Ignacio Lezaun

English edition
2021

Fundamentals of Finance

1
 2

Contents of the course

1. The role of the Chief Financial Officer

2. Statement of cash flows
3. Working capital management
4. Short-term finance instruments
5. The time value of money
6. Conclusions

11/20/2021
Unit 3: Working Capital 3

Management UNIT 3

OBJECTIVES
1. Background
2. Managing and Measuring Liquidity
3. Managing Accounts Receivable
4. Managing Accounts Payable
5. Managing Inventory
6. Working Capital Management
11/20/2021
 4

UNIT 3

3.1 Background

11/20/2021
 5
All activities require resources UNIT 3
For example …

• An industrial company requires a supply of raw

materials, and to store the finished product before
distributing it

• In a commercial enterprise, merchandise must be

purchased, stored, and shipped

• In a service provision company, structural expenses

must be borne until the service provision is
completed
11/20/2021
Operating and cash cycles of a 6

firm UNIT 3

+ Manufacturing

11/20/2021
What is working capital 7

management? UNIT 3

 Deals with short-term aspects of corporate finance activities

 A way to ensure a firm has access to funds for day-to-day expenses

without compromising on asset investment
 For example: if incoming cash is delayed (e.g. because of
uncollected receivables) or if cash leaves too quickly (e.g. by making
payments earlier than due), short-term liquidity becomes an issue
for day-to-day expenses

To avoid this, the firm needs effective working capital

management

11/20/2021
Finance definition 8

UNIT 3

11/20/2021
 9
Accounting definition
UNIT 3

WORKING CAPITAL =

CURRENT ASSETS – CURRENT

LIABILITIES

11/20/2021
Accounting definition: Apple example 10

UNIT 3

Working capital

= 134,931 - 89,704

= 45,227

11/20/2021
Accounting definition: Spotify example 11

UNIT 3

Working capital

= 2,231- 2,439

= (208)

11/20/2021
But where does liquidity come 12

from? UNIT 3

1. Primary Sources:
 E.g. cash balances, short-term funds
 Changes don’t usually result in change in company’s operations

2. Secondary sources:
 E.g. liquidating assets, filing for bankruptcy protection
 May lead to significant changes in firm structure and operations
 Could indicate firm’s deteriorating financial position

11/20/2021
Is it better to have too much or too 13

little liquidity? UNIT 3

 It depends …

 Too little indicates firm might be in trouble

 Too much can mean firm is inefficient (untapped resources,
shareholders to be rewarded)
 But sometimes the liquidity position can be part of a well defined
strategy: inorganic growth in turnaround/volatile contexts (competitors,
clients, suppliers to be purchased, etc.)

Managing liquidity is therefore critical

11/20/2021
 14

Reasons for little liquidity UNIT 3

 A drag on liquidity occurs when cash coming into firm is

delayed due to:
 Uncollected receivables
 Obsolete inventory

 A pull on liquidity happens when:

 Cash leaves the firm too quickly (early repayments, reduction
in trade credit)
 Access to credit is reduced because of reduction in financial
credit

11/20/2021
 15
Reasons for little liquidity
UNIT 3

11/20/2021
 UNIT 3

3.2 Managing and measuring

liquidity
Measuring liquidity:
Current ratio UNIT 3

CURRENT RATIO = CURRENT ASSETS ÷ CURRENT

LIABILITIES

 A higher current ratio means firm is better positioned to meet

short-term obligations

WORKING CAPITAL = CURRENT ASSETS - CURRENT

LIABILITIES ÷÷

 Current ratio of less than one means negative working capital

(i.e. working capital is less than zero)
 Negative working capital implies firm may have liquidity
crisis
Current ratio: Apple example
UNIT 3

Current ratio

= 134,931 ÷ 89,704

= 1.50
This means there is positive
working capital
Current ratio: Spotify example
UNIT 3

Current ratio:

= 2,231÷ 2,439

= 0.91

This means there is

negative working capital, as
the ratio is less than one
Measuring liquidity:
Quick ratio (a.k.a. Acid test) UNIT 3

QUICK RATIO = (CURRENT ASSETS – INVENTORY) ÷ CURRENT

LIABILITIES

Accounting definition: Ratio of quick assets to current

liabilities
Quick assets are those that can be easily converted to
cash and exclude inventory (because it is usually the
least liquid current asset)
In other words (finance definition):

[accounts receivable + cash] vs. [accounts payable]

Quick ratio: Apple example
UNIT 3

Quick ratio

= (134,931- 3,355)
÷ 89,704

= 1.47
 UNIT 3
Is measuring liquidity enough?

