Liquidity and Working Capital Management
Liquidity and Working Capital Management FINA 4300
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Date Created: 10/25/15
CASH FLOW STATEMENT 2 Main Purposes 1 Gives you information about the firm s cash inflows and outflows 2 Gives you information about the firm s investing and financing activities Cash Flow Statement helps assess 4 things 1 The firm s ability to generate future cash flows 2 a the firm s ability to meet its obligations cash outflows b the firm s ability to pay dividends c the firm s need for future financing 3 it explains the difference between net income and cash flows 4 tells you about both the cash and noncash aspects of the firms investing and its financing activities Purpose of the Cash Flow Statement 0 to explain the change in the cash accounting between years Cash Equivalent short term highly liquid investment security that meet 2 criteria 1 Security must give you a known amount of cash at the end of its life 2 The instrument must be so near to maturity that a change in interest rates will not impact its value 90 days or less Cash Flow Statement can be prepared in 2 formats 1 direct method 2 indirect method most common 3 Sections on Cash Flow Statement 1 investing activities 2 financing activities 3 operating activities Investing Activities 0 only three transactions that qualify o investing activities are your cash inflow and outflows from o lending money and collecting on those loans 0 buying or selling someone else s securities 0 buying or selling productive assets PPampE Financing Activities 0 are the cash inflows and outflows from o borrowing money and repaying those loans o obtaining resources from owners and providing them a return on their investment I selling or buying your common stock Operating Activities 0 any activity that is not financing or investing o it is the cash portion of the transactions that will impact the income statement 0 if you have cash interest received or cash dividends received they are an operating activity 0 cash dividends paid are a financing activity INTRO Why does a firm hold cash or liquid assets 1 the cash outflows and cash inflows are not synchronized 2 Cash inflows and cash outflows are uncertain with respect to both amount and timing SO holding cash and liquid assets bridges those two problems 3 questions every cash manager must answer 1 how do I speed up cash inflows and slow down outflows 2 how should the firms portfolio of liquid assets be split between actual cash and other sources of liquidity 3 what should be the composition of the other sources of liquidity What is the difference between short and long term finance 1 the timing of the impact of the decision 2 reverseability a time to reverse the decision b the cost to reverse the decision GOAL OBJECTIVES AND STRATEGIES OF THE FIRM Goal maximize shareholder wealth the goal is not measurable or time bound Objective maximize the Net Present Value of the firm39s operating cash outflows the objective is measurable and time bound achieving the objectives mean you also achieve the goal Strategies what managements does everyday to achieve the objective 7 Strategies 1 speed up cash inflows 2 slow down outflows 3 minimize idle cash 4 minimize your transactions costs dealing with liquidity 5 minimize administrative costs dealing with liquidity 6 minimize your costs of providing back up liquidity 7 provide the best financial information possible to your operating managers YIELD CURVES yeild curves are the mos common way of forecasting interest rates there are two ways to forecast interest rates 1 interest rate futures contracts 2 yield curves a yield curve is simply yields over time for a particular risk class of securities 4 shapes of the Yield Curve A Ascending Yield Curve you get an ascending yield curve when interest rates are low long term rates are higher than short term rates market thinks that interest rates are going up if the curve is smooth we can say that rates are increasing at a decreasing rate B Descending Yield Curve you get a descending curve when interest rates are high long term rates are lower than short term rates market thinks that interest rates are going down if the curve is smooth rates are decrasing at a decreasing rate C Flat Yield Curve you get a flat rate when interest rates are in their mid ranges long term and short term rates are essentially the same tells you the market has no idea which way interest rates are going D Humped Yield Curve a hump always occurs in the short term rates a humped yield curve is the least common of the 4 curves occurs when interest rates are high long term rates are lower than short term rates the market thinks interes rates are going down this curve will always rise initially and than decline Interest Rates Over Time short term interest rates are much more volatile than long term rates RATIOS 2 Variables in finance that you can NEVER separate 1 Risk 2 Return Liquidity Ratios 0 Measure risk 