Corporate Financial Strategy (CFS)

A Few Selected Issues Relating to Your Assigned Reading

WEEK 2, Ensuring Liquidity: Working Capital (W/C) Management

MSIN3017/ MSINM013- Lecture Slides Set 1 of 2

(corr am 11.10.16)
Gentle Reminders..

1) For those still who do not have the CFS Course Core text (Pearson)– OBTAIN IT,
IMMEDIATELY* both in order to avoid falling behind and to help ensure that you possess
adequate understanding of foundation CF concepts critical to advanced issues in later weeks.

2) By deliberate design, remember that lecture slides do NOT comprise a substitute
for your completion the full assigned reading each week– Weekly lectures
concentrate on 2-3 issues of importance selected from the readings each week, while there
may well be twice that number of principal issues of importance.

continued…

*Available ONLY from Gower Street Waterstone’s (across the street from EFB bldg.) As this is a composite special text
special for this course, it is NOT available through alternative outlets, such as Amazon.com.
.
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Financial Purpose of the Corporation = LAST
Maximising Returns for Continuing Shareholders = WEEK
Maximising ROE (or would Stern/Copeland/ K&R say better still, CFROI?)

But Ensuring Liquidity Is 1st on FD’s Agenda

For W/O Adequate W/C to Sustain THIS
Existing Operations W/ Room for Contingencies and Growth, WEEK

v  Suppliers go unpaid; Next: cash-on-delivery w/ multiple negative consequences

v  Talent leaves, essential projects/investments are missed, as company ‘counts

pennies but loses pounds’ (Palm 2003 brought down by the ‘bean-counters’)

v  Rivals have ammunition for going after shared accounts with a negative message

v  Company loses credibility in ALL aspects, as the rudiments of effective financial
management is missed

v  Reduced income : emergency financing is expensive!

v  Possible adverse audit judgment (Non-continuing entity)

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 Agenda

1)  Requirements / Uses of Working Capital

2)  Primary and Secondary Sources of W/C

3)  The Cash Conversion Cycle: Surges, Bottlenecks

4)  Receivables (Debtors) Management

5)  Inventories: The Prohibitive Cost of Zero Stock-Outs

6)  The Working Capital (W/C) & Acid Test (AT)Paradox

7)  The Cash Paradox

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 1.
REQUIREMENTS FOR /
USES OF, WORKING CAPITAL
(W/C)

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Working Capital: requirements
Definition, Measures
Current Assets Minus Current Liabilities (ratio CA/CL, although for liquidity & solvency
purposes, the Quick or Asset Test ratio (CA-inventories) / CL) tends to be more useful.

Why Important
Bankrupt companies are often profitable at the time of filing, collapsing because of insufficient
liquidity. A company perceived as an insolvent loses firm its top talent, supplier and market
standing. In extreme instances, an irreversible ‘death spiral’ arises, as the following sequence
occurs: (a.) trade credit insurance is denied, (b.) company now must pay for its supplies in
advance, further stretching its liquidity at the worst possible time, whilst (c.) trade rumours by
rivals slow or stop the flow of incoming orders.

Manifestations of W/C Problems in Terms of Balance Sheet Line Items

By one or more of the following: (a.) excessive credit terms, slow receipts and mounting bad
debts; (b.) excessive inventories including loss, damage and theft, with slow conversion from
raw materials to finished inventory; (c.) excessive dormant (non-earning) cash balances; (d.)
insufficient exploitation of trade credit– creditors– opportunities; (e.) management oblivious to
seasonal patterns in liquidity requirements.

Determining W/C Adequacy

Coverage (ratios), internal patterns and trends, comparables (rivals, both spot and trend)
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Working Capital: uses
1.) In order to ensure sufficient liquidity to support daily operations
This is the financial ‘grease’ required to keep the gears of the corporate profit mechanism
running smoothly, whether company is in manufacturing or services. How do
W/C requirements differ for a services company as compared to a manufacturing firm?

2.) In support of the company’s business model and plan*

If the W/C strategy is inconsistent with the company’s business model– such as when sales are
far too great to be supported by available terms extended for raw materials, ‘something has to
give’– either prices must be raised to reign in volume, or supplier arrangements expanded, or
both, as an example.

3.) As an overall barometer of company operational performance

The company which is poorly managed in W/C terms faces likely concerns about other aspects
of its business, possibly including internal controls and reporting practices. Poor W/C alone is
sometimes a reason for excluding the company as a merger target or strategic alliance partner
(unless, of course, the would-be acquirer is particularly strong in these areas).
continued…
Increased sales usually mean that the level of trade receivables (debtors) will increase… Increased
output brings requirements for increases in all components of inventory, but particularly intermediate
stages (WIP) if inventory management is lacking…

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Working Capital: uses (con’t.)
4.) To reduce the company’s LT financing requirements
In the best-managed companies finance-wise, W/C is not a drain on scarce capital, but
rather, a reliable and cheap source of semi-permanent capital, thereby reducing the
company’s reliance on more expensive, longer term debt and equity financings.

