SHORT-TERM

FINANCIAL
MANAGEMENT

Chapter 1 - The Role of Working Capital

Prepared by Patricia R. Robertson

Kennesaw State University
2 Textbook Outline
Part I Introduction to Liquidity
Part II Management of Working Capital
Part III Corporate Cash Management
Part IV Forecasting & Planning
Part V Short-Term Investing &
Financing
Part VI Special Topics
 Part I - Introduction to Liquidity
3

Chapters  Chapter 1
Covered
 The Role of Working Capital
 Chapter 2
 Analysis of the Working Capital Cycle
 Chapter 3
 Cash Holdings
 After studying this chapter, you should be
4
able to:
• Identify the cash flows associated with short-term
financing decisions.
• understand how working capital flows and
depreciation charges create a disparity between
profit and operating cash flow.
• identify the basic issues involved in managing
working capital.
5 Chapter 1 Agenda
THE ROLE OF WORKING CAPITAL
Identify the cash flows associated
with short-term financing decisions,
understand how working capital flows
and depreciation charges create a
disparity between profit and
operating cash flow, and identify the
basic issues involved in managing
working capital.
 Working Capital Management
6

 Short-Term Financial Management (aka Working

Capital Management) is the day-to-day management
of 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 satisfy

both upcoming operational expenses and maturing
short-term debt.
 The Importance of Cash
7

 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 and profits.
 Financial Statements
8

 Financial statements report the performance of a firm, and

include 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 allows
for the accurate prediction of future cash flows.
 Financial Analysis
9

 Financial analysis is used to understand a firm’s 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
 The Balance Sheet
10

The balance sheet is a snapshot of the financial accounts of a

firm as of a particular date.
 Assets
11

Assets are 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).
 Liabilities & Owner’s Equity
12

Liabilities are categorized as current (CL) or long-term

(LTD).
• Liabilities are also listed in order
of liquidity.
• Current liabilities are expected to
be paid within a year, and will
require cash.
• Long-term liabilities have
maturities longer than one year.
• The difference between assets
and liabilities is owner‟s equity
(E).
 The Current Accounts
13

 The relationship between current assets and current

liabilities is critical to the ongoing operations of the
firm.
 Current Assets
14

 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,
“Cash Position” refers to cash
W-I-P, and finished goods.
on hand and in the bank, as
 Affected by valuation method/inflation. well as access to bank loans and
 Other short-term investments.
 Generally, Prepaid Expenses.
 Current Liabilities
15

 Accounts payable
 Amounts owed to suppliers
for purchases.
 Accruals
 Expenses incurred but not
yet paid (e.g. salaries, rent,
insurance, taxes, etc.).
 Short-term debt
 Short-term debt and/or the
principal portion of long-
term debt due within the
year.
 The term of debt should
match the type of asset
financed.
 Working Capital
16

 (Net) working capital = current assets – current liabilities

 Working capital is the operating liquidity available to a company
and 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.
 Long-Term Assets & Liabilities
17

 Long-term assets represent the investments made by the

firm.

 Long-term liabilities (LTD) represent the long-term financing

sources for those investments.
 Stockholder’s Equity
18

 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 reinvested

earnings.
 Sources & Uses of Cash
19

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

Sources (Inflows) Uses (Outflows)

 Buy inventory on credit  Buy inventory with cash

 Sell inventory for cash  Make sales on credit
 Collect receivables  Pay suppliers (A/P)
 Borrow short-term debt  Repay short-term loan
 Borrow long-term debt  Retire long-term debt
 Sell fixed assets  Buy fixed assets
 Sell common stock  Repurchase stock
 Liquidate investments  Pay dividends / taxes
 Make new investments
 The Income Statement
20

 The income statement measures financial performance over

a period of time.

 „Income,‟
„earnings,‟ and
„profit‟ are used
interchangeably.
 The Income Statement
21

 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.
 Earnings Quality
22

 Earnings quality is
affected by:
 Accounting choices,
methods, and
assumptions.

 Discretionary
expenditures.

 Non-recurring
transactions.

