Working Capital Management

1
Fall 2008

• Chapter 21
• Part 1
• Working Capital Management

2
WORKING CAPITAL THEORY AND POLICY

• Working capital management is important because
• it typically requires a greater investment than
  in fixed assets
• it requires daily management

3
CASH CONVERSION CYCLE

• The cash conversion cycle (CCC) is a flow
  representation of the working capital
  process.
• The CCC is the time between when payment is made
  to suppliers and when collection is received from
  customers.
• The CCC is a time gap that must be funded.

4

• The CCC is calculated from three
  components.
• The inventory conversion period is the average
  time between when raw materials and labor are
  acquired, and when a finished product is
  completed and sold.
• InvConvPd (inv x 365)/sales

5

• The receivables collection period is the average
  time between when a sale is made, and when
  collection occurs.
• RecCollPd (Rec x 365)/sales
• The payables deferral period is the average time
  between when raw materials and labor are
  acquired, and when payment is made to suppliers
  and labor.
• PayDefPd (Pay x 365)/COGS

6
Example

• Determine the cash conversion cycle for the Jones
  Company
• Sales 10,000,000
• Cost of goods sold 8,000,000
• Receivables 657,534
• Payables 657,534
• Inventories 2,000,000

7

• Inv conv pd 2 mil x 365 / 10 mil
• 73 days
• Rec coll pd 657,534 x 365 / 10 mil
• 24 days
• Pay def pd 657,534 x 365 / 8 mil
• 30 days
• CCC 73 24 30 67 days

8

• How would the conversion cycle for the Jones
  Company be illustrated in a diagram?
• 73 days 24 days
• 30 days 67 days

9
In-Class Exercise

• Determine the cash conversion cycle for the Smith
  Company
• Sales 730 million
• Cost of goods sold 438 mil.
• Receivables 73 million
• Payables 109.5 million
• Inventories 146 million

10

• Inv conv pd 146 mil x 365/730 mil
• 73 days
• Rec coll pd 73 mil x 365 / 730 mil
• 36.5 days
• Pay def pd 109.5 mil x 365 / 438 mil
• 91.25 days
• CCC 73 36.5 91.25 18.25 days

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Observations on the CCC

• We should prefer that the cash conversion cycle
  to be shorter.
• In terms of the CCC, we strive to
• shorten the receivables collection period
• shorten the inventory conversion period
• increase the payables deferral period

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• How can the inventory conversion period be
  shortened?
• - increase efficiency in production
• - reduce the average inventories in stock thru
  just-in-time or other methods
• - produce items by specific order so finished
  goods can be shipped out immediately upon
  completion (like Dell)

13

• How can the collection period be shortened?
• - change terms to a shorter net date
• - tighten controls on late payments
• - batch receivables more frequently

14

• How can the payable deferrals period be
  lengthened?
• - negotiate longer payment terms with suppliers

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Other common names for selected terms

• The cash conversion cycle is also known as the
  cash cycle
• The inventory conversion period is also known as
  days held in inventory
• The receivables collection period is also known
  as days sales outstanding
• The payables deferral period is also known as
  days payable outstanding

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Differences in Calculations in Some Other
Textbooks

• In some other textbooks
• The inventory conversion period may be calculated
  using COGS rather than SALES
• Each component of the CCC may be calculated using
  average balance sheet values (i.e., inventory,
  receivables, payables) rather than year-end values

17
Review of FCF and EVA

• Net operating working capital (nowc) and
  operating capital (OpCap) reflect the companys
  net investment in operations.
• nowc (cash rec inv)
• - (pay accruals)
• OpCap nowc FAnet
• Find OpCap for MicroDrive for 2005 and 2006.

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• Nowc(05) (15 315 415)
• (30 130) 585
• OpCap(05) 585 870 1455
• Nowc(06) (10 375 615)
• (60 140) 800
• OpCap(06) 800 1000 1800

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• Net operating profit after taxes (NOPAT)
  represents the after-tax profit the company would
  earn if it had no debt.
• NOPAT EBIT(1 T)
• Find nopat for MicroDrive for 2005 and 2006

20

• Nopat(05) 263(1 - .4) 157.8
• Nopat(06) 283.8(1 - .4) 170.3

21

• Free cash flow (FCF) represents the cash profit
  from operations after necessary investments in
  operating assets.
• FCF NOPAT ?OpCap
• Find FCF for MicroDrive for 2006

22

• FCF(06) 170.3 (1800 1455)
• 170.3 345
• - 174.7

23

• Economic value added (EVA) represents the true
  economic profit of the company. If EVA is
  positive, then operating performance exceeded
  expectations.
• EVA NOPAT (wacc x OpCap)
• Assume a wacc of 10 for each year, and find EVA
  for MicroDrive for 2005 and 2006

24

• EVA(05) 157.8 (.10 x 1455) 12.3
• EVA(06) 170.3 (.10 x 1800) - 9.7

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In-Class Exercise Improving MicroDrives EVA

• Now assume that MicroDrive Corp. reduces its inv
  conv pd and rec coll pd for 2006 by 10 days each,
  without affecting sales or cost of goods sold.
• What would be its revised value for the cash
  conversion cycle for 2006?
• New CCC 64.8 35.6 8.4 92 days
• This is an improvement because it is 20 days
  shorter.

