SHORT-TERM FINANCIAL MANAGEMENT

Terry S. Maness and John T. Zietlow

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Chapter 1 The Role of Working Capital

Sales

Inv

A /R

Cash

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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

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The Cash Flow Timeline

Order Placed

Order Received < Inventory >

Payment Sent Cash Received Accounts Collection < Receivable > < Float >

Sale

Time ==>
Accounts < Payable > Disbursement < Float >

Invoice Received

Payment Sent Cash Disbursed Copyright 2005 by Thomson Learning, Inc.

...in the beginning

Balance Sheet - June 1

Cash

$1,000

Debt Common Stock

$ 500 500

Total

$1,000

Total

$1,000

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The Next Day, June 2

Balance Sheet - June 2 Purchase Fixed Assets and Inventory

Cash $ 400 Inventory 300 Fixed Assets 600 Total $1,300

A/P Debt Common Stock Total

$ 300 500 500 $1,300

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End of June
Balance Sheet - June 30 Sale of product, incur operating expenses, incur depreciation, and generate profit

Cash $ 325 A/R 700 Inventory 0 Fixed Assets 600 (Accum Depr) (100) Total $1,525

A/P Accruals Debt Common Stock Retained Earnings Total

$ 300 200 500 500 25 $1,525

Copyright 2005 by Thomson Learning, Inc.

July 1
Balance Sheet - July 1 Pay operating accruals with cash

Cash $ 125 A/R 700 Inventory 0 Fixed Assets 600 (Accum Depr) (100) Total $1,325

A/P Accruals Debt Common Stock Retained Earnings Total

$ 300 0 500 500 25 $1,325

Copyright 2005 by Thomson Learning, Inc.

July 15
Balance Sheet - July 15 Pay payables with cash

Cash $ ( 175) A/R 700 Inventory 0 Fixed Assets 600 (Accum Depr) (100) Total $1,025

A/P Accruals Debt Common Stock Retained Earnings Total

0 0 500 500 25 $1,025

Copyright 2005 by Thomson Learning, Inc.

July 31
Balance Sheet - July 31 Collect accounts receivable

Cash $ 525 A/R 0 Inventory 0 Fixed Assets 600 (Accum Depr) (100) Total $1,025

A/P Accruals Debt Common Stock Retained Earnings Total

0 0 500 500 25 $1,025

Copyright 2005 by Thomson Learning, Inc.

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.

Copyright 2005 by Thomson Learning, Inc.

Important Points

The firm must manage its cost structure to generate a profit

WC accounts must be managed so that liquidity is maintained.

Copyright 2005 by Thomson Learning, Inc.

Relationship Between Accrual Income and Cash Flow

Income Statement Sales Cost of goods sold Operating expenses Adjustment Account - Change in accounts receivable - Change in accounts payable + Change in inventory - Change in operating accruals + Depreciation - Change in accrued interest - Change in accrued taxes - Change in deferred taxes Cash Flow Account = Cash collected = Cash paid to suppliers = Cash paid for operating expenses = Cash paid to creditors = Cash paid for taxes ___________________ Operating Cash Flow
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Interest Taxes _________________ Net Profit

Managing the Cash Cycle

Managing Inventory Managing Receivables Managing Payables

Electronic Commerce

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Managing Inventory

JIT Trade-offs between:

stock out costs cost of excess inventory ordering costs

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Managing Receivables

Who should receive credit and how much? Credit terms Monitoring the outstanding balance

Speeding up the receipt of payments through lockboxes

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Managing Payables

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

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Electronic Commerce

Revolutionizing management of cash cycle Proprietary systems Impact of Internet

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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 billioin cushion of investments

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How Management of Working Capital is Changing

Exhibit 1-6 Working Capital Requirements as a Percent of Sales 35% 30% 25%
Percent of Sales

20% 15% 10% 5% 0% -5% -10% Years 1994 1995 1996 1997 1998 1999 2000 2001 2002

Dell Apple Compaq Gateway

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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.

Copyright 2005 by Thomson Learning, Inc.