Effective Working Capital Management and Cash Flow Analysis

Posted on Jan 25, 2025 in Accounting and Finance

Working Capital

Accrual

• Revenue is recorded when earned (even if the money is not received)
• Expenses are recorded when the goods and services are received (even if the money is not yet paid)

• Do not rely on the income statement, but look at the cash flow statement
• Accounting profit may not reflect the cash flow reality facing the firm
• The cash flow statement helps to provide a clearer picture of where cash is coming from and where it is going

Working Capital Formula

• Current Assets – Current Liabilities
• (Current Assets – Inventory) – Current Liabilities
  • We subtract the inventory because it has no liquidity
  • Inventory is not worth anything because it is comprised of 3 things:

1. Raw materials
2. Work in process
3. Finished goods (the only thing that is worth anything)

Managing the Cash Cycle

Managing inventory (having too much inventory is not good)

• Managing receivables (these days you must extend a line of credit to customers, so you must be careful not to extend too much but not too little)
• Managing payables

How Much Working Capital is Enough?

• One View
  1. Optimal level is zero: it has to be zero because if it’s positive, it means you are not investing money into projects for growth, and if it’s negative, you don’t have any money for future projects. Cash sitting in the bank is not productive, so you want to minimize it; hence, you want to simply be at zero in the perfect world.
  2. In real life, it depends on the industry, but the standard is 2:1 working capital to liabilities. The more unpredictable the industry is, i.e., the fashion industry, the higher the ratio must be.
• How much in resources to commit?
  1. Inventory?
  2. Receivables and payables?
  3. Short-term investments
     • i.e. Chrysler’s $5 billion cushion investments

Earnings and Cash Flow

Cash is real, and earnings is the accountant’s imagination. Cash can be spent, counted, etc., but earnings can be manipulated and are not real.

• Reconciling earnings to cash

Traditional Working Capital Measures

Primary Tools

1. Current Ratio = Current Asset / Current Liabilities
   1. Current assets:
      • Cash
      • Marketable securities
      • Accounts receivable
      • Inventory
      • Prepaid expenses
      • Etc.
   2. Current liabilities:
      • Accounts payable
      • Accrued expenses
      • Notes payable
      • Current portion of long-term debt
      • Payroll deduction
      • Etc.
2. The current ratio is a ratio that, if it is under 1, indicates that a company’s liabilities are greater than its assets and suggests that the company in question would be unable to pay off its obligations if they came due at that point.
   1. Quick Ratio = (Current Assets – Inventories) / Current Liabilities
3. An indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets. For this reason, the ratio excludes inventories from current assets. The quick ratio is more conservative than the current ratio because it excludes inventories from current assets. The ratio derives its name presumably from the fact that assets such as cash and marketable securities are quick sources of cash. Inventories generally take time to be converted into cash, and if they have to be sold quickly, the company may have to accept a lower price than the book value of these inventories. As a result, they are justifiably excluded from assets that are ready sources of immediate cash.
   1. Net Working Capital = Current Assets – Current Liabilities
4. Indicates whether a company has enough short-term assets to cover its short-term debt. Anything below 1 indicates negative 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. Also known as “net working capital”.
   1. Working Capital Requirement = Current Operating Asset – Current Operating Liabilities
5. The minimum amount of resources that a company requires to effectively cover the usual costs and expenses necessary to operate the business. The general idea is to ensure there is enough revenue generated to cover the essential operations and allow for additional revenue to be generated in the future. (It only considers everything that is internally generated)
6. Weaknesses of the above ratios
   • Focuses on solvency: it focuses on bankruptcy and not survival
   • Assumes the same liquidity
   • Interpretation
7. Solution to these weaknesses
   • Cash Conversion Period:
   • Day Inventory Held (DIH): ((Inventory/COGS) x (365/1))
   • Days Sales Outstanding (Receivables) (DSO): ((Accounts Receivable/Sales) x (365/1))
   • Days Payables Outstanding (DPO): ((Accounts Payable/COGS) x (365/1))
8. It basically determines how long it will take for you to sell your inventory and convert them into cash.
   • Finally Cash Conversion Period (CCP) = DIH + DSO – DPO
   • The CCP is a period where you are exposed and need financing.
   • You want a small CCP.
   • To minimize your CCP, you must try to sell fast, collect faster, and pay debts slower.
   • The worldwide trend is that the CCP is getting lower, and firms are getting more and more efficient.
   • The CCP essentially shows the time that you are vulnerable and need financing to continue operations because you just paid disbursements.

Advanced Tools

1. Cash Holdings
   1. Why hold cash? Because:
      • Transactions for daily business
      • Precautionary for unexpected contingencies
      • Speculative in case you want to seize opportunities
2. Cash Conversion Efficiency (CCE) = (Operating Cash Flow / Revenue)
   1. Operating cash flow: Net Income + Depreciation + Interest + Taxes
   2. The interpretation of the CCE formula is how much cash is generated by each $ of sales
   3. The higher, the better. For example, if you get 80%, it means 80% is cash, and 20% is accrual, which we want to avoid.
3. Cash Ratio = (Cash / Total Assets)
   1. Provides the portion of assets held in cash; this is a key metric measuring system to assess corporate liquidity
4. Cash Burn Ratio = (Cash / (COGS/365))
   1. A measure used to estimate the number of days for which the firm can cover ongoing expenses with cash on hand
5. Net Liquid Balance = Cash – Notes Payable
   1. A negative Net Liquid Balance indicates reduced liquidity and not necessarily that the company will default on debt obligations
   2. A negative Net Liquid Balance suggests dependency on negative financing
   3. A negative Net Liquid Balance does not mean the company will default, but it only implies reduced liquidity.
   4. Net Working Capital = Working Capital Requirement + Net Liquid Balance
6. Current Liquidity Index = ((Cash (t-1) + Estimated[Operating Cash Flow]) / Notes Payable)
   1. This ratio must be very high if you want to consider it in your analysis.
   2. It demonstrates your ability to pay your short-term debts with liquidity.

Lambda

λ = ((Cash + Unused Credit Lines + Estimated[Operating Cash Flow])/ σ Operating Cash Flow)

1. A unique liquidity measure that accounts for the uncertainty of future cash inflows along with access to lines of credit. Also, it provides the probability of a firm experiencing illiquidity.
2. The numerator for λ represents overall liquidity, encompassing cash, remaining credit line capacity, and the next period’s expected cash inflow. The denominator is cash flow uncertainty, measured as the standard deviation of operating cash flow (remember that the standard deviation of a variable equals the square root of the average sum of squared deviations from the mean.)

Cash Management Models

• Baumol = Z* =

  1. F = Fixed transaction costs per sale of security
  2. TCN = Total cash needed during the period