 Non-operating gains and

losses.
 Profits vs. Cash
23

 Net income is not the same

as cash flow (economic
earnings).
 The firm earned $5,642
million, yet cash decreased
by $65 million.
 We look to the balance
sheet to reconcile
changes in cash.
 Cash Flow Timeline Example
24

A brand new Balance Sheet - Day 1

firm is Assets Liabilities & Net Worth

created. Cash $ 1,000 Debt $ 500

Stock $ 500
The owner
Total $ 1,000 Total $ 1,000
puts in half
the money
and borrows
the other
half.
 Cash Flow Timeline Example
25

Balance Sheet - Day 1

The next day,
the firm buys Assets Liabilities & Net Worth
a building and Cash $ 1,000 Debt $ 500
an initial Stock $ 500
supply of
Total $ 1,000 Total $ 1,000
inventory.

They pay cash Balance Sheet - Day 2

for the Assets Liabilities & Net Worth
building and Cash $ 400 Accounts Payable $ 300
the inventory
Inventory $ 300 Debt $ 500
is bought on
45-day credit Fixed Assets $ 600 Stock $ 500
from the Total $ 1,300 Total $ 1,300
firm‟s
suppliers.
 Cash Flow Timeline Example
26

Balance Sheet - Day 1

Buying the
inventory on Assets Liabilities & Net Worth

credit creates Cash $ 1,000 Debt $ 500

the liability, Stock $ 500
accounts Total $ 1,000 Total $ 1,000
payable.
Balance Sheet - Day 2
The size of
the firm Assets Liabilities & Net Worth

increases by Cash $ 400 Accounts Payable $ 300

$300. Inventory $ 300 Debt $ 500
Fixed Assets $ 600 Stock $ 500
Total $ 1,300 Total $ 1,300
 Cash Flow Timeline Example
27
Balance Sheet - End of Month
Assets Liabilities & Net Worth
Here‟s where Cash $ 325 Accounts Payable $ 300

we are at Accounts Receivable $ 700 Accruals $ 200

month-end. Inventory $ - Debt $ 500

Fixed Assets $ 600 Stock $ 500

The firm
(Accumulated Depreciation) $ (100) Retained Earnings $ 25
Total $ 1,525 Total $ 1,525
offers credit
Income Statement - End of Month
sales to
Sales $ 700
customers, Cost of Goods Sold $ 300
creating a Gross Profit $ 400
receivable Operating Expenses
and depleting Salaries, Advertising, Etc. $ 200
inventory. Depreciation $ 100
Operating Profit $ 100
Interest $ 50
Taxes $ 25
Net Profit $ 25
 Cash Flow Timeline Example
28
Balance Sheet - End of Month
Assets Liabilities & Net Worth
As the firm Cash $ 325 Accounts Payable $ 300

operates, it Accounts Receivable $ 700 Accruals $ 200

incurs Inventory $ - Debt $ 500

Fixed Assets $ 600 Stock $ 500
expenses (Accumulated Depreciation) $ (100) Retained Earnings $ 25
(salaries, Total $ 1,525 Total $ 1,525
utilities, rent, Income Statement - End of Month
etc.), which Sales $ 700
are accrued Cost of Goods Sold $ 300
until paid. Gross Profit $ 400
Operating Expenses
Salaries, Advertising, Etc. $ 200
Depreciation $ 100
Operating Profit $ 100
Interest $ 50
Taxes $ 25
Net Profit $ 25
 Cash Flow Timeline Example
29
Balance Sheet - End of Month
Assets Liabilities & Net Worth
Depreciation, Cash $ 325 Accounts Payable $ 300

a non-cash Accounts Receivable $ 700 Accruals $ 200

charge, is Inventory $ - Debt $ 500

Fixed Assets $ 600 Stock $ 500
expensed. (Accumulated Depreciation) $ (100) Retained Earnings $ 25
Total $ 1,525 Total $ 1,525

Income Statement - 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
 Cash Flow Timeline Example
30
Balance Sheet - End of Month
Assets Liabilities & Net Worth
Cash is used Cash $ 325 Accounts Payable $ 300

to pay Accounts Receivable $ 700 Accruals $ 200

interest and Inventory $ - Debt $ 500

Fixed Assets $ 600 Stock $ 500
taxes. (Accumulated Depreciation) $ (100) Retained Earnings $ 25
Total $ 1,525 Total $ 1,525

