Corporate Finance

Lecture 2

Chapter 14 Textbook (Exclude Sections 14.4-14.7)

Working Capital Management

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Topic 1 Revision 1. What should be the goal of a company’s management? 2. What is the difference between debt and equity financing? 3. If ANZ bank lends money to Mary, is there an agency

relationship between them? 4. What is the difference between direct and indirect

financing? 5. What is the difference between a commercial bank and an

investment bank?

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Topic 1 Revision 1. What is this?

2. a) Is BHP a security? b) What type of market is it traded in? c) How is it different from a bond?

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Code Last % Chg Bid Offer Open High Low Vol BHP 31.220 -1.2% 31.220 31.230 31.140 31.320 31.070 1,671,348

Topic 2 Working Capital Management

Case Study: David Jones 1. Accounting basics and definitions 2. Current assets and liabilities definitions and trade-offs 3. Working capital management two main decisions 4. Measuring working capital efficiency

Accounting Basics  The balance sheet identifies all the assets and funds (liabilities

and invested amounts) of a company at a point in time.

 A summary of a firm’s financial position shows:

Total Assets = Total liabilities + Shareholders’ Equity

• The left side of the balance sheet shows all assets the company owns and uses to generate revenues

• The right side represents the funds of the company (that are used to finance the company’s assets) – money that the company has borrowed from creditors and amounts invested by shareholders

Assets = Liabilities + Equity

Accounting Basics • Current Assets include all assets likely to be converted to

cash within a year (or within an operating cycle)

• Long-Term Assets are assets that the company acquires to produce its products and generate cash flows

• Current Liabilities include all liabilities that have to be paid within a year

• Long-Term Liabilities are Long-term debt or debts that have term-to-maturity of more than 1 year

• Equity – 2 major types of shares – Ordinary and Preference Shares (several other possibilities)

Definitions  Working Capital

• Funds invested in a company’s current assets • i.e. Cash, accounts receivable, inventories, short-term marketable

securities etc.  Liquidity

• The company’s ability to convert assets into cash quickly and without incurring financial loss

 Net Working Capital • NWC= Current Assets- Current liabilities • Measures a company's liquidity – the assets left over after

meeting current liability obligations  Working Capital Efficiency

• How efficiently does the company use its working capital?

Current Assets and trade offs • Benefits: Cash and marketable securities are the

most liquid assets and can be easily converted into cash if unexpected expenses occur.

• Costs: these assets provide a lower returns (i.e. bank deposits, treasury notes)

Cash and marketable securities

• Benefits: Accounts receivable is the total unpaid credit extended to customers (debtors) in order to encourage sales.

• Costs: It is costly to evaluate and monitor creditworthiness of debtors

Receivables

Current Assets and trade offs

• Benefits: Depositories of finished and raw goods in order to be able to quickly respond to changing sales.

• Costs: Large inventories are expensive to finance and to store.

Inventory

Current liabilities and trade offs • Trade credits provided by companies to suppliers • Benefits: Allows manager to delay payment and is a form

of financing • Costs: If payment is delayed or late on many occasions

the supplier may chose not to provide supplies in the future

Payables/ Trade Creditors

• Benefits: Your issued securities (financing) have a similar maturity to your current assets. Matching principle.

• Costs: The costs of issuing these securities can fluctuate

Issued Financial Assets and securities

Working Capital Management Definition :

• Management of Current assets and their financing.

• Fast –paced decisions made by management relating to a company’s day-to-day operations

 Two main questions: 1. What is the appropriate amount and mix of current assets for the

company to have on their balance sheet?

2. How should these current assets be financed?

1. Investment Strategies • Key manager decision: How much money do we invest in

current assets for a given amount of sales? 1. If we have more current assets

• More financial flexibility/ liquidity • Higher cost/ lower risk

2. If we have less current assets • Less financial flexibility/ liquidity • Lower cost/ higher risk

Flexible Strategy 1. Flexible current asset strategy (more current

assets) • Hold large balances of current assets (cash, tradeable securities

and inventory) on hand Benefits

Improves company ability to survive unforseen

threats. i.e. If there is an unforseen expense- we can convert assets into

cash and pay. This reduces exposure to

fluctuations in business activity

Costs

Low return on assets/ high inventory carrying costs

(storage, maintenance etc)

Opportunity cost of not investing in long-term assets such as term

deposits, bonds, shares etc. which have higher

returns

Restrictive Strategy 2. Restrictive current asset strategy (less current assets)

• Current asset levels kept at minimum. Company can get a higher return but runs risks of facing cash shortages.

