Short Term Financial Planning and Working Capital

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Short Term Financial Planning and Working Capital
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• Previously we examined long term financing and
  cash needs by focusing on long term planning
  tools
• Statement of Cash Flows
• Financial Plans
• However long term financial plans mask important
  intra-year activities
• Seasonality
• Timing of Cash Flows

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• Much of the impact of seasonality occurs within
  current asset and liability accounts
• Working Capital Accounts
• This chapter extends the financial planning
  discussion to
• The impact of working capital policy
• Cash Conversion Cycle
• Cash budgeting
• Creation of a monthly cash budget

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Working Capital Terminology

• Working capital
• refers to a companys investment in current
  assets (i.e. cash, marketable securities,
  accounts receivable, and inventory)
• Net Working capital
• is defined as current assets less current
  liabilities.

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• Net operating working capital (NOWC)
• NOWC is all current assets not earning explicit
  interest less all current liabilities not
  charging interest.
• Used in later discussions of free cash flow

• Working capital policy
• Policies that impact a firms investment in
  current assets or how a firm finances its
  investment in current assets.

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• Working capital management
• refers to the setting and implementing of current
  asset policies

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Why is Working Capital Management Important?

• For many companies the investment in current
  assets can reach and exceed 50 of total assets
• These accounts are impacted daily by the
  day-to-day operating decisions made within a
  company
• The dynamic nature of current assets and
  liabilities creates a spontaneity to these
  accounts.

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• In a economic downturn It is easy for these
  accounts to grow unchecked
• Inventories Swell
• Accounts Receivable Swell
• Reduces Asset Turnover which Reduces ROE
• Increased investment in current assets requires
  cash flow!!
• While proper long-term financial planning and
  capital budgeting are necessary for long term
  survival proper working capital management is
  necessary for short term survival.
• Fortunately the concepts are fairly simple.

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The Operating and Cash Cycles

• A Typical series of operating events in a company
  might look like this

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• Operating Cycle Number of days from the
  acquisition of inventory until the actual
  collection of a sale (90 days)
• Inventory Period Number of days from
  acquisition of inventory until sale of inventory
• Receivables Period The length of time from sale
  of inventory until collection

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• Cash Cycle The number of Days we are actually
  out-of-pocket. The time from when we pay for
  inventory until we collect on a sale.
• Payables deferral Period the portion of the
  operating cycle that is financed by suppliers
  through accounts payable and by employees through
  accrued wages and benefits.

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Zero Working Capital

• An increasingly popular working capital strategy
  aimed at achieving a zero or better cash cycle.
• By examining exhibit 5.2 we can see that a firm
  can reduce its need for working capital by
• Reducing the amount of time that goods are held
  as inventory. This can be accomplished by
  improving the inventory control process or by
  employing just-in-time inventory practices where
  suppliers deliver materials just as they are
  needed.

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• Collecting accounts receivable more quickly.
  Among the methods available to speed up the
  collection process are improving the efficiency
  of the collection process, offering larger
  discounts to encourage early payment and charging
  interest on accounts that are overdue.
• Paying bills more slowly.

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Calculating the Operating and Cash Cycles for
Trout Slayer Products

• What are the operating and cash cycle for TSP for
  2000 and 2001
• Relevant Income Statement Data

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• To calculate the Operating and Cash Cycles we
  need three things
• Inventory period
• Accounts receivable period
• Payables deferral period

• Operating Cycle
• Inventory Period

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• Improvements in Inventory Period reflect
  turnaround in business

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• Accounts Receivable Period

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• The Operating Cycle

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Cash Cycle

• Payables deferral period

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• Improvements in Inventory Period reflect
  turnaround in business

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• Cash Cycle

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The Link to profitability and Shareholder Returns

• The operating and cash cycles impact firms in a
  number of ways.
• Liquidity

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• Reducing the cash cycle by decreasing the
  operating cycle results in higher cash velocity.
  
• By reducing inventory or accounts receivables we
  decrease the time that cash sits in inventory and
  accounts receivable.
• The result is that a firm gets cash back sooner
  and can reinvest in growth internally without the
  need for more expensive external financing.

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• ROE and Profitability
• Remember
• Reducing the Operating Cycle improves Asset
  Turnover
• Reducing the need for external financing may
  improve profit margins

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Dell Reengineers Working Capital
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Cash Budget

• Previously we produced a first-pass of a
  financial plan for TSP Corp.
• EFR was 6.17 million
• This is the amount of external financing TSP will
  need to support growth in 2002.
• But does this actually reflect the maximum
  financing requirement for 2002?
• The forecasted balance sheet is reproduced here

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• Creating a Cash Budget
• Projected sales for 2002

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• Assumptions Used to Build the Cash Budget

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• Collections
• Sales for TSP are collected over a 3-month period
• 20 percent of sales collected during the month of
  sale.
• 50 percent collected the next month.
• The remaining 30 percent collected two months
  after sale

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• The Budget Collections

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• Disbursements
• TSP purchases inventory two months prior to
  sales.
• The cost of materials runs 50 percent of sales
• TSP pays for the inventory one month after
  purchase.

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• Putting it Together

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• Clearly the Cash needs of TPC are quite different
  than what we forecasted earlier.
• Need nearly 17 million in April
• What do you do?
• Is it temporary?
• Is it permanent?