Income Statement - 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
 Cash Flow Timeline Example
31
Balance Sheet - End of Month
Assets Liabilities & Net Worth
Profits are Cash $ 325 Accounts Payable $ 300

added to the Accounts Receivable $ 700 Accruals $ 200

balance sheet Inventory $ - Debt $ 500

Fixed Assets $ 600 Stock $ 500
as retained (Accumulated Depreciation) $ (100) Retained Earnings $ 25
earnings. Total $ 1,525 Total $ 1,525

Income Statement - 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
 Cash Flow Timeline Example
32
Balance Sheet - End of Month
Assets Liabilities & Net Worth
At the Cash $ 325 Accounts Payable $ 300
beginning of Accounts Receivable $ 700 Accruals $ 200
the next Inventory $ - Debt $ 500
month, the Fixed Assets $ 600 Stock $ 500
bills for the (Accumulated Depreciation) $ (100) Retained Earnings $ 25
accruals are Total $ 1,525 Total $ 1,525
paid with
cash. Balance Sheet - Beginning of Next Month
Assets Liabilities & Net Worth
Cash $ 125 Accounts Payable $ 300

The balance Accounts Receivable $ 700 Accruals $ -

sheet Inventory $ - Debt $ 500

decreases in Fixed Assets $ 600 Stock $ 500

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

Total $ 1,325 Total $ 1,325
 Cash Flow Timeline Example
33
Balance Sheet - Beginning of Next Month
Assets Liabilities & Net Worth
Cash is used Cash $ 125 Accounts Payable $ 300
to pay the
Accounts Receivable $ 700 Accruals $ -
accounts
payable once Inventory $ - Debt $ 500

due. Fixed Assets $ 600 Stock $ 500

(Accumulated Depreciation) $ (100) Retained Earnings $ 25
The firm made Total $ 1,325 Total $ 1,325
$25 but has
spent cash it
does not have. Balance Sheet - Middle of Next Month
Assets Liabilities & Net Worth
THE FIRM Cash $ (175) Accounts Payable $ -
HAS PAID Accounts Receivable $ 700 Accruals $ -
CASH FOR
Inventory $ - Debt $ 500
EXPENSES
BUT HAS Fixed Assets $ 600 Stock $ 500

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

NO MONEY Total $ 1,025 Total $ 1,025
FOR SALES.
 Cash Flow Timeline Example
34
Balance Sheet - Middle of Next Month

In the final Assets Liabilities & Net Worth

view, the A/R Cash $ (175) Accounts Payable $ -
are collected. Accounts Receivable $ 700 Accruals $ -
Inventory $ - Debt $ 500
The firm still
has $25 in Fixed Assets $ 600 Stock $ 500

profit, but has (Accumulated Depreciation) $ (100) Retained Earnings $ 25

$125 more in Total $ 1,025 Total $ 1,025
cash than it
had after Balance Sheet - Final View
buying the
Assets Liabilities & Net Worth
building.
Cash $ 525 Accounts Payable $ -
During the Accounts Receivable $ - Accruals $ -
cycle, the cash Inventory $ - Debt $ 500
ranged from a Fixed Assets $ 600 Stock $ 500
high of $525
(Accumulated Depreciation) $ (100) Retained Earnings $ 25
to a low of
($175). Total $ 1,025 Total $ 1,025
 Cash Flow Timeline Example
35

 Despite being profitable, why did the firm run out of cash
during the operating cycle?

 This is explained by differences in the timing of cash

disbursements and cash receipts.

 Firms must establish policies to manage working capital

accounts so that an adequate amount of liquidity is available
to run the business.
 The Cash Cycle
36

 We are concerned with the amount of cash flow, as well as

the timing.
 We have to build and sell products before we can generate cash
inflows.
 In the meantime, we incur cash outflows for supplies and labor.
 We are concerned with the success of operations, or cash
generated internally.
 Externally generated cash comes from investing and financing
activities.
 Temporary operating shortfalls can be satisfied with borrowing,
but ultimately a firm must generate cash.
 The Cash Cycle
37

 Cash flows in a cycle into, around, and out of a business…it

is the lifeblood of the firm.
 Inventory, if purchased on credit,
creates an accounts payable.
 Inventory, if sold on credit, generates an
accounts receivable.
 Receivables are collected in cash.
 Payables are paid out of cash from
sales, by drawing down liquid reserves,
or by borrowing.
 If the firm were to stop its operating activities, most (if
not all) of the cash tied up in working capital would be
released; the operating cycle affects the timing of
 Cash Flow Timeline
38

The cash  The firm is a system of cash flows.

conversion
period is the
 These cash flows are unsynchronized and uncertain.
time between
when cash is
received versus
paid.

