Cash Flow and Working Capital Management - Module 2 - Comprehensive Liquidity Index, Cash Conversion...

Module 2:

Managing Corporate Liquidity

Net Working Capital Components

CA CL

Cash

Mkt. Sec A/P

A/R N/P

Inventory CMLTD

Prepaid Accruals

CA CL

Cash

Mkt. Sec A/P

A/R N/P

Inventory CMLTD

Prepaid Accruals

CA CL

Cash

Mkt. Sec A/P

A/R N/P

Inventory CMLTD

Prepaid Accruals

NWC = CA - CL WCR = A/R + INV + Pre A/P - Accruals NLB = Cash + M/S N/P - CMLTD

Net Working Capital = Working Capital Requirements + Net Liquid BalanceLegend:

CA = Current Assets NWC = Net Working Capital

CL = Current Liabilities WCR = Working Capital Requirements

Mkt. Sec. = Marketable Securities Pre = Prepaid

A/R = Accounts Receivable NLB = Net Liquid Balance

A/P = Accounts Payable

N/P = Notes Payable

CMLTD = Current Maturing Long Term Debt

Net Working Capital Requirements

Index of working capital needs

Spontaneous uses/sources of funds over operating cycle

Expands or contracts with sales

If seasonal , working capital is financed with Net Liquid Balance (NLB) or short term borrowings

Net Working Capital Requirements

If permanent due to growth, finance with long term capital

Negative number means cash cycle is a source of financing

Net Liquid Balance

Measure of liquidity rather than solvency

Current funds that are available to finance short term needs

Negative number indicates need for external financing which means reduced financial flexibility

Cash Conversion Cycle

Dr. Pepper Manufacturing Corp. is a diversified manufacturing company.

Determine the companys 2013 operating cycle and the cash cycle after computing the appropriate ratios for inventory, receivables and payables.

Cash Conversion PeriodInventory Stocked Inventory Sold

Cash Received

Days Inventory Held Days Sales Outstanding

Days Payable Outstanding Cash Conversion Period

Cash Disbursed

Cash Conversion Period = Days Inventory Held + Days Sales Outstanding - Days Payable Outstanding


2013 2012

Assets

Current Assets

Cash $ 500,000 $ 500,000

Marketable Securities (at cost) $ 500,000 $ 450,000

Accounts Receivable less allowance for bad

debts

$ 2,000,000 $ 1,600,000

Inventories $ 3,000,000 $ 2,000,000

Total current assets $ 6,000,000 $ 4,550,000

Dr. Pepper Manufacturing Corporation Balance Sheet


2013 2012

Liabilities

Current Liabilities

Accounts payable $ 1,000,000 $ 750,000

Notes payable $ 1,500,000 $ 500,000

Accrued expenses payable $ 250,000 $ 225,000

Taxes payable $ 250,000 $ 225,000

Total current liabilities $ 3,000,000 $ 1,700,000



2013 2012

Consolidated Income Statement

Net Sales $ 11,500,000 $ 10,700,000

Cost of sales and operating expenses:

