is used

to pay

interest and

taxes.









Sales 700$


Gross Profit 400$

Operating Expenses

Salaries, Advertising, Etc. 200$Depreciation 100$


Interest 50$

Taxes 25$

Net Profit 25$



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Profits are

added to the

balance sheet

as retained

earnings.









Sales 700$


Gross Profit 400$

Operating Expenses

Salaries, Advertising, Etc. 200$Depreciation 100$


Interest 50$

Taxes 25$

Net Profit 25$



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At the

beginning of

the next

month, the

bills for the

accruals are

paid with

cash.

The balance

sheet

decreases in

size.








Accounts Receivable 700$ Accruals -$






Balance Sheet - Beginning of Next Month




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Cash is used

to pay the

accounts

payable once

due.

The firm made

25 but has

spent cash it

does not have.

THE FIRM

HAS PAID

CASH FOR

EXPENSES

BUT HAS

COLLECTED

NO MONEY

FOR SALES.







Cash (175)$ Accounts Payable -$






Balance Sheet - Middle of Next Month


Balance Sheet - Beginning of Next Month



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In the final

view, the A/R

are collected.

The firm still

has 25 in

profit, but has

125 more in

cash than it

had after

buying the

building.

During the

cycle, the cash

ranged from a

high of 525

to a low of

( 175).

Cash (175)$ Accounts Payable -$






Cash 525$ Accounts Payable -$

Accounts Receivable -$ Accruals -$





Balance Sheet - Middle of Next Month


Balance Sheet - Final View



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Despite being profitable, why did the firm run out of cashduring the operating cycle?

This is explained by differences in the timing of cash

disbursementsand cash receipts.

Firms must establish policies to manage working capitalaccountsso that an adequate amount of liquidity is availableto run the business.


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The Cash Cycle36

We are concerned with the amount of cash flow, as well asthe timing.

We have to build and sell products before we can generate cashinflows.

In the meantime, we incur cash outflows for supplies and labor.

We are concerned with the success of operations, or cashgenerated internally.

Externally generated cash comes from investing and financingactivities.

Temporary operating shortfalls can be satisfied with borrowing,but ultimately a firm must generate cash.


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Cash Flow Timeline38

The cash

conversion

period is the

time between

when cash is

received versus

paid.

The shorter the

cash conversion

period, the

more efficient

the firms

working capital

and more cash

is generated.

The firm is a system of cash flows.

These cash flows are unsynchronized and uncertain.


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Operating Versus Cash Cycle39

The Operating Cycle is the length of time from buyinginventory to collecting cash.

Say, we buy inventory on credit and pay the bill 30 days later.We sell the inventory 30 days after that, and get paid after 45days.

The Operating Cycle is 105 days.

The Cash Cycle (Cash Conversion Period) is the elapsedtime between the firms payment to suppliers and receipt of

customer payments.

Here, the Cash Cycle is 75 days (10530).


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The Cash Cycle

Firms must manage cash flowsandprofits to ensure it has thenecessary cash for daily

operations. Any gaps must be filled by short-

term borrowing or using cashreserves.

Alternatively, the firms can alterthe cycle by changing the timingof the cash flows.

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We need to isolate the cash component of the accrual-basedincome statement entries:

Operating Cash Flows, together with other sources and usesof cash, explain the change in cash on the balance sheet.

Analysis also includes adjustments for non-recurring items.

Operating Cash Flows42

Cash Collected From Customers

- Cash Paid To Suppliers- Cash Paid For Operations

- Cash Paid To Creditors

- Cash Paid For Taxes

= Cash Flow From Operations


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Operating Cash Flows43

Cash Flow Statement

Income Statement Adjustment Cash Flow Account

Sales - A/R = Cash Collected

- A/P

+ Inv

- Op Accr

- DepInterest - Acc Int = Cash Paid to Creditors

- Accrued Txs

- Deferred Txs

Net Profit Operating Cash Flow

CGS

Operating Expenses

Taxes

= Cash Paid to Suppliers

= Cash Paid for Op Exps

= Cash Paid for Taxes

We look to the income statement and changes on thebalance sheet to reconcile changes in cash at a singlepoint in time.