Higher quick and current ratios indicate greater

liquidity
But to see if a given ratio is good or bad, we need to
look at:
 Trends in ratios
 How they compare with ratios of competitors
For this, we look at accounts receivable, accounts
payable and inventory
Class exercise: Laserlus company
◼ The following information about the company Laserlus SL is provided: UNIT
◼ Balance sheet for the years 2020 and 2021
2
◼ Income statement for the year 2021

◼ For the year 2021, calculate:

1. Current ratio
2. Quick ratio (acid test)
3. Calculate CR and QR for 2020 (assuming same Income statement)
4. Comment on the evolution

11/20/2021
Class exercise: Laserlus company

GROSS ASSETS
31/12/20
150,000.00 €
31/12/21
150,000.00 € CAPITAL
31/12/20
120,000.00 €
UNIT
31/12/21
120,000.00 €
DEPRECIATION
NON-CURRENT
-30,000.00 € -35,000.00 € RESERVES 18,000.00 € 2 21,600.00 €
ASSETS 120,000.00 € 115,000.00 € NET INCOME 6,000.00 € 7,500.00 €
INVENTORIES 18,500.00 € 5,000.00 € NET EQUITY 144,000.00 € 149,100.00 €
CUSTOMERS 38,000.00 € 20,000.00 € NON-CURRENT LIABILITIES -€ -€
CASH 24,900.00 € 33,975.00 € SUPPLIERS 15,000.00 € 4,125.00 €
CURRENT ASSETS 81,400.00 € 58,975.00 € TAXES PAYABLE 2,400.00 € € 750.00
OTHER DEBTS 40,000.00 € 20,000.00 €
CURRENT LIABILITIES 57,400.00 € € 24,875.00
TOTAL ASSETS 201,400.00 € 173,975.00 € TOTAL EQUITY + LIABILITIES 201,400.00 € 173,975.00 €

INCOME STATEMENT 2021

Sales 120,000.00 €
Cost of materials 30,000.00 €
Direct labor cost 37,500.00 €
Indirect costs 35,000.00 €
Depreciation 5,000.00 €
Gross margin 12,500.00 €
General expenses 2,000.00 €
EBIT 10,500.00 €
Interests € 500.00
EBT 10,000.00 €
Tax 2,500.00 €
Net Income 7,500.00 €

11/20/2021
 UNIT 3

3.3 Managing accounts receivable

 Collections
• The collection is the monetary flow that comes from a real transaction of
goods/services.

• From the moment a transaction occurs, the company has a collection right that
will be reflected in the balance sheet, in its current assets.

• Now, do all sales or services have to be on time? No

• What are the main components of collection management?

1. The assessment of the customer's credit risk.

2. The credit limit that will be granted to each client and the payment term.
3. The way to document the debt with the client and the means to collect it.
4. The guarantees requested from the client (endorsement, reservation of title over the goods
delivered ...)
5. The discount or surcharge for advance or late payment.
6. The procedures for claiming payment from customers at maturity (new deferrals or initiating
recovery through appropriate actions).
7. Actions to take in the event of non-payment, late payment interest, expenses ...

11/20/2021
Customer account 27

The balance of the customer account is determined by the sales made by

the company and not collected:

1. Suppose that on January 31, 2021, all the invoices issued have been
collected and the balance of the customer account is € 0.00.-.

2. On February 1, 2021, the company sells goods worth € 100,000 (VAT

not included), what will be the balance of the account Debtors,
customers receivable in the accounting that day?

3. The balance of the customer account will be € 121,000.- (if the

applicable VAT is 21%). And that balance will remain in the balance,
and will be increased by the rest of the sales that are made in the
following days until the moment of payment arrives.

11/20/2021
 Customer account 28

◼ At that moment, that outstanding balance disappears from the

customer account, and appears in the treasury.

◼ In this case, we are working with past events, but to carry out
good management it is important to determine what the
collection period will be from our clients to determine what
our treasury needs will be since while the due date of the debt
of our clients, we have a series of obligations to attend
(suppliers, payroll, taxes, supplies, loans, ...).

◼ It is essential to determine a collection term policy that does

not compromise the viability of the company.

11/20/2021
Accounts receivable: Apple example
UNIT 3
Accounts receivable UNIT 3

 Accounts receivable is the amount of money

owed by clients to a firm after goods or services
have been delivered and/or used
 Purpose of management: Ensure outstanding
accounts receivable items can be converted into
cash easily and fast
 Methods of management:
1. Accounts receivable turnover
2. Number of days of receivables

 Companies define client credit policies, and

actively monitor and manage these indicators
Accounts receivable turnover UNIT 3

ACCOUNTS RECEIVABLE TURNOVER = NET CREDIT SALES ÷ AVERAGE

ACCOUNTS RECEIVABLES

 Measures how many times, on average, accounts receivable are

created by sales and collected over a period
 A turnover close to the industry average is desirable

 Net credit sales = Net sales – Net Cash Sales

 VAT consideration: In financial statements, sales do not include VAT

but accounts receivable do: are the numerator and denominator
consistent?