Cost of goods sold $ 8,200,000 $ 7,684,000

Depreciation $ 300,000 $ 275,000

Selling and administrative expenses $ 1,400,000 $ 1,325,000

Operating profit $ 1,600,000 $ 1,416,000

Dr. Pepper Manufacturing Corporation Income Statement


Compute average inventory first

Ave. Inventory = $ 3 million + $ 2 million

2

= $ 2.5 million


2013 2012

Assets

Current Assets

Cash $ 500,000 $ 500,000


Accounts Receivable less allowance for bad debts $ 2,000,000 $ 1,600,000

Inventories $ 3,000,000 $ 2,000,000




Compute Inventory Turnover Ratio

Inventory Turnover Ratio = Cost of Goods

Ave. Inventory

= $ 8.2 million

$ 2.5 million

= 3.3

This means an inventory cycle of 3.3 times per year


2013 2012


Net Sales $ 11,500,000 $ 10,700,000



Depreciation $ 300,000 $ 275,000





Compute for Days in Inventory

Days in Inventory = 365 days

Inventory Turnover Ratio

= 365 days

3.3

= 110.6 daysThis means inventory cycle is around 110 days


Compute for Average Accounts Receivable and Average Receivable Turnover

Ave. Accounts Receivable = $ 2.0 million + $ 1.6 million

2

= $ 1.8 million

Ave. Receivable Turnover = Credit Sales*

Ave. Accounts Receivable

= $ 11.5 million

$ 1.8 million

= 6.4

*Assumes company has no cash sales


2013 2012

Assets

Current Assets

Cash $ 500,000 $ 500,000



debts

$ 2,000,000 $ 1,600,000

Inventories $ 3,000,000 $ 2,000,000




2013 2012


Net Sales $ 11,500,000 $ 10,700,000



Depreciation $ 300,000 $ 275,000





Compute for Days in Receivable

Days in Receivables = 365 days

Ave. Receivable Turnover

= 365 days

6.4

= 57 days


Compute for Average Payables

Ave. Payables = $ 1.0 million + $ 0.75 million

2

= $ 0.875 million

Accounts Payable Deferral Period = Cost of Goods Sold

Average Payables

= $ 8.2 million

$ 0.875 million

= 9.4


2013 2012


Net Sales $ 11,500,000 $ 10,700,000



Depreciation $ 300,000 $ 275,000





2013 2012

Liabilities

Current Liabilities


Notes payable $ 1,500,000 $ 500,000


Taxes payable $ 250,000 $ 225,000




Compute for Days in Payables

Days in Payables = 365 Days

Accounts Payable Deferral Period

= 365 Days

9.4

= 38.8 days


Compute for Operating Cycle and Cash Cycle

Operating Cycle = Days in Inventory + Days in Receivable

= 110.6 days + 57 days

= 167.6 days

Cash Cycle = Operating Cycle Days in Payables

= 167.6 days 38.8 days

= 128.8 days

Current Liquidity Index

Current Liquidity Index

= Cash Assets + Cash Flow From Operations

Notes Payable + Current Maturing Long Term Debt

Measuring Liquidity:Alternative Liquidity Measures

Comprehensive liquidity index (CLI) is an adjusted current ratio.

Liquidity weighted version of the current ratio.

Traditional current ratio treats all assets and liabilities as being of equal degree of liquidity.

CLI avoids this by weighing each current asset or current liability based on its turnover or nearness to cash

The accounts receivable, inventory, accounts payable and accrued expenses are adjusted by a turnover factor.


Comprehensive liquidity index Each current asset or liability is multiplied by one,

minus the inverse of the of the assets or liabilitys turnover ratio.

Accounts receivable x [ 1 ( 1/arto)]

In cases of more than one turnover required to generate cash from the asset, the inverse of each of these ratios is subtracted.

Inventory x [1 (1/arto) (1/invto)]

Comprehensive Liquidity Index

Comprehensive Liquidity Index = Adjusted Current Asset

Adjusted Current Liability

Comprehensive liquidity index considers the degree of liquidity of current assets and time to repay current liabilities


Specific weight is assigned to each current asset considering their liquidity degree and their adjusted amount is calculated

A coefficient of one is assigned to cash and short term investments due to their high liquidity quality and their weight does notneed to be adjusted


Accounts receivable is adjusted

Adjusted Accounts Receivable = Average Accounts Receivable * [1 (1 /Accounts Receivable Turnover)]




2

= $ 1.8 million



= $ 11.5 million

$ 1.8 million

= 6.4



2013 2012

Assets

Current Assets

Cash $ 500,000 $ 500,000



debts

$ 2,000,000 $ 1,600,000

Inventories $ 3,000,000 $ 2,000,000




Inventory is adjusted

AINV = INV * [1 (1/ARTO) (1/INVT)]

Adjusted Inventory = Average Inventory * [1 (1 /Accounts Receivable Turnover) (1/Inventory Turnover Ratio)]

AINV = Adjusted Inventory

INV = Average Inventory

ARTO = Accounts Receivable Turnover Ratio

INVT = Inventory Turnover Ratio




2

= $ 1.8 million



= $ 11.5 million

$ 1.8 million

= 6.4



2013 2012

Assets

Current Assets

Cash $ 500,000 $ 500,000


Accounts Receivable less allowance for bad debts $ 2,000,000 $ 1,600,000

Inventories $ 3,000,000 $ 2,000,000




Compute average inventory first

Ave. Inventory = $ 3 million + $ 2 million

2

= $ 2.5 million


2013 2012

Assets

Current Assets

Cash $ 500,000 $ 500,000



debts

$ 2,000,000 $ 1,600,000

Inventories $ 3,000,000 $ 2,000,000




Compute Inventory Turnover Ratio

Inventory Turnover Ratio = Cost of Goods

Ave. Inventory

= $ 8.2 million

$ 2.5 million

= 3.3

This means an inventory cycle of 3.3 times per year

Comprehensive Liquidity Index2012 Amount Adjusted

Weight

Adjusted

Amount

Assets

Current Assets

Cash $ 500,000 100 % $ 500,000

Marketable Securities (at cost) $ 500,000 100 % $ 500,000

Average Accounts Receivable (AR) less allowance

for

bad debts

($ 2,000,000 +

$ 1,600,000)/2

= $ 1,800,000

Adj. AR = Ave.

