Chapter 1 The Role of Working Capital

1
Chapter 1The Role of Working Capital
Sales
Inv
A /R
Cash
2
Objectives

• View firm as a system of cash flows
• How WC and depreciation create disparities
  between profit and cash flow
• Management aspects of various WC accounts
• Discussion of appropriate level of WC

3
The Cash Flow Timeline
Order Order Sale
Cash Placed Received
Received

Accounts Collection lt
Inventory gt lt Receivable gt lt Float
gt Accounts Disbursement Time
gt lt Payable gt lt Float gt
Invoice
Payment Cash
Received Sent
Paid
4
...in the beginning
Balance Sheet - June
1 Cash 1,000 Debt 500
Common Stock 500 Total
1,000 Total
1,000
5
The Next Day, June 2
Balance Sheet - June 2 Purchase Fixed
Assets and Inventory Cash 400 A/P
300 Inventory 300 Debt 500 Fixed
Assets 600 Common
Stock 500 Total 1,300 Total 1,300
6
End of June
Balance Sheet - June 30 Sale of
product, incur operating expenses, incur
depreciation, and generate profit Cash
325 A/P 300 A/R 700 Accruals
200 Inventory 0 Debt
500 Fixed Assets 600
Common Stock 500 (Accum Depr)
(100) Retained Earnings
25 Total 1,525 Total 1,525
7
July 1
Balance Sheet - July 1 Pay
operating accruals with cash Cash
125 A/P 300 A/R 700 Accruals
0 Inventory 0 Debt
500 Fixed Assets 600
Common Stock 500 (Accum Depr)
(100) Retained Earnings
25 Total 1,325 Total 1,325
8
July 15
Balance Sheet - July 15
Pay payables with cash Cash (
175) A/P 0 A/R 700 Accruals
0 Inventory 0 Debt
500 Fixed Assets 600
Common Stock 500 (Accum Depr)
(100) Retained Earnings
25 Total 1,025 Total 1,025
9
July 31
Balance Sheet - July 31
Collect accounts receivable Cash
525 A/P 0 A/R
0 Accruals 0 Inventory
0 Debt 500 Fixed Assets 600
Common Stock 500 (Accum
Depr) (100) Retained Earnings
25 Total 1,025 Total 1,025
10
Profit versus Cash Flow

• Question Why did the firm end up with 125 in
  additional cash while earning a profit of 25?
• Answer Some expenses are not cash expenses.
• Question Why did the firm run out of cash during
  its operating cycle?
• Answer The cash deficit was due to the
  differences between the timing of cash
  disbursements and cash receipts.

11
Important Points

• The firm must manage its cost structure to
  generate a profit
• WC accounts must be managed so that liquidity is
  maintained.

12
Relationship Between Accrual Income and Cash Flow
Income Statement Adjustment Account Cash Flow
Account Sales - Change in accounts
receivable Cash collected Cost of goods sold -
Change in accounts payable Change in
inventory Cash paid to suppliers Operating
expenses - Change in operating accruals -
Depreciation Cash paid for
operating expenses Interest - Change in
accrued interest Cash paid to
creditors Taxes - Change in accrued taxes -
Change in deferred taxes Cash paid for
taxes _________________ ___________________ Ne
t Profit Operating Cash Flow
13
Managing the Cash Cycle

• Managing Inventory
• Managing Receivables
• Managing Payables
• Electronic Commerce

14
Managing Inventory

• JIT
• Trade-offs between
• stock out costs
• cost of excess inventory
• ordering costs

15
Managing Receivables

• Who should receive credit and how much?
• Credit terms
• Monitoring the outstanding balance
• Speeding up the receipt of payments through
  lockboxes

16
Managing Payables

• Search for terms that match with cash receipts
• Timing of payment
• Controlled disbursement

17
Electronic Commerce

• Revolutionizing management of cash cycle
• Proprietary systems
• Impact of Internet

18
How Much WC is Enough

• One view
• optimal level is zero
• WC is an idle resource
• Provides little value
• How much in resources to commit?
• Why inventory?
• Why receivables and payables?
• Why short-term investments?
• Chryslers 5 billion cushion of investments

19
Summary

• Firm must operate at a profitable level
• A profitable firm may still struggle financially
• Working capital soaks up cash flow and may cause
  an otherwise profitable firm to fail
• A successful firms operation is managed from a
• profit and a
• cash flow perspective