The shorter the

cash conversion
period, the
more efficient
the firm‟s
working capital
and more cash
is generated.
 Operating Versus Cash Cycle
39

 The Operating Cycle is the length of time from buying

inventory 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 45
days.
 The Operating Cycle is 105 days.

 The Cash Cycle (Cash Conversion Period) is the elapsed

time between the firm’s payment to suppliers and receipt of
customer payments.
 Here, the Cash Cycle is 75 days (105 – 30).
40
 The Cash Cycle
41

 Firms must manage cash flows

and profits to ensure it has the
necessary cash for daily
operations.
 Any gaps must be filled by short-
term borrowing or using cash
reserves.
 Alternatively, the firms can alter
the cycle by changing the timing
of the cash flows.
 Operating Cash Flows
42

 We need to isolate the cash component of the accrual-based

income statement entries:
Cash Collected From Customers
- Cash Paid To Suppliers
- Cash Paid For Operations
- Cash Paid To Creditors
- Cash Paid For Taxes
= Cash Flow From Operations

 Operating Cash Flows, together with other sources and uses

of cash, explain the change in cash on the balance sheet.
 Analysis also includes adjustments for non-recurring items.
 Operating Cash Flows
43

We look to the income statement and changes on the

balance sheet to reconcile changes in cash at a single
point in time. Cash Flow Statement
Income Statement Adjustment Cash Flow Account
Sales - ∆ A/R = Cash Collected
- ∆ A/P
CGS = Cash Paid to Suppliers
+ ∆ Inv
- ∆ Op Accr
Operating Expenses = Cash Paid for Op Exps
- ∆ Dep
Interest - ∆ Acc Int = Cash Paid to Creditors
- ∆ Accrued Txs
Taxes = Cash Paid for Taxes
- ∆ Deferred Txs
Net Profit Operating Cash Flow
 Converting I/S to Cash Flows
44

Cash Flow Statement

Income Statement Adjustment Cash Flow Account
Sales - ∆ A/R = Cash Collected Assets
- ∆ A/P ↑ = Use
CGS = Cash Paid to Suppliers
+ ∆ Inv ↓ = Source
- ∆ Op Accr
Operating Expenses = Cash Paid for Op Exps
- ∆ Dep
Interest - ∆ Acc Int = Cash Paid to Creditors Liabilities
Taxes
- ∆ Accrued Txs
= Cash Paid for Taxes
↓ = Use
- ∆ Deferred Txs ↑ =Source
Net Profit Operating Cash Flow
 Converting I/S to Cash Flows
45

If A/R increased,
Cash Flow Statement
then not all of the
Income Statement Adjustment Cash Flow Account sales recorded
Sales - ∆ A/R = Cash Collected during the period
- ∆ A/P have been
CGS = Cash Paid to Suppliers
+ ∆ Inv collected; less cash
- ∆ Op Accr was collected than
Operating Expenses
- ∆ Dep
= Cash Paid for Op Exps
recorded on the
Interest - ∆ Acc Int = Cash Paid to Creditors
accrual-based
income statement.
- ∆ Accrued Txs
Taxes = Cash Paid for Taxes
- ∆ Deferred Txs
If A/R decreased,
Net Profit Operating Cash Flow
cash from prior
period sales was
collected.
 Converting I/S to Cash Flows
46

If A/P increased,
Cash Flow Statement then not all of the
Income Statement Adjustment Cash Flow Account inventory expensed
Sales - ∆ A/R = Cash Collected in CGS has been
- ∆ A/P paid for; less cash
CGS
+ ∆ Inv
= Cash Paid to Suppliers was paid to suppliers
than reflected on
- ∆ Op Accr
Operating Expenses = Cash Paid for Op Exps the income
- ∆ Dep
statement.
Interest - ∆ Acc Int = Cash Paid to Creditors

