SHORT-TERM

FINANCIAL MANAGEMENT
Chapter 1 - The Role of Working Capital

Prepared by Patricia R. Robertson

Kennesaw State University

Textbook Outline
Part I

Introduction to Liquidity

Part II

Management of Working Capital

Part IIICorporate Cash Management

Part IVForecasting & Planning
Part V

Short-Term Investing & Financing

Part VISpecial Topics

Part I - Introduction to
Liquidity

Chapter 1

Chapter
s
Covered

Chapter 2

The Role of Working Capital

Analysis of the Working Capital
Cycle

Chapter 3

Cash Holdings

Chapter 1 Agenda
THE ROLE OF WORKING CAPITAL
Identify the cash flows associated with
short-term financing decisions,
understand how working capital flows
and depreciation charges create a
disparity between profit and operating
cash flow, and identify the basic issues
involved in managing working capital.

Working Capital Management

5

Short-Term Financial Management (aka Working

Capital Management) is the day-to-day
management of the operating needs of a firm through
its current assets and current liabilities.

It involves managing cash, accounts receivable, inventory,

accounts payable, and accruals.

The goal is to ensure a firm has the ability to satisfy

both upcoming operational expenses and maturing
short-term debt.

S.T. Finance Versus L.T. Finance

6

In other courses, you studied long-term financial

decision-making.

For example, the asset investment decision evaluated

the cash flows associated with long-term capital
budgeting projects.

Short-term finance involves cash flows that occur

within the year.

Since these cash flows are unsynchronized and

uncertain, the timing of these cash flows is critical.

Newspaper Headlines
7

The
following
headlines
reinforce
the
importanc
e of cash
and the
disconnec
t between
profits
and cash
flow.

Shell Expects Output, Cash Flow to Grow

Facebook Cites Rapid Growth in Users, Cash

Flow

Xerox Seeks to Reassure Investors Over Cash

Position

Cisco Free Cash Flow

Exxon Draws Down Cash Reserves

Owens Lowers Expectations for Cash Flow

Penney Sees Cash Gains

Renault Swings to Loss, But Makes Cash

Ford Earnings: Cash Flows a Concern?

BHP Has the Cash, Needs the Growth

Firms Weigh Options for Those Piles of Cash

The Importance of Cash

8

You can miss your earnings targets and survive, but you
can only run out of cash once. -- Edward Liebert

Cash flow is the lifeblood of a firm.

The firm must design a cost structure to operate profitably or it

will fail.

Similarly, profitable companies, if cash-strapped, can also fail.

Profits and cash flow are highly correlated in short-term decisionmaking.

Therefore, firms must manage cash flows and profits.

Financial Statements
9

Financial statements report the performance of a firm, and

include the:

Balance sheet
Income statement
Statement of retained earnings
Statement of cash flows

These interrelated statements show where money came

from, where it went, and where it is now.

We need to understand if and where the firm generated cash, and

where it was used.

While this course focuses on short-term financial management, we

will review long-term sources and uses of cash, too.

Understanding the sources and uses of cash historically allows for

the accurate prediction of future cash flows.

Financial Analysis
10

Financial analysis is used to understand a firms historical

and present financial position, as well as its prospects.

The objective of financial statement analysis depends on

the perspective of the user:

Management

Creditors

Investors

Suppliers

Analysts

Regulators

The Balance Sheet

11

The balance sheet is a snapshot of the financial

accounts of a firm as of a particular date.

Assets
12

Assets are categorized as current (CA) or fixed (FA).

Assets are listed on the
balance sheet in order of
liquidity.
Frequently, more than
one timeframe is
presented for
comparison.
Current assets are
expected to be
converted to cash within
a year.
Fixed assets have a
relatively long life, and
can be tangible (e.g.

Liabilities & Owners Equity

13

Liabilities are categorized as current (CL) or long-term

(LTD).
Liabilities are also
listed in order of
liquidity.
Current liabilities are
expected to be paid
within a year, and will
require cash.
Long-term liabilities
have maturities longer
than one year.
The difference between
assets and liabilities is
owners equity (E).

The Current Accounts

14

The relationship between current assets and current

liabilities is critical to the ongoing operations of the
firm.

Current Assets
15

Cash & equivalents

Short-term investments

Cash and highly-liquid investments.

Investments to be liquidated within the
year.

Accounts receivable

Sales made to customers on credit.

Displayed net of doubtful accounts.

Inventory

Some combination of raw materials, WI-P, and finished goods.