AR x [( 1 1/ARTO)]

$ 1,800,000 x

[( 1 1/ARTO)]

Average Inventories (INV) ($ 3,000,000 +

$ 2,000,000)/2

= $ 2,500,000

Adj. INV =

Ave. INV x [( 1

1/ARTO) (1/INVT)]

$ 2,50,000 x

[( 1 1/ARTO) (1/INVT)]

Total current assets $ xxxxxxxx.00

Note:

Adj. AR = Adjusted Accounts Receivable

Ave. AR = Average Accounts Receivable


Adj. INV = Adjusted Inventory

Ave. INV = Average Inventory




Specific weight is assigned to each current liabilities considering their timing of repayment and their adjusted amount is calculated


Accounts Payable is adjusted

AAP = AP * [1 (1/APT)]

APT = PUR/AP

Adjusted Inventory = Average Inventory * [1 (1 /Accounts Receivable Turnover) (1/Inventory Turnover Ratio)]

AAP = Adjusted Accounts Payable

AP = Average Accounts Payable

APT = Accounts Payable Turnover Ratio

PUR = Total purchases


Compute for Average Payables

Ave. Payables = $ 1.0 million + $ 0.75 million2

= $ 0.875 millionAccounts Payable Deferral Period = Cost of Goods Sold

also called Accounts Payable Turnover Average Payables= Total Purchases

Average Accounts Payables= $ 8.2 million

$ 0.875 million= 9.4


2013 2012


Net Sales $ 11,500,000 $ 10,700,000



Depreciation $ 300,000 $ 275,000





2013 2012

Liabilities

Current Liabilities


Notes payable $ 1,500,000 $ 500,000


Taxes payable $ 250,000 $ 225,000




Other components of liabilities can be adjusted by the same method

Comprehensive Liquidity Index2013 Amount Adjusted Weight Adjusted Amount

Liabilities

Current Liabilities

Average Accounts Payable ($ 1,000,000 +

$ 750,000)/2

= $ 875,000

Adj. AP = Ave. AP x [1 (1/APT)]

$ 875,000 x [( 1 1/APT)]

Average Notes Payable ($ 1,500,000 +

+ $ 500,000)/2

= $ 1,000,000

Adj. NP =

Ave. NP x [ 1 (1/NPT)]

$ 1,000,000 x

[ 1 (1/APT) (1/NPT)]

Average Accrued Expenses

payable

($ 250,000 +

$ 225,000)/2

= $ 237.50

Adj. AEP =

Ave. AEP x [ 1 (1/AEPT)]

$ 237,500

x [ 1 (1/APT) (1/AEPT)]

Taxes Payable ($ 250,000 +

$ 225,000)/2

= $ 237.50

Adj. TP = Ave. TP x [ 1 (1/TPT)]

$ 237,500 x

[ 1 (1/APT) (1/TPT)]

Total current liabilities $ xxxxxxx.00


Note:

Adj. AP = Adjusted Accounts Payable = Ave. AP x [1 (1/APT)]

Ave. AP = Average Accounts Payable

APT = Accounts Payable Turnover Ratio = Total Purchases/ Ave. Accounts Payable

ANP = Adjusted Notes Payable = Ave. Notes Payable x [1 (1/NPT)]

NPT = Notes Payable Turnover

AAEP = Adjusted Accrued Expenses Payable = Ave. Accrued Expenses Payable x [ 1 (1/AEPT)]

AEPT = Accrued Expenses Payable Turnover

ATP = Adjusted Taxes Payable = Ave. Taxes Payable x [1 (1/TPT)]

TPT = Taxes Payable Turnover

Comprehensive Liquidity IndexMc. Ilhenny Co. has the following short term balance sheet below:

Its account receivable turnover ratio is 20, while its inventory turnover ratio is 12.