5.) Towards maximising the ongoing wealth of the firm’s owners

Beyond merely ‘maximising shareholder value’ as a corporate mantra, expressed
excessively, enacted rarely if ever.

The company with too much cash, too slow an inventory turnover rate, and/or
which pays insufficient attention to uncollectible (bad) debts and obsolete
inventory is diminishing the performance of the company, as
each of those deficiencies in working capital financial management directly translates
into reductions in future CF, and thus, company worth.

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 2.
PRIMARY, SECONDARY
SOURCES OF WORKING
CAPITAL LIQUIDITY

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‘Sources’ of W/C:

There are Some W/C Sources that Commonly Come to Mind….

Trade credit (purchases of goods and services on credit) and bank overdrafts as the
tend to emerge as the sources that are most easily obtainable by companies.

Where do both of these appear in the firm’s balance sheet? Are trade credit and
overdrafts reflected in the company’s gearing ratio (leverage) calculation?

…But Then There Are Other Opportunities That May Be Neglected, If Not
Ignored Entirely

Less attention is usually paid to the sources of W/C

on the asset side of the balance sheet, which precedent suggests may rival or
even exceed.

How are debtor actions coordinated with creditor actions by the FD

who is an effective W/C manager?

Why might ‘asset-side sources’ of W/C be less emphasised

than debt side sources? 10
 3.
THE CASH CONVERSION
CYCLE: SURGES,
BOTTLENECKS

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Converting Raw Materials to Cash:
Process Steps, Complexity, Bottlenecks

Typically, working capital / cash cycles are depicted in circular fashion, with the time
duration from point to point emphasised.

While such graphically appropriately emphasis the importance of SPEED (days’

inventory to sales, etc.), equally important aspects of relative size (surges) and
bottlenecks (obstacles) are ££
sometimes under-emphasised. RM work in
process
raw materials
WIP

debtors

SURGES (oversized balances in WIP,

debtors. BOTTLENECK from debtors to
finished cash, because of bad debts, slow-pay terms
goods inventory FG
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 4.
RECEIVABLES (DEBTORS)
MANAGEMENT

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Debtors: Behind the Metrics
General Measures May Not Always Indicate the Source of the Problem

Days Sales Outstanding (DSO) is the most widely cited receivables (debtors) ratio,
with a lower number indicating faster conversion of accounts receivables to cash:

Accounts Receivable
X Number of Days*
Total Credit Sales

But without some additional analysis, the cause of a high DSO does
is difficult to uncover. Additional investigations:

- Timing of debtors
What information comes
- Analysis of credit terms v rivals from each analysis. Why are
- Bad debt early and present all three analyses important?
indicators
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*Quarterly or annually
 5.
INVENTORIES: THE
PROHIBITIVE COST OF ZERO
STOCK OUTS

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 A Situation:

The ‘marketeers’ in your office just returned from a Treat the Customer As King
lark conference, where the importance of ensuring a DEE-LIGHTFUL!!

shopping experience for EACH AND EVERY customer was emphasised.

The MD overhead their discussion, and was suitably impressed. As a

consequence, he has proclaimed a NO STOCK OUTS EVER POLICY.

Do you have any misgivings about this new idea from the ferrets
in marketing? If so, what can/should you point out to the MD to ensure
that it’s the Finance Dept., not the marketing people, who get the next
boondoggle?

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 6.
THE W/C and ATR Paradox

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Increases in Working Capital Ratios (CA/CL) and
Asset Test Ratios ((CA-Inventories)/CL) Are Generally Considered
Positives...

… Under What Circumstances an Increase in ATR Be a NEGATIVE?

Creditors
(Trade
Debtors Payables)
(Accounts
Receivables) Other ST
Liabilities
Cash
Current Portion
of LTD

CA-Inventory CL
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 7.
CASH PARADOX

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Not Enough Cash? BAD, BAD, BAD…
Cannot service debt, possibly leading to default and bankruptcy

Cannot pay top talent on time, and they go off to the competitor, filled with an angry desire to
beat your firm in the marketplace

Pay suppliers late or not at all, resulting in loss of preferential credit terms and, in extreme
instances, low of trade insurance

BUT Excessive Cash may ALSO be BAD, BAD, BAD…

Cash is an underproductive asset, so value is being destroyed

Temptation for fraud or outright theft

Company elevated as a possible acquisition target: ‘Other Peoples’ Money’

Are there some other recent cash dilemmas of this sort, from your suggested continuing
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readings in business publications suggested in Week 1 and also in the CMO?