Taxes
- ∆ Accrued Txs
= Cash Paid for Taxes If A/P decreased, we
- ∆ Deferred Txs paid for items this
Net Profit Operating Cash Flow period expensed in a
prior period.
 Converting I/S to Cash Flows
47

If inventory increased,
Cash Flow Statement it represents an
Income Statement Adjustment Cash Flow Account additional use of cash
Sales - ∆ A/R = Cash Collected to purchase inventory
- ∆ A/P not yet sold and not
CGS
+ ∆ Inv
= Cash Paid to Suppliers
included in CGS.
- ∆ Op Accr
Operating Expenses = Cash Paid for Op Exps If inventory decreased,
- ∆ Dep
the firm did not
Interest - ∆ Acc Int = Cash Paid to Creditors
replenish inventory
Taxes
- ∆ Accrued Txs
= Cash Paid for Taxes sold, freeing up cash
- ∆ Deferred Txs previously held in the
Net Profit Operating Cash Flow working capital cycle.
 Converting I/S to Cash Flows
48

An increase in
Cash Flow Statement
accrued expenses
Income Statement Adjustment Cash Flow Account indicates we
Sales - ∆ A/R = Cash Collected expensed items for
- ∆ A/P which cash has not
CGS = Cash Paid to Suppliers
+ ∆ Inv yet been paid.
- ∆ Op Accr
Operating Expenses
- ∆ Dep
= Cash Paid for Op Exps
A decrease in
Interest - ∆ Acc Int = Cash Paid to Creditors
accruals mean we
paid for items
- ∆ Accrued Txs
Taxes = Cash Paid for Taxes expensed in a prior
- ∆ Deferred Txs
period.
Net Profit Operating Cash Flow

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.
 Converting I/S to Cash Flows
49

Cash Flow Statement

Income Statement Adjustment Cash Flow Account
Sales - ∆ A/R = Cash Collected Similarly (and not
CGS
- ∆ A/P
= Cash Paid to Suppliers
included on the
+ ∆ Inv chart), an increase
- ∆ Op Accr in Prepaid Expenses
Operating Expenses = Cash Paid for Op Exps
- ∆ Dep is a cash outflow
Interest - ∆ Acc Int = Cash Paid to Creditors for items not yet
- ∆ Accrued Txs
expensed, so is
Taxes = Cash Paid for Taxes added to Operating
- ∆ Deferred Txs
Expenses.
Net Profit Operating Cash Flow

Accrued expenses are the opposite of prepaid expenses.

 Converting I/S to Cash Flows
50

The income
Cash Flow Statement statement includes
Income Statement Adjustment Cash Flow Account the non-cash
Sales - ∆ A/R = Cash Collected charge,
- ∆ A/P depreciation.
CGS = Cash Paid to Suppliers
+ ∆ Inv
Adjust operating
- ∆ Op Accr
Operating Expenses = Cash Paid for Op Exps expenses to
- ∆ Dep
include current
Interest - ∆ Acc Int = Cash Paid to Creditors
period
Taxes
- ∆ Accrued Txs
= Cash Paid for Taxes depreciation, a
- ∆ Deferred Txs non-cash expense.
Net Profit Operating Cash Flow

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.
 Converting I/S to Cash Flows
51

Deferred taxes
Cash Flow Statement
result from timing
Income Statement Adjustment Cash Flow Account (temporary)
Sales - ∆ A/R = Cash Collected differences.
- ∆ A/P Accrued taxes are
CGS = Cash Paid to Suppliers
+ ∆ Inv permanent
- ∆ Op Accr differences
Operating Expenses
- ∆ Dep
= Cash Paid for Op Exps
between tax
Interest - ∆ Acc Int = Cash Paid to Creditors
returns and
financial
- ∆ Accrued Txs
Taxes = Cash Paid for Taxes statements (e.g.:
- ∆ Deferred Txs
depreciation
Net Profit Operating Cash Flow
methods on fixed
assets).