0 Are bankruptcy measures 0 As your liquidity ratios get low you have higher risk of bankruptcy Activity Ratios o Are a component of your profitability ratios 0 Measure of return 0 Tell you how efficiently you using your assets DebtLeverage Ratios 0 Primary risk measures o If these ratios get out ofline you will find that the market will see you as being much riskier o What is meant by out of line 0 3 things you can compare it too I 1 An industry average I 2 A group of peer companies set by management I 3 Against your own firmyourself over time o The comparison will tell you how well you are doing Profitability Ratios 0 Primary measure of return ACTIVITY RATIOS Current Ratio 0 Current asset assets that will be converted to cash within one year 0 Current debt liability you will pay off within one year 0 3 problems with the current ratio 0 1St assumption we will liquidate all current assets to pay off your current liabilities I If you are doing an analysis you don t care to look at a bankrupt company 0 2nd assumption assumes dollar for dollar conversion of current assets to current liabilities I Not necessarily truepossible o 339 Current ratio is very easy to manipulate 0 Current ratio tells you that if the firm liquidated all its current assets how many times will it cover and pay its current liabilities 0 Higher number looks better o Is measured as a percentage meaning it s a relative measure Quick Ratio o Is a more severe test ofthe firm s liquidity 0 Quick ratio gets rid of the 1St and 2nd problem with the current ratio o It does not get rid of the 3rd because you are still using cash amp marketable securities Net Working Capital 2 definitions of NWC One uses short term assets amp liabilities The other uses long term assets amp liabilities NWC CA CL a Of the two definitions this is the more popular one b Is measured in dollars therefore it gives you an absolute measure of liquidity NWC long term debt indeterminate debt equity fixed and other assets a What does it mean when NWC is positive Long term debt indeterminate debt equity gt fixed and other assets Part of the long term financing is financing my current assets If the above statement is true the company has a matched or conservative working capital policy b What does it mean when NWC is negative i A portion of long term assets are financed with short term debt ii The company has a matched or aggressive working capital policy 0 3 types of Indeterminate debt 0 1 Deferred income taxes 0 2 Unfunded pension liabilities o Minority interest claims I Claims by minority shareholders o Deferred Income Taxes o Firm has two sets of books 1 financial accounting books and 2 tax books therefore the firm has two incomes a year 0 Financial accounting income is what you find in the financial statements and is what the public sees so you want it to be as high as possible 0 Tax income is what you will pay taxes on to the government so you want it to be as low as possible 0 Tax expense what you owe not necessarily what you will pay I taxabe income x tax rate o It is indeterminate because you don t know how much of the deferred income tax you will end up paying and if you will even have to pay it at all 0 Unfunded Pension Liabilities o PPA pension plan assets 0 DBO defined benefit obligation pension plan liabilities 0 These are indeterminate because unfunded pension liabilities are in the market so depending on the market movement you can t know for sure how much will be unfunded o Minority Interest Plans 0 When a company approaches bankruptcy the minority shareholders get a much larger say 0 Indeterminate because you won t know how much say minorities get until the company reaches the point of near bankruptcy LIQUIDITY RATIOS cont d Inventory to working capital 0 If inventory working capital 1 it means most of the firms liquidity is in inventory 0 If accounts receivable working capital 1 it means the firm s liquidity is tied up in a less liquid current asset 0 Those two ratios measure the quality of your liquidity Net Sales to Working Capital 0 aka Working Capital Turnover Ratio 0 this ratio tells you if you have enough liquidity to support your sales 0 the higher this ratio gets the faster the firm s cash cycle must go ACTIVITY RATIOS ART ratio accounts receivable turnover ratio 0 we would like a high numerator of credit sales and low denominator of AR 0 we would like the ratio to be higher 0 higher ratio means you are doing a good job at collecting your receivables 0 you want to use net accounts receivableS39 net of your doubtful accounts 0 do not use yearend AR number 0 that would cause the ratio to be easily manipulated 0 you want to use your average receivables over the year 0 ART tells you 3 things 0 1 How efficiently the firm is collecting its receivables o 2 Tells you the potential for bad debt write offs the longer and AR is uncollected the higher the probability it will be a bad debt 0 3 If you see a sudden jump in the ART ratio it tells you that the company