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Converting I/S to Cash Flows44

Cash Flow Statement



- A/P

+ Inv

- Op Accr

- Dep

Interest - Acc Int = Cash Paid to Creditors

- Accrued Txs

- Deferred Txs


CGS

Operating Expenses

Taxes




Assets

= Use

= Source

Liabilities

= Use

=Source


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Cash Flow Statement



- A/P

+ Inv

- Op Accr

- Dep


- Accrued Txs

- Deferred Txs


CGS

Operating Expenses

Taxes




If A/R increased,

then not all of the

sales recorded

during the period

have been

collected; less cash

was collected than

recorded on the

accrual-based

income statement.

If A/R decreased,

cash from prior

period sales was

collected.


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Cash Flow Statement



- A/P

+ Inv

- Op Accr

- Dep


- Accrued Txs

- Deferred Txs


CGS

Operating Expenses

Taxes




If inventory increased,

it represents an

additional use of cash

to purchase inventory

not yet sold and not

included in CGS.

If inventory decreased,

the firm did not

replenish inventory

sold, freeing up cash

previously held in the

working capital cycle.


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Cash Flow Statement



- A/P

+ Inv

- Op Accr

- Dep


- Accrued Txs

- Deferred Txs


CGS

Operating Expenses

Taxes




An increase in

accrued expenses

indicates we

expensed items for

which cash has not

yet been paid.

A decrease in

accruals mean we

paid for items

expensed in a prior

period.

Accruals can be recorded as assets or liabilities. In either case, it is simply a matter of

timing; the transaction has occurred but money has not changed hands. An example

is interest. For investments, interest income is an accrued asset. For a loan, interest

expense is an accrued liability.


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Cash Flow Statement



- A/P

+ Inv

- Op Accr

- Dep


- Accrued Txs

- Deferred Txs


CGS

Operating Expenses

Taxes




Similarly (and not

included on the

chart), an increase

in Prepaid Expenses

is a cash outflow

for items not yet

expensed, so is

added to Operating

Expenses.

Accrued expenses are the opposite of prepaid expenses.


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Cash Flow Statement



- A/P

+ Inv

- Op Accr

- Dep


- Accrued Txs

- Deferred Txs


CGS

Operating Expenses

Taxes




We are interested in current period depreciation. If using the income statement,

simply use the depreciation expensed during the year. If getting this information

from the balance sheet, use the change in accumulated depreciation. Note that the

latter could and likely does) have noise from the sale of fixed assets during the

period that affected accumulated depreciation.

The income

statement includes

the non-cash

charge,

depreciation.

Adjust operating

expenses to

include current

period

depreciation, a

non-cash expense.


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Cash Flow Statement



- A/P

+ Inv

- Op Accr

- Dep


- Accrued Txs

- Deferred Txs


CGS

Operating Expenses

Taxes




Deferred taxes

result from timing

(temporary)

differences.

Accrued taxes are

permanent

differences

between tax

returns and

financial

statements (e.g.:

depreciation

methods on fixed

assets).

A deferred expense has been incurred but not yet paid; an accrued expense has not yet

been incurred.


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Cash Flow Statement



- A/P

+ Inv

- Op Accr

- Dep


- Accrued Txs

- Deferred Txs


CGS

Operating Expenses

Taxes




A firm must be

able to translate

earnings (profits)

into cash.

If a firm has

negative operating

cash flow, it did

not generate cash

from its primary

operations and

must liquidate

investments or

borrow.


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Back To This Example53

Presented are

two points in

timeDay 1

and the final

view.

Lets

reconcile the

change in

cash from

1,000 to

525.

