L07 - Financial Planning & Working Capital Management

Cash-in, Cash-Out and Working Capital

Example:

• pay out extra $10M in cash dividend
  • decreases cash by $10M
  • decreases WC by $10M
• Receive $2.5k from customer (from previous sale)
  • increase cash by $2.5k
  • no change (was already under receivables)
• Pay $50.0k previously owed to suppliers
  • decrease cash
  • but was already booked under current liabilities → balances out

Developing a short term financial plan

• bank loan (borrow money)
• stretching payables (put off payments of bills)

Financial Planning

Free-Cash-Flow Model

Planning

Plan for at least 5 years, accurate forecasting

But not too deep into details, it’s “art”

Working Capital Management

Working Capital is the difference between a company’s current assets and current liabilities.

$$\text{working capital}=\text{current assets}-\text{current liabilities}$$

Working Capital Requirement

operational concept → how much capital a business needs to tie up to fund it’s operating cycle (gap between paying for inputs and receiving payments from customers)

$$\text{WCR}=\text{operating current assets}-\text{operating current liabilities}$$

which simplifies to

$$\text{WCR}=\text{inventory}+\text{accounts receivable}-\text{accounts payable}$$

Operating cycle: total time

Cash Cycle

cash cycle = inventory period + accounts receivable period - accounts payable period

measures how long it takes for a company to convert it’s cash investments in inventory back into cash from sales.
= net number of days your own cash is locked up in the operating cycle

• average inventory period = $\frac{\text{inventory}}{\text{daily cost of goods sold}}$
• average receivables period = $\frac{\text{receivables at start of year}}{dailysales}$
• average payment period = $\frac{\text{payables at start of year}}{dailycostofgoodssold}$

Important KPI (amazon has had negative CC for years → collect from customers before you pay suppliers)

Link to WCR
The CashCycle and WCR are two sides of the same coin:

• WCR = how much cash is tied up in the cycle (a stock, in €/$)
• CCC = how long cash is tied up in the cycle (a duration, in days)

You can derive WCR from CC: WCR = Revenue x (CC / 365)

• daily revenue = revenue / 365
• how long that cash is tied up
  if revenue doubles → WCR also doubles → too much cash tied up / increases cash requirements

Example Effects on the Cash Cycle

• Customers are given a larger discount on cash transactions

  • Effect: CCC shortens ↓
  • A discount incentivizes customers to pay immediately (cash) rather than on credit. This reduces the receivables period (DSO) — you collect cash faster instead of waiting 30, 60, 90 days.

• The firm adopts a policy of reducing accounts payable

  • Effect: CCC lengthens ↑
  • Reducing accounts payable means the firm pays its suppliers sooner (or takes on less payable balance). This decreases the payables period (DPO).

Inventories

• raw materials
• work in progress
• finished goods (should be empty → sold to clients)

Goal → minimise cash tied up in inventory

Tools to minimise inventory:

• just in time
• order size:
  • increase order size → order number falls (more per order) → order costs decline
    • however: increase in order size → increase average inventory amount
  • strike a balance

Accounts Receivable Management

• Trade Credit: Receivables from one company to another
• Consumer Credit: receivables from customers

Five questions for management

1. How long time for customers to pay bills?
   1. Prepared to offer Cash discount for prompt payment?
2. How do you determine which customers likely pay their bills?
3. How much credit are you prepared to extend each customer? (play it safe vs. risk acceptance)
4. How do you collect the money when it comes due?
   1. what about reluctant payers or deadbeats?

Terms: ex: “2/10 net 31”

• 2: percent discount for early payment
• 10: number of days discount is available
• 31: days until the bill is due (no discount)

Credit Analysis: determine likelihood customer pays their bills

• credit agencies
• financial ratios

Credit Policy: standards set to determine the amount and nature of credit to extend to customers
Credit Scoring: What your lender won’t tell you

• extending credit gives you probability of profit → not guarantee
  • still a chance of default
• denying credit guarantees neither profit nor loss
  Collection Policy: procedures to collect and monitor receivables
  Factoring: Arrangement whereby a financial institution buys a company’s accounts receivable and collects the debt

Cash Management

→ cash does not pay interest

• Move money from cash into short-term securities
  • usually less than one year notes
• “sweep programmes”
• pooling