s17 Cash and Cash Conversion Cycle
s17 Cash and Cash Conversion Cycle
s17 Cash and Cash Conversion Cycle
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Chapter 17
Cash and Cash Conversion Cycle
Cash is King
PLEASE NOTE: This book is currently in draft form; material is not final.
During the financial crisis of 2008 many of the very wealthy were doing the
unthinkable: they were flying commercial! Instead of taking the private jet to Aspen
or Monaco, the wealthy were arriving two hours early for flights and going through
security (just like us commonfolk). The rich were reducing spending in other ways
as well: luxury car sales were down, as were vacation home sales and purchases of
art and collectables. The affluent were looking for bargains. Why such austere
measures amongst those whose assets were valued in the millions? The collapse of
financial markets and the decline in real estate values, among other factors, created
a situation of having wealth on paper, but lacking liquid assets, that is, cash.
Cash flow is important in business, too. Assets on financial statements do not always
translate into money available to pay workers or suppliers. The financial crisis took
its toll on many companies as well and led to bankruptcies for large companies such
as Lehman Brothers, General Motors, and CIT Group, Inc. Cash management is like a
see-saw that companies need to balance between keeping cash on hand and
investing in assets. They need enough cash to be liquid enough to pay suppliers and
please creditors, but demanding too much cash from investors can increase
financing costs. In this chapter we discuss the cash flow of a firm, including taxes,
and describe techniques that can be used to forecast future cash production or
need.
260
Financial Planning
LEARNING OBJECTIVES
1. Describe a corporate financial plan.
2. Distinguish and explain the difference between short-term and longterm plans.
KEY TAKEAWAYS
A financial plan is an assessment of a companys current financial
situation and a projection of their future situation.
Short-term plans are 12 years and long-term plans are typically 210
years.
1. An evaluation of a companys
current financial state and a
plan for the future.
261
EXERCISES
1. Why does a company need a financial plan?
2. In what ways is a corporate financial plan similar to a personal financial
plan? Do you have a personal financial plan? If not, do you have plans to
create one?
262
PLEASE NOTE: This book is currently in draft form; material is not final.
LEARNING OBJECTIVES
1. Describe a cash budget and its components.
2. Distinguish and explain the difference between cash inflows and
outflows.
3. Identify the parts of a sales forecast.
Creating a cash budget is a way for a firm to estimate its short-term cash income
and expenditure requirements. Typically cash budgets are for a one-year period,
usually divided into months to capture the seasonality experienced by many
businesses. Just like an individual would want to plan for higher heating bills in the
winter, a business would want to plan for seasonal fluctuations, such as lower sales
for snowblowers in the summer. A cash budget is very different from the cash flow
statement.
263
Cash increases occur anytime you have a decrease in any asset or an increase in
liabilities. How is this? If any of your assets decrease (for example accounts
receivable or inventory) this means that cash has been freed up to be held as cash
instead of being tied up as AR or in inventory. In essence we put money in the safe
(a cash inflow) and a have a decrease in our asset. Conversely, a companys cash
balance decreases (cash outflow) if there is an increase in any of its assets. If accounts
receivable or inventory increases, then that is more money held as that asset and
therefore less money held as cash. So the companys cash balance decreases.
With liabilities the opposite is true. An increase in any liability such as accounts
payable results in an inflow of cash. In other words, if accounts payable increases
than that means we did not pay as much on our payables and therefore we are
holding more cash. If accounts payable decreases, then we have a cash outflow
because we used cash to pay our payables. Profit is a bit easier. So easy in fact we
can sum it up in one sentence: Any profit is a cash inflow and any loss is a cash
outflow.
264
KEY TAKEAWAYS
Cash management is vital to the health of any company. A cash budget is an
vital tool in cash management as it helps with a companys financial
planning, both short-term and long-term.
A cash budget is an important tool in financial planning.
Key in accurate prediction of a cash budget is the sales forecast and any
other external or internal variables
Cash inflows are positive, cash outflows are negative.
EXERCISES
265
PLEASE NOTE: This book is currently in draft form; material is not final.
LEARNING OBJECTIVES
1. Identify working capital and why working capital is needed.
2. Explain different strategies for determining the level of working capital.
Related to cash is net working capital. Net working capital is not specifically cash
but instead the diference between what we currently owe and what we currently
own. These are our immediate sources and uses of cash. To see if we can pay our
bills we need to manage our current assets and liabilities; as these will all come due
within a year. Working capital management is the creation of a working capital
policy and the day to day management of cash, inventories, receivables, accruals
and payables and is a large part of a financial managers job. It includes the
determinination of the level of each of these items and also the financing of these
items. Working capital policy impacts a firms balance sheet, financial ratios and
possibly credit rating. Businesses risk defaulting if they dont have enough cash to
pay their debts.
Net working capital4 is the difference between current assets and current
liabilities. Change in net working capital is most simply the change in current assets
minus the change in current liabilities.
If Current Assets > Current Liabilties, then Net Working Capital is positive
If Current Assets < Current Liabilities, then Net Working Capital is negative
266
Seasonal Requirements
Demand for working capital is not constant. Weve discussed how net working
capital can increase due to growth or new projects, but companies can also have
seasonal current asset requirements. Ski resorts, ice cream shops, department
stores, and many tourist businesses have seasonal funding requirements: they may
have different levels of current assets at different times of the year.
