OM FINAL

MEASURING AND MANAGING LIQUIDITY MANAGING CASH

CHAPTER EIGHT: WORKING CAPITAL MANAGEMENT

Yi Zhou

Associate Professor Department of Finance

College of Business San Francisco State University

YI ZHOU CHAPTER EIGHT: WORKING CAPITAL MANAGEMENT

MEASURING AND MANAGING LIQUIDITY MANAGING CASH

INTRODUCTION MEASURE OF LIQUIDITY OPERATING AND CASH CONV. CYCLES COMPANY A COMPANY B

INTRODUCTION

Liquidity is the ability of the company to satisfy its short-term obligations using assets that are readily converted into cash.

Liquidity management is the ability of the company to generate cash when and where needed.

The operating cycle is the length of time it takes a company’s investment in inventory to be collected in cash from customers.

The net operating cycle (or the cash conversion cycle) is the length of time it takes for a company’s investment in inventory to generate cash, considering that some or all of the inventory is purchased using credit.

The length of the company’s operating and cash conversion cycles is a factor that determines how much liquidity a company needs.

The longer the cycle, the greater the company’s need for liquidity.

YI ZHOU CHAPTER EIGHT: WORKING CAPITAL MANAGEMENT

MEASURING AND MANAGING LIQUIDITY MANAGING CASH

INTRODUCTION MEASURE OF LIQUIDITY OPERATING AND CASH CONV. CYCLES COMPANY A COMPANY B

MEASURE OF LIQUIDITY

Liquidity ratios

Current ratio = Current assetsCurrent liabilities : The ability to satisfy current liabilities using current assets.

Current assets= Cash and equivalents + Short- and long-term investments + Accounts receivable + Inventories + Prepaid expenses

Current liabilities= Accounts payable + Accrued expenses + Income tax payable + Short-term notes payable + Portion of long-term debt payable

Quick ratio = Cash+Short-term investments+ReceivablesCurrent liabilities : The ability to satisfy current liabilities using the most liquid of current assets.

Ratios indicating management of current assets

Receivables turnover = Total revenueAverage receivables : How many times accounts receivable are created and collected during the period.

Payables turnover = Cost of goods soldAverage payables : How many times accounts payable are created and collected during the period.

Inventory turnover = Cost of goods soldAverage inventory : How many times inventory is created and sold during the period.

YI ZHOU CHAPTER EIGHT: WORKING CAPITAL MANAGEMENT

MEASURING AND MANAGING LIQUIDITY MANAGING CASH

INTRODUCTION MEASURE OF LIQUIDITY OPERATING AND CASH CONV. CYCLES COMPANY A COMPANY B

OPERATING AND CASH CONV. CYCLES

Number of days of inventory = InventoryAverage day’s cost of goods sold = 365

Inventory turnover : The average time it takes to create and sell inventory.

Number of days of receivables = ReceivablesAverage day’s revenues = 365

Receivables turnover : The average time it takes to collect on accounts receivable.

Number of days of payables = Accounts payableAverage day’s purchases = 365

Accounts payables turnover : The average time it takes to pay its suppliers.

Operating cycle = Number of days of inventory + Number of days of receivables.

Net operating cycle or Cash conversion cycle = Number of days of inventory + Number of days of receivables − Number of days of payables.

YI ZHOU CHAPTER EIGHT: WORKING CAPITAL MANAGEMENT

MEASURING AND MANAGING LIQUIDITY MANAGING CASH

INTRODUCTION MEASURE OF LIQUIDITY OPERATING AND CASH CONV. CYCLES COMPANY A COMPANY B

COMPANY A

Cash and cash equivalents: 200, Inventory: 500, Receivables: 600, Accounts payable: 400, Revenues: 3,000, Cost of goods sold: 2,500.

Current ratio = 200+500+600400 = 3.25

Quick ratio = 200+600400 = 2

Receivables turnover = 3,000600 = 5

Payables turnover = 2,500400 = 6.25

Inventory turnover = 2,500500 = 5

Number of days of receivables = 3655 = 73

Number of days of payables = 3656.25 = 58.4

Number of days of inventory = 3655 = 73

Operating cycle = Number of days of inventory + Number of days of receivables = 146

Cash conversion cycle = Number of days of inventory + Number of days of receivables − Number of days of payables = 87.6

YI ZHOU CHAPTER EIGHT: WORKING CAPITAL MANAGEMENT

MEASURING AND MANAGING LIQUIDITY MANAGING CASH

INTRODUCTION MEASURE OF LIQUIDITY OPERATING AND CASH CONV. CYCLES COMPANY A COMPANY B

COMPANY B

Cash and cash equivalents: 200, Inventory: 900, Receivables: 1,000, Accounts payable: 600, Revenues: 6,000, Cost of goods sold: 5,200.

Current ratio = 200+900+1,000600 = 3.5

Quick ratio = 200+1,000600 = 2

Receivables turnover = 6,0001,000 = 6

Payables turnover = 5,200600 = 8.67

Inventory turnover = 5,200900 = 5.78

Number of days of receivables = 3656 = 60.8

Number of days of payables = 3658.67 = 42.1

Number of days of inventory = 3655.78 = 63.15

Operating cycle = Number of days of inventory + Number of days of receivables = 124

Cash conversion cycle = Number of days of inventory + Number of days of receivables − Number of days of payables = 81.9

YI ZHOU CHAPTER EIGHT: WORKING CAPITAL MANAGEMENT

MEASURING AND MANAGING LIQUIDITY MANAGING CASH MANAGING CASH

MANAGING CASH Management of the cash position of a company has a goal of maintaining positive cash balances throughout the day. Companies tend to maintain a minimum balance of cash (a target cash balance) to protect against a negative cash balance. Examples of Cash Inflows

Receipts from operations, broken down by operating unit, departments, etc. Fund transfers from subsidiaries, joint ventures, third parties Maturing investments Debt proceeds (short and long term) Other income items (interest, etc.) Tax refunds

Examples of Outflows Payables and payroll disbursements, broken down by operating unit, departments, etc. Fund transfers to subsidiaries Investments made Debt repayments Interest and dividend payments Tax payments

YI ZHOU CHAPTER EIGHT: WORKING CAPITAL MANAGEMENT