Affected by valuation method/inflation.

Other

Generally, Prepaid Expenses.

Cash Position refers

to cash on hand and in
the bank, as well as
access to bank loans
and short-term
investments.

Current Liabilities
16

Accounts payable

Accruals

Amounts owed to suppliers

for purchases.
Expenses incurred but not yet
paid (e.g. salaries, rent,
insurance, taxes, etc.).

Short-term debt

Short-term debt and/or the

principal portion of long-term
debt due within the year.
The

term of debt should match

the type of asset financed.

Working Capital
17

(Net) working capital = current assets current liabilities

Working capital is the operating liquidity available to a company

and is positive in a healthy firm and varies by industry.

If a firm has negative working capital, it might have to sell assets

at fire sale prices to raise cash.

Note: Capital is used

interchangeably with assets.
Net working capital is an
exception.

18

Long-Term Assets &

Liabilities

Long-term assets represent the investments made by the firm.

Long-term liabilities (LTD) represent the long-term financing

sources for those investments.

Long-term is anything longer than one-year (12.5 months or 12.5

years).

Stockholders Equity
19

The residual interest in assets after deducting

liabilities.

Includes Common Stock (at par), Additional Paid-InCapital, Retained Earnings, and Treasury Stock.
Retained

earnings.

Earnings is not idle cash; rather reinvested

Balance Sheet Identity

20

A=L+E

NWC = CA - CL

NWC + FA = LTD + E

NWC = (Cash + Other CA) CL

Cash = LTD + E + CL CA Other Than Cash FA

Some activities increase cash and others

decrease cash.

Sources & Uses of Cash

21

On the balance sheet, there are both short and longterm sources and uses of cash; they are the opposite of
each other.
Sources (Inflows)

Uses (Outflows)
Buy inventory with cash

Buy inventory on credit

Make sales on credit

Sell inventory for cash

Collect receivables

Borrow short-term debt

Repay short-term loan

Borrow long-term debt

Retire long-term debt

Sell fixed assets

Sell common stock

Liquidate investments

Pay suppliers (A/P)

Buy fixed assets

Repurchase stock

Pay dividends / taxes

Make new investments

The Income Statement

22

The income statement measures financial

performance over a period of time.

Income,
earnings, and
profit are used
interchangeably.

The Income Statement

23

Revenue is recognized
when earned, not
collected (accrual
accounting).

Expenses are booked to

match the timing of
revenue recognition.

The income statement

does not reflect cash
flows.

We are concerned with

cash flows.

Earnings Quality
24

Earnings quality is
affected by:

Accounting choices,
methods, and
assumptions.

Discretionary
expenditures.

Non-recurring
transactions.

Non-operating gains
and losses.

Profits vs. Cash

25

Net income is not the same as

cash flow (economic earnings).

The firm earned $5,642 million,

yet cash decreased by $65
million.

We look to the balance

sheet to reconcile changes
in cash.

26

Cash Flow Timeline

Example
A brand
new firm
is
created.
The
owner
puts in
half the
money
and
borrows
the other
half.

27

Cash Flow Timeline

Example
The next
day, the firm
buys a
building and
an initial
supply of
inventory.
They pay
cash for the
building and
the
inventory is
bought on
45-day
credit from
the firms
suppliers.

28

Cash Flow Timeline

Example
Buying
the
inventory
on credit
creates
the
liability,
accounts
payable.
The size
of the
firm
increases
by $300.

29

Cash Flow Timeline

Example
Heres
where we
are at
monthend.
The firm
offers
credit
sales to
customers
, creating
a
receivable
and
depleting
inventory.

30

Cash Flow Timeline

Example
As the
firm
operates,
it incurs
expenses
(salaries,
utilities,
rent,
etc.),
which are
accrued
until paid.

31

Cash Flow Timeline

Example

Depreciat
ion, a
non-cash
charge, is
expensed
.

32

Cash Flow Timeline

Example

Cash is
used to
pay
interest
and
taxes.

33

Cash Flow Timeline

Example

Profits
are added
to the
balance
sheet as
retained
earnings.

34

Cash Flow Timeline

Example
At the
beginning
of the next
month, the
bills for
the
accruals
are paid
with cash.
The
balance
sheet
decreases
in size.

35

Cash Flow Timeline

Example
Cash is used
to pay the
accounts
payable once
due.
The firm
made $25 but
has spent
cash it does
not have.
THE FIRM
HAS PAID
CASH FOR
EXPENSES
BUT HAS
COLLECTED
NO MONEY
FOR SALES.