Benefits

Company can invest more assets in long-term assets

which have a higher return than cash or other current assets (i.e. Bond,

long-term deposits)

Costs

Financial Shortage costs: if unforseen circumstances require immediate funds,

the company may not have sufficient current assets (cash and marketable

securities) and will need to use emergency financing or default

Operating Shortage costs: If insufficient raw materials are held as inventory,

production and sales may be disrupted. This may cost the company revenue.

Working Capital

Source: Qantas 2013 Annual Report Discussion Questions: 1. What is the Net working capital for Qantas according to the above 2013 figures?? 2. What type of current asset management strategy is Qantas pursuing and what are the

disadvantages of this strategy?

2. Financing Working Capital • Managers can use a combination of short-term debt,

long-term debt and equity • Managers attempt to match the maturities of their

assets and liabilities (funding) • Fund short-term assets with short-term funding, and long-

term assets with long-term funding • Some forms of financing are:

• Accounts Payable • Short-term bank loans • Promissory loans We will discuss this more at the end of the lecture

The cash conversion cycle • Arrange the following processes in order:

– Company Purchases raw materials – Customers pay for cash for bought products – Finished goods are sold on credit to customers – Finished goods are held as inventory until they are sold

1.

2.

3.

4.

Calculating Cash Conversion Cycle Length

• We will calculate ratios used to make up the cash conversion cycle based on the 2012 Annual Report of David Jones

• Calculation Process: 1. Calculate the operating cycle 2. Use the operating cycle to calculate the cash

conversion cycle

Case Study • David Jones Annual Report 2012 • Industry background/ Market Data:

• What has been happening to DJ’s share price? (remember in topic 1 what factors can affect share price)  Video: http://www.news.com.au/business/breaking-news/david-jones-

sales-figures-hit-record-low-with-low-consumer-confidence-carbon- tax-fear/story-e6frfkur-1226094649129

• Recently (July-August 2014) DJ has been taken over by South African Company Woolworths with shareholders accepting a $4 per share buyout  http://www.smh.com.au/business/retail/federal-court-approves-david-

jones-takeover-bid-after-last-minute-hiccup-20140717-zty6t.html

David Jones Annual Report 2012 p.72

1) Operating Cycle • The average time between the receipt of raw materials

and receipt of cash for the sale of the finished goods • This has two components/ratios:

• DSI- Days’ sales in inventory (Stage 2 of the cycle) • DSO- Days’ sales outstanding (Stage 3 of the cycle)

DSI Ratio 1: Days’ Sales in Inventory (DSI) • Shows how long a company holds inventory before selling

it

• Where do you get a Cost of Sales figure? • Income Statement

• Where do you get an Inventory figure? • Balance sheet

DSI= 365 days/ Inventory Turnover

Inventory Turnover= Cost of Sales/ Inventory

Example

• Ratio 1: Days’ Sales in Inventory (DSI) • DSI= 365 days/ (Cost of Sales/ Inventory) • Group Activity: For DJ in 2011?

• DSI= 365/ (1,194,474/288,850)=88.27 days • Group Activity: For DJ in 2012?

• DSI= 365/ (1,167,987/279,099)= 87.22 days • We would also usually make an industry

comparison

DSO • Ratio 2: Days’ sales outstanding (DSO) • Shows how long (on average)it takes DJs to collect its

outstanding accounts receivable

• Where do we get a Net Sales figure? • Income Statement (sales revenue)

• Where do we get an Accounts receivable figure? • Balance sheet

DSO= 365/ Accounts receivable turnover Accounts receivable turnover= Net

sales/Accounts receivable

Example

• Ratio 2: Days’ sales outstanding (DSO) • DSO= 365/ (Net sales/Accounts receivable) • Group Activity: For DJ in 2011?

• DSO= 365/ (1,961,744/19,637)=3.65 days • Group Activity: For DJ in 2012?

• DSO=

We would also usually make an industry comparison

Operating Cycle • Operating cycle= DSO+DSI

• Group Activity: DJ Operating Cycle 2011? • = 88.27+ 3.65 =91.92 days

• Group Activity: DJ Operating Cycle 2012? • = What does it mean? • David Jones has reduced the number of days it takes to

convert raw materials into receipt of cash for the sales of these materials as final products.

