Working Capital Management

Intro Video Transcript

Hello everyone, and welcome. My name is Joseph Ori. I am executive managing director of Paramount Capital Corporation. We are a Bay Area, Northern California-based corporate finance and real estate advisory firm. And I am pleased to present for Illumeo learning our corporate finance series presentation on working capital analysis and management.

We have a 47-slide PowerPoint here that we will go through. It's broken down into three sections. And we prefer that you go through the whole presentation at once. And then there will be a short quiz and a short final exam for your CPE credit. So if you just follow along with me, we'll go through the presentation. Let's move on to the next slides, slide one.

There's my contact information. Again, we are in Walnut Creek, California, right outside across the bay from San Francisco. My email address is there and our website. And feel free to contact me, any questions, comments, etc.

Let's move on to the next slide, slide two. As I stated, this presentation is broken down into three modules of approximately 20 minutes each. Participants can view the entire presentation or each module. Again, we prefer that you go through the entire presentation and then take the short quiz and final exam for your CPE credit.

Let's move on to slide three. This is our executive summary. And beginning on slide 4, working capital is defined as a firm's current assets minus current liabilities, not to be confused with the current ratio, which is current assets divided by current liabilities. So working capital is key in every company because most companies, especially if you're a manufacturer or a merchandiser or you have any type of inventory, it has a lot of money tied up in accounts receivable and inventories. And how you manage those can be critical to your liquidity and profitability.

The second point there, working capital management is how to invest excess cash, control accounts receivable, inventory, and accounts payable to increase profits and maximize a firm's liquidity. Again, this is key. This is one area, especially in small private companies, start-up companies, that get into trouble. One of the main reasons is they don't manage their inventory and accounts receivables, especially the inventory. They start a business. They're selling a product. They staff their store or warehouse with a product, and it doesn't sell. And then they're stuck carrying this big inventory. And then they have cash flow problems and liquidity issues. So again, working capital management is critical.

The last point on slide four, working capital investment policy is how to finance your current assets. And we will talk about that in a number of the subsequent slides. Let's move on to the next slide, slide five.

The first bullet point, key ratios in working capital are the current ratio, inventory turnover, days inventory, accounts receivable turnover, days receivables, accounts payable turnover, and days accounts payable. Those are the ratios we're going to analyze for our hypothetical company in this presentation, Acme Corporation. They're a widget manufacturer. And we will use their data. And that'll be coming up in a few slides to analyze these ratios and working capital management and analysis.

The second bullet point there is working capital financing policies can be long term, short term or matching. Every company, not every, but most companies have to have a bank line or a term loan or a credit line to finance part of their working capital. And how you do that financing is also critical to your profitability and liquidity.

The last item on slide five is the cash conversion cycle. The cash conversion cycle . . . The first bullet point there, we will talk about how to increase returns on cash holdings. Even though we're in a very low interest rate environment today, you should note companies should have idle cash. It should be invested in short-term securities, treasury bills, money market funds, commercial paper, if you're in that market, anything that has a better return than idle cash.

The second bullet point there, we will talk about cash budgeting for effective cash management. And for our company, our hypothetical company, Acme Corporation, I've prepared a pro forma budget for the first three months of 2014. And you can see the cash collections coming in and the cash payments going out and, is there a cash surplus or a cash deficit in each of the months? And if there's a cash deficit, normally, that is funded or made up by a short-term bank loan. And we will see that in some of the upcoming slides.

The last point on slide six is credit policy. The policy you have with your customers can affect sales, accounts receivable, and bad debts. What do we mean by credit policy? That means, what are the terms of payment? Is there a discount if the customer pays early? If not, how long do they get to pay? Those things make a difference in how quickly you get paid and your volume of sales, receivables, and bad debts. And we will talk about that, some of the more specifics of credit policy, in some of the upcoming slides.

Let's move on to slide seven. Slide seven begins the section on working capital.

Let's go to slide eight. Let's talk about working capital in detail. As we said in the summary, working capital is a firm's current assets minus current liabilities. The three primary current assets are cash/investments or marketable securities, accounts receivable, and inventory. The three primary current liabilities are accounts payable, accrued liabilities, such as accrued taxes, accrued salaries and wages, and notes payable. And remember the definition of current assets and current liabilities. These are assets and liabilities that are going to be used or consumed or paid within one year or the operating cycle of the business, whichever is less. Typically, we use one year. So these are short-term current assets and liabilities. And the most significant ones are inventory and accounts receivable. And the better we manage those, the more profitable, more efficient we'll be as a company. So again, these are key things to be cognizant of from the CEO down to the CFO of a company.

Let's move on to slide number nine. Effective management of working capital can increase profits significantly in most firms. That involves, as we mentioned, investment of the excess cash. Even though, again, we're in a low interest rate environment, getting one and a half percent on a short-term investment is better than getting ten basis points in a savings account. So you have to invest the excess cash.

The second point there, high turnover of inventory reduces inventory carrying and financing costs. Inventory should turn over as quick as possible. If you have a company, whether you're manufacturing a product or buying a product for resale, the quicker that inventory moves through your company, from the day you purchase it to the day it is sold and you collect the cash on it, the better. That increases your profits. Remember, when you buy inventory, you have to purchase it. There's a payment there. Or you have to borrow money to fund the payment. You have to ship it to your location, store, or warehouse. You have to warehouse it. And then it gets sold. So all those are big costs in most companies that have inventory.

