Working Capital Management

Advanced Corporate Finance

WINTER Shanghai 2014- week 7

FINC 5880 Webster University

HAPP¥ N€W ¥€AR !

Look at the past success of Dell BTO strategy..

WC Dell

Remember WC= current assets used for

operations Net WC=current assets-current

liabilities Net Operating WC=Cash + AR+

Inventory-AP-Accruals Current ratio Acid test ratio WC policy; target levels and

finance WC Management: setting targets,

organize, lead, monitor…day to day…

Reduced WC creates value FCF will increase since delta WC

decreases over time EVA increases since the total

operating capital decreases and thus WACC*TOC

Remember EVA=NOPAT-WACC*TOC

Also ROE increases since total assets reduces

Remember ROE=ROS*Sales/Total Assets*Total Assets/Equity

Cash conversion cycle

Cash Purchase inventory Process goods Sell goods on credit Collect AR Cash

Conversion calculated Inventory Conversion:

Inventory/Sales per day (say 72 days)

Receivables Conversion: (also DSO) Receivables/Sales per day (say 24 days)

Payables Conversion: Payables/Purchases per day (note at COGS) (say 30 days)

Conversion cycle=72+24-30=66 days

Shorter conversion cycles create value!

Companies that pursue WCM actively

Boeing Guess PepsiCo Cisco Johnson Controls Mac Donald’s Eastman Kodak

WC score cards CFO magazine

calculates WC performance for main industries

Check their website at www.cfo.com

Barely Working: The 2003 Working Capital Survey Maybe they were preoccupied with governance

issues. But whatever the reason, U.S. companies blew some good chances last year to generate extra cash via working capital improvements. That's the primary conclusion of CFO's annual CFO's annual working capital survey, conducted by REL Consultancy Group.

The survey, which examines the 1,000 largest U.S. companies, showed the average company improved its days working capital (DWC) by a meager 2.1 percent. That's a poor showing compared with previous years — for 2001 the improvement was 9 percent. It's also just a fraction of the 7.6 percent improvement recorded by European companies

WC Performance… U.S. Versus Europe

A comparison of the top 1,000 companies (by sales, in $billions, for all figures) here and in Europe show European firms narrowing the gap.

Despite deterioration in DPO, they improved their average DWC by 7.6 percent. Their U.S. counterparts displayed an unimpressive 2.1 percent improvement in DWC in 2002.

Zero WC General Electric.. Inventory should be

financed by suppliers So force payables to this

level WC=AR+ Inventory-AP

these three elements are intensively managed

Companies carry on average 20 cts per USD in WC

The WC is turned over 5 times per year!

Cash management Reasons for holding cash: Transaction balances for

day to day payments Compensating balances

allowing banks to provide for costs of loans

Precaution Speculation

Advantage of holding cash Benefit the discounts for

paying promptly Maintain good credit ratings Take advantage of special

offers/discounts on opportunity buys

Meet emergencies as strikes, fires, marketing campaigns of competition, and cyclical downturns

The cash budget Forecast of Cash in

versus cash out Per month, week,

day Based on past

experience and updated with new knowledge

Focusing on a Cash target level

Inventory Supplies Raw materials WIP Finished goods

Inventories should be available at the right time

Ordering and carrying costs of all inventory should be minimized

Inventory control

The red line method Two bin method Computerized inventory control JIT Outsourcing

Accounts Receivable

Quantity: DSO Quality: aging schedule

Credit policy: Credit period Discounts for early payment Credit standards (credit worthiness of

customers) Collection policy (how to approach slow

payers)

EOQ (Economic Order Quantity)

Order Cost= D/Q*Co Holding Cost= 1/2Q*Ch Total Cost= D/Q*Co+1/2Q*Ch d(Tc/Q)=0 Then Q= (2DCo/Ch)0.5

Assignment: Working Capital Analyze the WC of your company Determine the cash cycle time and compare it

to it’s main competitors If you were in charge in this company what

would you do to better manage WC What is the implied value impact of your

actions on the company’s value?