36

Cash Flow Timeline

Example
In the final
view, the A/R
are
collected.
The firm still
has $25 in
profit, but
has $125
more in cash
than it had
after buying
the building.
During the
cycle, the
cash ranged
from a high
of $525 to a
low of
($175).

37

Cash Flow Timeline

Example

Despite being profitable, why did the firm run out of

cash during the operating cycle?

This is explained by differences in the timing of cash

disbursements and cash receipts.

Firms must establish policies to manage working

capital accounts so that an adequate amount of
liquidity is available to run the business.

The Cash Cycle

38

We are concerned with the amount of cash flow, as well as

the timing.

We have to build and sell products before we can generate cash

inflows.

In the meantime, we incur cash outflows for supplies and labor.

We are concerned with the success of operations, or cash

generated internally.

Externally generated cash comes from investing and financing

activities.

Temporary operating shortfalls can be satisfied with borrowing,

but ultimately a firm must generate cash.

The Cash Cycle

39

Cash flows in a cycle into, around, and out of a

businessit is the lifeblood of the firm.

Inventory, if purchased on credit,

creates an accounts payable.

Inventory, if sold on credit, generates

an accounts receivable.

Receivables are collected in cash.

Payables are paid out of cash from

sales, by drawing down liquid reserves,
or by borrowing.
If the firm were to stop its operating activities, most (if

not all) of the cash tied up in working capital would be

released; the operating cycle affects the timing of cash
flow.

Cash Flow Timeline

40

The cash
conversion
period is the
time between
when cash is
received
versus paid.
The shorter
the cash
conversion
period, the
more efficient
the firms
working
capital and
more cash is
generated.

The firm is a system of cash flows.

These cash flows are unsynchronized and

uncertain.

41

Operating Versus Cash

Cycle

The Operating Cycle is the length of time from

buying inventory to collecting cash.

Say, we buy inventory on credit and pay the bill 30 days

later. We sell the inventory 30 days after that, and get paid
after 45 days.
The

Operating Cycle is 105 days.

The Cash Cycle (Cash Conversion Period CCP) is

the elapsed time between the firms payment to
suppliers and receipt of customer payments.

Here, the Cash Cycle is 75 days (105 30).

42

The Cash Cycle

43

Firms must manage cash flows

and profits to ensure it has the
necessary cash for daily
operations.

Any gaps must be filled by short-term

borrowing or using cash reserves.

Alternatively, the firms can alter

the cycle by changing the timing
of the cash flows.

Operating Cash Flows

44

We need to isolate the cash component of the accrualbased income statement entries:
Cash Collected From Customers
- Cash Paid To Suppliers
- Cash Paid For Operations
- Cash Paid To Creditors
- Cash Paid For Taxes
= Cash Flow From Operations

Operating Cash Flows, together with other sources and uses

of cash, explain the change in cash on the balance sheet.

Analysis also includes adjustments for non-recurring items.

Operating Cash Flows

45

We look to the income statement and changes on

the balance sheet to reconcile changes in cash at a
single point in time.

Converting I/S to Cash Flows

46

Assets
= Use
= Source
Liabilities
= Use
=Source

Converting I/S to Cash Flows

47

If A/R
increased,
then not all
of the sales
recorded
during the
period have
been
collected;
less cash was
collected
than
recorded on
the accrualbased income
statement.
If A/R

Converting I/S to Cash Flows

48

If A/P
increased,
then not all of
the inventory
expensed in
CGS has been
paid for; less
cash was paid
to suppliers
than reflected
on the income
statement.
If A/P
decreased, we
paid for items
this period
expensed in a
prior period.

Converting I/S to Cash Flows

49

If inventory
increased, it
represents an
additional use of
cash to
purchase
inventory not
yet sold and not
included in CGS.
If inventory
decreased, the
firm did not
replenish
inventory sold,
freeing up cash
previously held
in the working
capital cycle.

Converting I/S to Cash Flows

50

An increase in
accrued
expenses
indicates we
expensed
items for
which cash
has not yet
been paid.
A decrease in
accruals mean
we paid for
items
Accruals can be recorded as assets or liabilities. In
either case,
expensed
in a
it is simply a matter of timing; the transaction hasprior
occurred
but
period.
money has not changed hands. An example is interest. For
investments, interest income is an accrued asset. For a loan,
interest expense is an accrued liability.