Operating cycle= DSO+DSI

2) Cash conversion cycle • Similar to operating cycle but only begins when a company

pays for its inventory • Length of time between the cash outflow for materials/

inventory and cash inflow for sales • Two Steps to calculate: 1. Calculate Days’ Payables Outstanding

• Average length it takes a company to pay their suppliers

2. Calculate Conversion Cycle

DPO= 365/ Accounts Payable Turnover DPO= 365/ (Cost of sales/ Accounts payable)

Conversion cycle= Operating cycle-DPO Conversion Cycle= DSO+DSI-DPO

Example 1. Days’ Payables Outstanding

• Group Activity: For David Jones 2011? • DPO= 365/ (1,194,474/216,429)=66.14

• Group Activity: For David Jones 2012? • DPO= 365/ (1,167,987/264,595)= 82.69

2. Cash conversion Cycle • Cash Conversion cycle= DSO+DSI-DPO

= Operating cycle - DPO

Cash Conversion Cycle For David Jones 2011?

• =Operating cycle- DPO • =91.92-66.14= 25.78 days

For David Jones 2012? • =Operating cycle- DPO • =

What does this mean? • Positive number means that (in 2011) DJs paid it suppliers an average of 25.78

days before it received its cash from its customers. • In 2011 David Jones needed to find external financing for 25.78 days of

operation • What changed in 2012? Why do you think it changed?

• Decreased to 7.7 days, increased working capital efficiency and decreased reliance on external financing. Why?

Time line for operating and cash conversion cycles

Textbook Example

What can you say about the cash conversion cycle of the above company?

Live Review Quizzes  There is a quiz at end of each lecture. Doing these will make up

15% of your mark (see Assessment 3 description)  To do these in class download “Socrative Student” to your

smart phone  The lecturer will then launch each quiz

1. The “room name” you have to enter to do the quiz live is FIN203 with your campus first letter in front. i.e. AFIN203 for Adelaide

2. Then enter your first name 3. Do the questions on the phone in the allocated time 4. Get instant feedback from the lecturer 5. You get marks for attempting a MINIMUM of 80% of the quizzes

and scoring a good average across Weeks 1-11

Quiz 2 Look back through the lecture the answer the following questions in groups: 1. The appropriate mix of current assets is not a working capital management decision. a. True b. False 2. Net working capital is important because it is a measure of liquidity and represents the net short-term investment the company keeps in the business. a. True b. False 3. Working capital management involves making decisions regarding the use and sources of current assets. a. True b. False

Quiz 2 4.Working capital efficiency refers to the length of time it takes for a company to convert the raw material to a finished product. a. True b. False 5.Liquidity is the ability of a company to convert assets-real or financial-into cash quickly without suffering a financial loss. a. True b. False 6. The operating cycle begins when the company uses its

cash to purchase raw materials and ends when the company collects cash payments on its credit sales.

a. True b. False

In the news Dick Smith and working capital: Lessons from the big end of town Dick Smith went into administration in 2016. One reason being their failure to manage their WC . A really good way to get a handle on how well your growth is being managed is to measure the change in your cash conversion cycle. The table below shows Dick Smith’s cash conversion cycle, with a comparison to its competitor JB Hi-Fi for the 2015 financial year. For Dick Smith you can see:

The figure that really stands out is stock says. Dick Smith sold technology-based products that quickly become obsolete….It is clear that the slow stock turnover also affected creditor payment timeframes. The comparison to JB Hi-Fi’s working capital cycle is telling.

Source: http://www.smartcompany.com.au/finance/dick-smith-and-working-capital-lessons-from-the-big-end-of-town/

Discussion: What do we define as “stock days” in this topic. What happened to this measure at Dick Smith compared to its competitors?

Topic 2 Formulas

The formulas used in this topic will be provided to students in the exam.

1. Explain and apply basic accounting concepts to do with the balance sheet, income statement and statement of cash flows

2. Define of working capital, liquidity, net working capital, working capital efficiency

3. Define and identify the trade offs of holding different amounts of current asset and liabilities

4. Define working capital management and the two main working capital decisions made by managers1) investment strategies 2) financing

5. Measure working capital efficiency by calculating the cash conversion cycle a. Calculate operating cycle (DSI and DSO) b. Calculate cash conversion cycle (Using DSI, DSO and DPO)

Learning Outcomes Topic 2