267
268
269
KEY TAKEAWAYS
Working capital is the difference between current assets and current
liabilities.
There are different strategies to manage working capital including
aggressive and conservative.
EXERCISES
270
PLEASE NOTE: This book is currently in draft form; material is not final.
LEARNING OBJECTIVES
1. Describe the parts of the cash conversion cycle.
2. Calculate the cash conversion cycle.
3. Explain how to manage the cash conversion cycle to manage operating
capital.
The cash conversion cycle is divided into three parts: the average payment period,
the average collection period and the average age of inventory. The firms
operating cycle6 is length of time from the receipt of raw materials to the
collection of payment for the goods sold. This is, essentially, how long it takes from
the start of making a new product until we receive cash (on average). The operating
cycle is thus the sum of the inventory conversion period7 (the average time
between when raw materials are received into inventory and product is sold) and
the receivables conversion period8 (the average time between a sale and
collection of the receipt).
271
The inventory conversion period can be estimated if we know the average balance
of our inventory and the average value of goods sold each day of the year. The latter
should be equal to cost of goods sold for the year divided by 365.
Equation 17.1 Inventory Conversion Period
InventoryConversionPeriod =
Avg. Inventory
Invent
=
Avg. DailyCostof GoodsSold
(COGS/
272
ReceivablesConversionPeriod =
Avg. Receivables
A/R
=
Avg. DailyRevenues
(Revenues/365)
PayablesConversionPeriod =
Avg. Payables
A/P
=
Avg. DailyPurchases
(Purchases/365)
273
CashConversionCycle =
OperatingCycle Pa
= InventoryConversionPeriod + ReceivablesC
A/
Inventory
=
+
(COGS/365)
(Revenu
Our examples cash conversion cycle is thus 20 days + 30 days 15 days = 35 days.
Figure 17.5 Cash Conversion Cycle Example
Typically, the shorter the cash conversion cycle, the better, as it means we are
keeping our cash moving instead of having it tied up in Net Working Capital. There
are other considerations, however. Perhaps, extending collections of receivables,
for example, might entice more sales from our customers. Then we need to balance
the benefits from the extra sales with the additional costs in Net Working Capital
due to the lengthening cash conversion cycle.
274
CABS Example
Figure 17.6 CABS Balance Sheet
Lets calculate the cash conversion cycle for 2011. Lets assume that purchases are
90% of the COGS.
First, need to determine the inventory conversion period. Average daily COGS is
910.4 thousand/365 days = 2.49 thousand per day. Ending inventory in 2011 was 33.6
thousand, so 33.6 thousand/2.49 thousand per day = 13.5 days.
275
Average daily revenues are 1,680 thousand/365 days = 4.60 thousand per day.
Ending A/R in 2011 was 162.5 thousand, so 162.5 thousand/4.60 thousand per day =
35.3 days.
Annual purchases are 90% 910.4 thousand = 819.4 thousand. Average daily
purchases are 819.4 thousand/365 days = 2.24 thousand per day. Ending A/P in 2011
was 135 thousand, so 135 thousand/2.24 thousand per day = 60.3 days.
The cash conversion cycle is therefore 13.5 + 35.3 60.3 = 11.5 days. Since our
payables conversion period is so long (almost twice the receivables conversion
period), we end up paying for the materials after weve received payment from our
customers!
276
KEY TAKEAWAY
The shorter the cash conversion cycle, the better we are managing our
cash flow.
EXERCISES
1. What does each of the components of the cash conversion cycle
represent?
2. Calculate the cash conversion cycle given the following
information:
Inventory Conversion Period = 25.3 days
Receivables Conversion Period = 19.9 days
Payables Conversion Period = 14.7 days
277
PLEASE NOTE: This book is currently in draft form; material is not final.
LEARNING OBJECTIVES
1. Explain how cash and cash budgets fit into the larger picture of financial
management.
2. Describe some ethical considerations of cash budgets and management.
Ethical Considerations
When considering cash management, its tempting to try to decrease our cash
conversion cycle at all costs. Some strategies may hurt our relationship with our
customers: overly aggressive collections can alienate customers, or we might deny
credit to customers when they need our support most.
Unscrupulous managers might also manipulate reporting of current assets to falsely
represent the state of the company. They might not properly account for bad debts;
net income will consequently be higher, but only as accounts receivable swells into
a ticking time-bomb. If the manager is rewarded for raising revenue, he or she
might relax credit standards and sell to customers who have no capacity to pay.
Even if the customer can scrape together the payments, perhaps the burden
would be too much (for example, a low-income customer leasing a luxury
automobile).
278
KEY TAKEAWAYS
Proper cash management is vital.
Policies regarding cash have the potential to alienate customers. Balance
is key in proper cash management.
EXERCISE
1. Your company has a 90 day collection policy for receivables. A customer
is having a cash flow issue, and asks for more lenient payment terms.
What are some of the ethical considerations for this scenario?
279
PLEASE NOTE: This book is currently in draft form; material is not final.
EXERCISES
280