The last point on slide nine is accounts receivable. High turnover of accounts receivable increases cash flow. Receivables, the quicker, just like inventory, we can turn over our receivables, the better. That means we're getting paid quicker. And the quicker you get paid, the quicker cash comes in your business, the more profitable you will be because you won't have to go out and borrow money to plug any liquidity gaps in your business.

Most companies do not generate enough cash flow internally from their business and retained earnings to fund their business. And they have to go out and have a term loan or a revolving line of credit with a bank and borrow that money at times when their liquidity is down. It may be seasonality, or it may be your turnover of inventory and receivables isn't as high as you want. So they're going to have to borrow money. But the higher you can get the turnover on both of these items, inventory and receivables, the less amount of money you'll have to borrow. And anytime you can borrow less money, that's lower interest costs.

And remember, money generated internally in a company is pretty much free money. There's a cost of capital to it, but there's no interest cost to it, okay? And that's the cheapest source of capital in a company is retained earnings or internal cash flow. The next cheapest source is bank loans. The next cheapest source is preferred stock. And the most expensive capital for a company is common stock. So let's move on to slide ten.

The first bullet point on slide ten, let's talk about the liability side. Deferral of payment of current liabilities, accounts payable, and accrued liabilities can increase cash flow and profits. Now, we're not saying you don't pay your short-term liabilities. But the longer you can defer them, legally, in accordance with the contract you have with your vendors, the better.

And the second point there is the cash conversion cycle. That's the process of buying/selling inventory, collecting the accounts receivable, and paying the related accounts payable. And again, we'll show you an example of how to calculate it. It's calculated in days. It's the days accounts receivable, the days of inventory minus the days of payables. And the lower the cash conversion cycle, the better.

Let's move on to slide 11. Now we're in a working capital ratios section. Let's move on to the next slide, 12. In the Working Capital Ratios section on slide 12, let's talk about the specific ratios for working capital management. The first one that we talked about previously is working capital, current assets minus current liabilities. The second one is the current ratio, current assets divided by current liabilities. The third one on slide 12 is accounts receivable turnover. That is sales divided by accounts receivable.

One thing about the ratios, and this was stated on the prior slide, if I can go back a second here to slide 11, if you look at the note on the bottom there. Whenever you're calculating a ratio with a balance sheet item and income statement item, remember the income statement item is for a period. Let's say it's for the whole year. The balance sheet item is just for one point in time. That would be the end of the year. So it is better to do an average of the balance sheet items. So if you're calculating the inventory turnover which is cost of goods sold divided by inventory for 2013, the cost of goods sold would be for the whole year. Inventory, you should take the beginning of the year, the January 1st inventory amount plus the December 31st end of year inventory amount and divide it by two and just take the average. That just makes for a better ratio when you're doing working capital ratio analysis.

In this presentation, just to keep everything simple and more easier to analyze, we just took the end of the year amounts for our Acme Corporation company in calculating the ratios.

So let's go back to slide 12. Those are the three ratios we talked about. Let's go on to the next slide, slide 13. At the top, days receivable is 365 divided by the accounts receivable turnover from the prior slide. Inventory turnover is cost of goods sold divided by inventory. Days inventory is 365 divided by inventory turnover. Accounts payable turnover is cost of goods sold divided by accounts payable.

Moving on to the next slide, 14. Days payable is 365 divided by accounts payable turnover. So you can see for the inventory turnover, accounts receivable turnover, and accounts payable turnover, once you determine the turnover number, all you have to do is divide that into 365, and you get the number of days. The last point on slide 14 is the cash conversion cycle. That's the days receivable plus the days inventory minus the days payable. And again, the lower the cash conversion cycle days, the better. And we will show you an example in one of the upcoming slides on how much you would save if your debt cost was 5% in your company by lowering that cash conversion cycle days.

Let's move on to the next slide.

Slide 15, we're going to talk in more detail about the cash conversion cycle. And let's go to slide 16.

The cash conversion cycle, here is some more detail on how it's calculated. You take 365, divide it by the accounts receivable turnover, plus 365, divided by the inventory turnover, minus 365, divided by the accounts payable turnover. So those will all be in days. And the lower the cash conversion cycle, the better. A low cash conversion cycle indicates that the firm is selling goods faster, collecting accounts receivable faster, and deferring payment of accounts payable. A low cash conversion cycle will reduce holding costs and interest expense, increase income and profits.

Again, this is a key metric in every company that has inventory and accounts receivable. Even if you don't have inventory, you're a service company, you should know your cash conversion cycle. And again, the lower, the better. And we have an example coming up with our hypothetical company, Acme Corporation, on how to calculate it and what the cost is of each component in the cash conversion cycle.

So let's move on to the next slide, slide 17. First bullet point on slide 17, the dollar amount of the cash conversion cycle is the amount a firm has tied up in these working capital items. If you put a dollar amount on the three things in the cash conversion cycle formula, accounts receivable, inventory, and accounts payable, take the amounts off your balance sheet at the end of the year, that's the net dollar amount, receivables plus inventory minus accounts payable that a firm has tied up in its working capital items. And depending on your firm, that can be a very sizable amount.

The second point there is if a firm's cost of debt is 5%, then 5% of the cash conversion cycle amount is the cost of carrying these working capital items. So if I take my accounts receivable, dollar accounts receivable at the end of the year, plus my inventory at the end of the year minus my accounts payable, whatever that number is, if I multiply that by 5%, that's my cost of capital in my company. That's what it's costing me to carry those working capital items. And again, we have an example coming up of how to calculate this.

And the last point there on slide 17, an improvement in the cash conversion cycle will increase a firm's free cash flow and profits. And we will show you the dollar effect of that in a couple upcoming slides.