A deferred expense has been incurred but not yet paid; an accrued expense has not yet
been incurred.
 Converting I/S to Cash Flows
52

Cash Flow Statement

Income Statement Adjustment Cash Flow Account
Sales - ∆ A/R = Cash Collected A firm must be
- ∆ A/P able to translate
CGS
+ ∆ Inv
= Cash Paid to Suppliers earnings (profits)
- ∆ Op Accr
into cash.
Operating Expenses = Cash Paid for Op Exps
- ∆ Dep
If a firm has
Interest - ∆ Acc Int = Cash Paid to Creditors
negative operating
Taxes
- ∆ Accrued Txs
= Cash Paid for Taxes cash flow, it did
- ∆ Deferred Txs not generate cash
Net Profit Operating Cash Flow from its primary
operations and
must liquidate
investments or
borrow.
 Back To This Example
53
Balance Sheet - Day 1

Presented are Assets Liabilities & Net Worth

two points in Cash $ 1,000 Debt $ 500

time…Day 1 Stock $ 500

and the final Total $ 1,000 Total $ 1,000

view.

Let‟s Balance Sheet - Final View

reconcile the Assets Liabilities & Net Worth

change in Cash $ 525 Accounts Payable $ -

cash from Accounts Receivable $ - Accruals $ -

$1,000 to Inventory $ - Debt $ 500

$525. Fixed Assets $ 600 Stock $ 500

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

Total $ 1,025 Total $ 1,025

 Reconciliation of Cash
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

$ 300
+ ∆ Inv $ - + ∆ Short-Term Debt $ -

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

$ 200
- ∆ 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

Cash Reconciliation

Operating Cash Flow $ 125

We will do a more complex LT Change in Cash -$600
example in a minute…for Total Change in Cash $ (475)
now, become acquainted with
the format. Beginning Cash $ 1,000

Total Change in Cash $ (475)

54 Ending Cash $ 525

 Reconciliation of Cash
Cash Flow Statement

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

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

2
CGS $ 300 - ∆ A/P $ - - Depreciation $ 100
$ 300
+ ∆ Inv $ - + ∆ Short-Term Debt $ -

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

$ 200
- ∆ 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

Cash Reconciliation
IMPORTANT:
Operating Cash Flow $ 125
1) EVERY line item on the balance sheet must
be accounted for somewhere in the analysis. LT Change in Cash -$600

2) Don’t double-count depreciation. Use Total Change in Cash $ (475)

EITHER the change in net fixed assets and

add back change in accumulated Beginning Cash $ 1,000
depreciation OR use change in gross fixed Total Change in Cash $ (475)

55 assets. Ending Cash $ 525

 Operating Cash Flows
56

 The analyst should be concerned with:

 The success (or failure) of firm in generating cash
from operations.
 The underlying causes of (and magnitude of)
positive or negative operating cash flow.
 Fluctuations in operating cash flows over time.
57 Managing the Cash Cycle
 Managing The Cash Cycle
58

 Managing the cash cycle includes:

 Reducing idle inventory
 Stretching payables
 Aggressively managing receivables

 Receivables and inventory

absorb cash; payables supply
cash.
 Working Capital Management
59

 The cheapest and best source of cash exists as

working capital within the business:
 Managing The Cash Cycle
60

 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.
 Shareholder Value Creation
61

 Value can be created from many short-term financial

management activities.
Inventory Cash Management
Level Amount & Timing of Collections
Mix Amount & Timing of Disbursements
Timing 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 Vendors
Utilization Customer Integration Maturity
Timing Information System Integration Hedging
Supplier Negotiation Yield
Purchasing Integration Diversification
Information System Integration Liquidity
Information System Integration
 Managing Inventory
62

 Inventory levels should be adequate to meet uncertain

client demand without investing cash in too much
inventory.
 There is a trade-off between:
 Stock-out costs
 Cost of excess inventory (holding costs)
 Ordering costs

More in Chapter 4.
 Managing Receivables
63

 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.

 Managing Payables
64

 Payables can be viewed as interest-free financing.

 The financial manager wants:
 The longest and/or most favorable credit terms available from its
suppliers.
 Terms can include cash discounts.
 The timing of the payment to be on the due date and not before
depending on the benefit to the firm from the discount versus the
foregone cash.

More in Chapters 7 & 11.

 A Few Introductory
65
Thoughts…
 Short-Term Planning
66

 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.
 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 to
commit to working capital and, specifically, cash
and liquid assets.
 In typical economic times, 3.3% – 4.1% of the
balance sheet would be in cash (10% in times of
economic distress).
 Early Warning Signs
68

 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.