has pulled future revenue into the current period this will be impactlower their profitability Days Sales Outstanding D80 0 Frequently called the average collection period 0 Would like a small numerator and large denominator o The lower the ratio the better 0 The DSO tells you the number of days of sales that are tied up in accounts receivables o Expect DSO to increase as sales rise decrease as sales fall Inventory Turnover o COGSAvg Inventory 9 theoretically correct way to find inventory turnover 0 Salesinventory 9 popular yet not correct sales contains profit margin which fluctuates o The ratio tells you how quickly or how well the firm is selling its inventory 0 You would like a large COGS because it tells you that you are making sales you don t want a large average inventory 0 The biggest problem with this ratio is the inventory valuation method used 0 You cannot compare the inventory turnover ratio of a firm that uses FIFO with a inventory turnover ratio for a firm that use LIFO Fixed Asset Turnover Ratio 0 Net fixed assets gross fixed assets accumulated depreciation 0 Just because the ratio is higher doesn t necessarily mean we are using assets efficiently It could be that assets just got fully depreciated RATIOS cont d LEVERAGE RATIOS Leverage ratios are your primary risk measures If you let leverage ratios get out of line than your market will see you as being too risky Debt Ratio 0 3 Problems with the debt ratio 0 1 There is a significant difference between the amount of debt and the amount ofthe payment on the debt each year 0 2 If you take a standard not repayment schedule than over the life ofthe debt gets smaller so as time passes the ratio gets smaller and looks better but the amount you have to repay each year remains the same 0 3 Over the life of the note the value of the assets can change through depreciation or by changing your inventory valuation method Debt to Equity Ratio 0 Answers the question will my equity cover all my debt 0 Problem with this ratio it has a measuring problem 0 There are many ways to measure debt I All liabilities I All liabilities except current liabilities I Only your long term interest paying liabilities I Do we or do we not include in determinant debt 0 There are many ways to measure equity I The entire stockholder s equity I Both preferred and common stock I Common stock only 0 You can t compare firms that use different measures to measure their debt to equity ratio Times Interest Earned Ratio 0 EBITInterest o This is the ratio that creditors are most interested in Fixed Charge Coverage Ratio 0 Will always be lower because the denominator is larger WORKING CAPITAL POLICIES overarching statement the firm s working capital policy depends upon how it finances its assets o 3 Working Capital Policies 1 Conservative 2 Matched 3 Aggressive o 2 types of risk 0 Rollover risk 0 Liquidity risk 0 2 kinds of rollover risk 0 First that when you want to refinance it will cost you more money to refinance 0 Second that when you want to refinance you can t get any more money at all 0 Liquidity risk the risk that you don t have enough cash to cover your outflows CONSERVATIVE WORKING CAPITAL POLICY 0 All assets are financed with long term debt and equity 0 Rollover risk for a conservative policy is low because you have long term financing and don t have to rollover often 0 Liquidity risk for a conservative policy is very low because we have marketable securities so when you need money you can sell some 0 Returns for a conservative policy are lower because there is a low risk involved 0 Assuming an ascending yield curve we paid higher interest rates for our longterm financing therefore interest expense will be higher and overall returns will be lower MATCHED WORKING CAPITAL POLICY 0 Rollover Risk compared to the conservative policy matched policy has more rollover risk because now we are financing our temporary current assets with short term financing 0 Liquidity risk compared to the conservative policy matched has a higher liquidity risk because we no longer have marketable securities 0 Return assuming an ascending yield curve since we now finance some of our assets short term my interest expense for a matched policy will be less than the interest expense for a conservative policy therefore there are more returns 0 Because short term rates are lower than longterm rates AGGRESSIVE WORKING CAPITAL POLICY 0 In an aggressive policy both temporary current assets and permanent current assets are financed short term 0 Rollover risk is higher compared to the conservative policy because we finance more assets with short term debt 0 Liquidity risk is higher compared to the conservative policy 0 Returns should also be higher 0 Assuming an ascending yield curve short term rates are lower than long term rates and since we finance more with short term debt my interest expense will be lower and my overall return would be higher 0 In industry you normally see aggressive working capital policies