Assets

Current Assets

Cash $ 15,000,000

Average Accounts Receivables $ 50,000,000

Average Inventories $ 75,000,000

Total current assets $ 140,000,000

Comprehensive Liquidity IndexMc. Ilhenny Co. has the following short term balance sheet below:

Its accounts payable turnover ratio is 3.64, while its wages payable turnover ratio is 8.33.

What is its comprehensive liquidity index and its

current ratio?

Liabilities

Current Liabilities

Average Accounts Payable $ 110,000,000

Average Wages Payable $ 60,000,000

Total current liabilities $ 170,000,000

Comprehensive Liquidity IndexAmount Adjusted Weight Adjusted Amount

Assets

Current Assets

Cash $ 15,000,000 100 % $ 15,000,000

Average Accounts Receivables (AR) $ 50,000,000 Adj. AR = Ave. AR x [(

1 1/ARTO)]$ 50,000,000 x [( 1

1/20)]

= $ 47,500,000

Average Inventories (INV) $ 75,000,000 Adj. INV = Ave. INV x

[( 1 1/ARTO) (1/INVT)]

$ 75,00,000 x ( 1 1/20) (1/12)]

= $ 65,000,000

Total adjusted current assets $ 127,500,000

Note:

Adj. AR = Adjusted Accounts Receivable

Ave. AR = Average Accounts Receivable


Adj. INV = Adjusted Inventory

Ave. INV = Average Inventory



2013 Amount Adjusted Weight Adjusted Amount

Liabilities

Current Liabilities

Average Accounts Payable $ 110,000,000 Adj. AP = Ave. AP x [1 (1/APT)]

$ 110,000,000 x [( 1 1/3.64)]

= $ 79,750,000

Average Wages Payable $ 60,000,000 Adj. NP =

Ave. NP x [ 1 (1/NPT)]

$ 60,000,000 x

[ 1 (1/3.64) (1/8.33)]

= $ 52,800,000

Total current liabilities $ 132,550,000


Comprehensive Liquidity Index = Adjusted Current Asset

Adjusted Current Liability

= $ 127,500,000

$ 132,550,000

= 0.96

Current Ratio = ( $ 15,000,000 + $ 50,000,000 + $ 75,000,000)

($ 110,000,000 + $ 60,000)

= 0.82


Lambda = Liquid resources + Expected cash flow

Uncertainty of cash flow during analysis horizon

= Cash Flow at beginning of month + Cash Flow during the month

+ Unused Short Term Borrowing Facility

Standard deviation or Cumulative degree of fluctuation from beginning of the year up to that point

Lambda

Lambda= Initial Liquid Reserve + Total Anticipated Net Cash Flow During Analysis

Horizon

Uncertainty of net cash flow during analysis horizon

Initial Liquid Reserve = Cash Balances + Marketable Securities/Short Term Investments + Available Unused Credit Lines but

not inventory and receivables

Expected Cash Flow = Net Cash Flow Expected to be received or paid during the analysis period (the difference between cash receipts and disbursements)

Uncertainty of net cash flow during analysis horizon = standard deviation of the net cash flow expectation


Lambda Index Liquid resources include cash, marketable securities, and

unused credit lines.

Expected cash flow includes any expected planned financing and investment as well as net cash from operation from operations for the time period of the analysis.

This term can be either positive or negative.

Lambda Index

Helps a company forecasts where it will have adequate cash and credit to survive or not enough, and will become insolvent and go bankrupt

Lambda Index

Measures the uncertainty about the companys future cash flows using standard deviation of those cash flows

Lambda Index

The numerator of the Lambda Index measures total cash available over time, while the denominator measures expected volatility of cash

Lambda Index

The higher the Lambda value obtained, the smaller the chance that the company's cash requirements will exceed its cash on hand

Lambda Index

Lambda Index model has proven itself statistically superior to both bond rating models and Altman's Z-score bankruptcy model in various studies of its predictive accuracy

Lambda Index

The Lambda Index can be used to estimate the probability of default since it measures the viability of the current liquidity reserve of a company

Lambda Index

A Lambda index of 15 is considered safe, while index below 2 means the company is in serious trouble

A Lambda index of 1.64 means there is a chance of one in 20 that cash requirements will exceed cash on hand

Lambda Index

A Lambda index of 3.00 means there is a chance of one in 1,000 that cash requirements will exceed cash on hand


Lambda Index


Cash Flow and Working Capital Management - Module 2 - Comprehensive Liquidity Index, Cash Conversion...

Documents

Transcript of Cash Flow and Working Capital Management - Module 2 - Comprehensive Liquidity Index, Cash Conversion...