Converting I/S to Cash Flows

51

Similarly (and
not included
on the chart),
an increase in
Prepaid
Expenses is a
cash outflow
for items not
yet expensed,
so is added to
Operating
Expenses.
Accrued expenses are the opposite of prepaid expenses.

Converting I/S to Cash Flows

52

The income
statement
includes the
non-cash
charge,
depreciation.
Adjust
operating
expenses to
include
current
period
depreciation,
We are interested in current period depreciation. aIfnon-cash
using the
income statement, simply use the depreciation expensed
expense.
during the year. If getting this information from the balance
sheet, use the change in accumulated depreciation. Note that
the latter could (and likely does) have noise from the sale of

Converting I/S to Cash Flows

53

Deferred
taxes result
from timing
(temporary)
differences.
Accrued
taxes are
permanent
differences
between tax
returns and
financial
statements
(e.g.:
depreciation
A deferred expense has been incurred but not yet methods
paid; an on
fixed assets).
accrued expense has not yet been incurred.

Converting I/S to Cash Flows

54

A firm must
be able to
translate
earnings
(profits) into
cash.
If a firm has
negative
operating
cash flow, it
did not
generate
cash from its
primary
operations

Back To This Example

55

Presented
are two
points in
timeDay
1 and the
final view.
Lets
reconcile
the
change in
cash from
$1,000 to
$525.

Reconciliation of Cash

We will do a more
complex example in a
minutefor now, become
acquainted with the
format.
56

Reconciliation of Cash
2

IMPORTANT:

57

1) EVERY line item on the balance sheet

must be accounted for somewhere in
the analysis.
2) Dont double-count depreciation. Use
EITHER the change in net fixed assets
and add back change in accumulated
depreciation OR use change in gross
fixed assets.

Operating Cash Flows

58

The analyst should be concerned with:

The success (or failure) of firm in generating

cash from operations.

The underlying causes of (and magnitude of)

positive or negative operating cash flow.

Fluctuations in operating cash flows over

time.

59

Managing the Cash Cycle

Managing The Cash Cycle

60

Managing the cash cycle includes:

Reducing idle inventory

Stretching payables

Aggressively managing receivables

Receivables and inventory

absorb cash; payables supply
cash.

61

Working Capital
Management

The cheapest and best source of cash exists as

working capital within the business:

Managing The Cash Cycle

62

The cash flow cycle refers to the continual flow of

resources through the working capital accounts.

This results in periods of cash surpluses and deficits.

The

faster a firm is growing, the more cash it needs.

While a firm can operate with negative cash flow for short
periods of time, it must generate positive cash flow longterm.

Some firms try to manage working capital to zero.

Zero investment in working capital increases cash.

Zero investment in working capital is a permanent increase

in earnings.

Shareholder Value Creation

63

Value can be created from many short-term

financial management activities.

Managing Inventory
64

Inventory levels should be adequate to meet uncertain

client demand without investing cash in too much
inventory.

There is a trade-off between:

Stock-out costs

Cost of excess inventory (holding costs)

Ordering costs

More in Chapter 4.

Managing Receivables
65

The Financial Manager decides:

Which customers may buy on credit.

How much credit is offered and on what terms.

e.g.:

Net 30, 2/10; Net 30

The process for monitoring collections.

The procedures for processing remittances to minimize float.

Float

is time it takes to convert the remittance to cash.

More in Chapters 5, 6 & 9.

Managing Payables
66

Payables can be viewed as interest-free financing.

The financial manager wants:

The longest and/or most favorable credit terms available

from its suppliers.
Terms

can include cash discounts.

The timing of the payment to be on the due date and not

before depending on the benefit to the firm from the
discount versus the foregone cash.

More in Chapters 7 & 11.

67

A Few Introductory Thoughts

Short-Term Planning
68

The ultimate goal of short-term planning is to make

sure there is enough cash on hand to operate.

Over the six-month planning period, this

firm has ample cash. Yet, DURING the sixmonths, it ran out of cash.

How Much WC Is Enough?

69

Approximately 40%-50% of assets in U.S. firms

are invested in working capital accounts.

The firm must decide how much in resources

to commit to working capital and, specifically,
cash and liquid assets.

In typical economic times, 3.3% 4.1% of the

balance sheet would be in cash (10% in times of
economic distress).

Early Warning Signs

70

Early warning signs of insufficient working capital

include:

Pressure on existing cash reserves.

Unusual cash generating activities (e.g. offering big cash

discounts).

Bank overdrafts.

Emergency bank loans.

Partial payments to suppliers and creditors.