Cash 1,000$ Debt 500$

Stock 500$


Cash 525$ Accounts Payable -$

Accounts Receivable -$ Accruals -$





Balance Sheet - Final View





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R ili ti f C h


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Cash Flow Statement

Inccome Statement 2009 Adjustment Change Cash Flow LT Sources/Uses Change

Sales 700$ - A/R -$ 700$ - Fixed Assets 500$

CGS 300$ - A/P -$ - Depreciation 100$

+ Inv -$ + Short-Term Debt -$

Operating Expenses 300$ - Op Accr -$ + Long-Term Debt -$

- Dep 100$ + Other Liabilities -$

Interest 50$ - Acc Int -$ 50$ - Dividends Paid -$

Taxes 25$ - Def Txs -$ 25$ LT Change in Cash (600)$

Net Profit 25$ Operating Cash Flow 125$

125$

-$600

(475)$

1,000$

(475)$

525$

Beginning Cash

Total Change in Cash

Ending Cash

Cash Reconciliation

300$

200$

Operating Cash Flow

LT Change in Cash

Total Change in Cash

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Reconciliation of Cash

IMPORTANT:1) EVERY line item on the balance sheet must

be accounted for somewhere in the analysis.2) Dont double-count depreciation. Use

EITHER the change in net fixed assets andadd back change in accumulateddepreciation OR use change in gross fixedassets.

2


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Managing the Cash Cycle57


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Managing The Cash Cycle58

Managing the cash cycle includes:

Reducing idle inventory

Stretching payables

Aggressively managing receivables

Receivables and inventory

absorb cash; payables supplycash.


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Working Capital Management59

The cheapest and best source of cash exists as

working capital within the business:


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Managing The Cash Cycle60

The cash flow cycle refers to the continual flow of

resources through the working capital accounts.

This results in periods of cash surpluses and deficits.

The faster a firm is growing, the more cash it needs. While a firm can operate with negative cash flow for short

periods of time, it must generate positive cash flow long-

term.

Some firms try to manage working capital to zero. Zero investment in working capital increases cash.

Zero investment in working capital is a permanent increase

in earnings.


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Shareholder Value Creation61

Value can be created from many short-term financialmanagement activities.

Inventory Cash Management

Level Amount & Timing of Collections

Mix Amount & Timing of DisbursementsTiming Amount & Timing of Concentration

Customer Integration Receivables Banking System

Supply Chain Integration Quality Information System Integration

Information System Integration Quantity

Collection Short-Term Investing & Borrowing

Payables Timing VendorsUtilization Customer Integration Maturity

Timing Information System Integration Hedging

Supplier Negotiation Yield

Purchasing Integration Diversification

Information System Integration Liquidity

Information System Integration


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Managing Inventory62

Inventory levels should be adequate to meet uncertainclient demand without investing cash in too muchinventory.

There is a trade-off between:

Stock-out costs

Cost of excess inventory (holding costs)

Ordering costs

More in Chapter 4.


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Managing Receivables63

The Financial Manager decides:

Which customers may buy on credit.

How much credit is offered and on what terms.

e.g.: Net 30, 2/10; Net 30 The process for monitoring collections.

The procedures for processing remittances to minimize float.

Float is time it takes to convert the remittance to cash.

More in Chapters 5, 6 & 9.


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A Few IntroductoryThoughts

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Sh t T Pl i


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Short-Term Planning66

The ultimate goal of short-term planning is to

make sure there is enough cash on hand to

operate.

Over the six-month planning period, this firm has ample

cash. Yet, DURING the six-months, it ran out of cash.

H M h WC I E h?


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How Much WC Is Enough?67

Approximately 40%-50% of assets in U.S. firms

are invested in working capital accounts.

The firm must decide how much in resources tocommit to working capital and, specifically, cash

and liquid assets.

In typical economic times, 3.3%4.1% of thebalance sheet would be in cash (10% in times of

economic distress).

E l W i Si


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Early Warning Signs68

Early warning signs of insufficient working capital

include:

Pressure on existing cash reserves.

Unusual cash generating activities (e.g. offering big cash

discounts).

Bank overdrafts.

Emergency bank loans.

Partial payments to suppliers and creditors.

Documents

Chapter 1 - Controllership