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• What would be its revised value for inventories
  and receivables for 2006?
• InvInvCovPdxSales/365
• New Inv 64.8 x 3,000/365 532.6
• RecRecCollPdxSales/365)
• New Rec 35.6 x 3,000/365 292.6
• These are improvements because our working
  capital investment is smaller

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• What would be its revised value for operating
  capital for 2006?
• OpCap(06) (10 292.6 532.6) (60 140)
  1,000 1635.2
• This is an improvements because our operating
  capital investment is smaller

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• What would be its revised value for free cash
  flow for 2006?
• ?OpCap 1635.2 1455 180.2
• FCF(06) 283.8(1 - .4) (180.2) -9.9
• Although FCF is still negative, it reflects a
  much smaller need for outside funding.
• (-9.9 mil vs -174.72 mil)

29

• What would be its revised value for economic
  value added for 2006?
• EVA(06) 283.8(1 - .4) - .10(1635.2)
• 6.8
• This is a huge improvement! EVA changes from
  -9.72 mil to 6.8 mil. Shareholder wealth is
  increased instead of destroyed.

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The Connection Between CCC and EVA

• There is a connection between the cash conversion
  cycle (CCC) and economic value added (EVA).
• The inventory conversion period can be reduced by
  reducing the average amount of inventories held
  in stock, which then reduces net operating
  working capital and operating capital, which then
  increases both free cash flow and economic value
  added.

31

• ?Inv ?NOWC (Rec ?Inv) (Pay)
• ?OpCap ?OpCap ?NOWC FA
• ?EVA ?EVA NOPAT - ?OpCap
• Also ??OpCap ?OpCap OpCapLastYear
• ?FCF NOPAT - ??OpCap

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• Likewise, the receivables collection period can
  be reduced by reducing time to collection of
  receivables, which then reduces net operating
  working capital and operating capital, which then
  increases both free cash flow and economic value
  added.

33

• ?Inv ?NOWC (?Rec Inv) (Pay)
• ?OpCap ?OpCap ?NOWC FA
• ?EVA ?EVA NOPAT - ?OpCap
• Also ??OpCap ?OpCap OpCapLastYear
• ?FCF NOPAT - ??OpCap

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• Finally, the payables deferral period can be
  increased by increasing time to payment to
  suppliers, which then reduces net operating
  working capital and operating capital, which then
  increases both free cash flow and economic value
  added.

35

• ?Inv ?NOWC (Rec Inv) (?Pay)
• ?OpCap ?OpCap ?NOWC FA
• ?EVA ?EVA NOPAT - ?OpCap
• Also ??OpCap ?OpCap OpCapLastYear
• ?FCF NOPAT - ??OpCap

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Applying the Concept to the Jones Company

• Suppose the Jones Company can produce the
  following changes w/o change to sales or
  cogs
• inv conv pd 73 -gt 65 days
• rec coll pd 24 -gt 23 days
• pay def pd 30 -gt 31 days

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• What will be the new level of inventory?
• Rearrange the InvConvPd formula
• Inv InvConvPd x (sales/365)
• 65 x (10,000,000/365)
• 1,780,822

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• What will be the new level of receivables?
  
• Rearrange the RecCollPd formula
• Rec RecCollPd x (sales/365)
• 23 x (10,000,000/365)
• 630,137

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• What will be the new level of payables?
  
• Rearrange the PayDefPd formula
• Pay PayDefPd x (cogs/365)
• 31 x (8,000,000/365)
• 679,452

40

• What will be the change in net operating working
  capital?
• ?NOWC (?Rec ?Inv) (?Pay)
• -- or --
• ?NOWC NOWCnew - NOWCold
• NOWCnew
• 1,780,822 640,137 679,452
• 1,731,507

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• NOWCold
• 2,000,000 657,534 657,534
• 2,000,000
• ?NOWC NOWCnew - NOWCold
• 1,731,507 2,000,000
• -268,493

42

• What change would this produce in free cash
  flow?
• OpCap NOWC FA
• ?OpCap ?NOWC ?FA
• -268,493 0 -268,493
• FCF1 NOPAT1 (OpCap1 OpCap0)
• ?FCF ?NOPAT (?OpCap1 ?OpCap0)
• 0 - (-268,493 - 0) 268,493

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• What change would this cause in economic value
  added (EVA)? (Assume wacc is 15)
• EVA NOPAT wacc x OpCap
• ?EVA ?NOPAT wacc x ?OpCap
• 0 - .15 x (-268,493)
• 40,274

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How Does a Company Efficiently Manage the CCC?

• Aggressively monitor receivables
• Implement effective cash collections
• Minimize idle inventory through reducing
  production time and producing items by specific
  order
• Stretch payables to last possible point without
  losing discounts or customer goodwill
• Use effective disbursement systems

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• Important Points
• An excessively long CCC places financial pressure
  on the company, and may generate liquidity
  crises
• Negative FCF (even negative NOPAT) is common for
  start-up companies, but FCF must ultimately turn
  positive for a company to remain viable.

46

• Otherwise, a continued negative FCF may force a
  firm to delay needed investments in fixed assets
  and servicing creditors, which can ultimately
  lead to bankruptcy.

47
The Master of the CCC Dell Corp

• 1999 2001 2003
• InvConvPd 7.1 5.8 3.9
• RecCollPd 49.6 33.1 26.7
• PayDefPd 62.3 62.1 75.8
• CCC -5.6 -23.1 -45.3
• Note how the CCC declined tremendously over time
  (huge improvement!)

48

• The negative value for the CCC for Dell means
  that working capital is actually a source of
  funds rather than something that must be funded.
• The continued drop in the CCC over time means
  that this source of funds was actually increasing
  in size over time.