1. CORPORATE FINANCE Lawrence Booth & W. Sean Cleary SECOND EDITION
INTRODUCTION TO
CORPORATE FINANCE
SECOND EDITION
Lawrence Booth & W. Sean Cleary
Prepared by Ken Hartviksen & Jared Laneus

2. Chapter 23 Working Capital Management: General Issues
23.1 The Importance of Working Capital Management 23.2 An Integrated Approach to Net Working Capital (NWC) Management 23.3 Analyzing Cash Inflows and Outflows 23.4 Working Capital Management
Booth/Cleary Introduction to Corporate Finance, Second Edition

3. Learning Objectives
23.1 Explain why the management of net working capital is critical for the survival of a firm Explain how managing receivables, inventory, and payables is related to an integrated approach to net working capital management Explain how the financing and current asset investment decisions interact to determine a company’s overall working capital position List and describe some common ways to analyze a firm’s management of its net working capital.
Booth/Cleary Introduction to Corporate Finance, Second Edition

4. The Importance of Working Capital Management
Working capital management is the way in which a firm manages both its current assets and current liabilities
Good working capital management is characterized by:
Maintaining optimal cash balances
Investing any excess liquid funds in marketable securities that provide the best possible return, considering any liquidity or default-risk constraints
Effectively managing accounts receivable
Efficiently managing inventory
Maintaining an appropriate level of short-term financing in the least expensive and most flexible manner
Booth/Cleary Introduction to Corporate Finance, Second Edition

5. An Integrated Approach to Net Working Capital Management
Cash flow management is important because the exhaustion of liquid resources can leave a firm insolvent (i.e., unable to pay its obligations as they come due)
Firms can deplete liquid financial resources for bad reasons:
Continuing to produce inventory even when sales are falling
Selling products and services for less than their variable cost of production
Booth/Cleary Introduction to Corporate Finance, Second Edition

6. An Integrated Approach to Net Working Capital Management
Firms can also deplete liquid financial resources for seemingly good reasons:
Rapid growth in production and sales can cause a firm to use up all of its cash pursuing growth, leaving it invested in illiquid assets like inventories, accounts receivable and net fixed assets
A firm may be highly profitable in an accounting sense, but on the verge of bankruptcy if it cannot collect its receivables to generate the cash necessary to fund sales growth
Booth/Cleary Introduction to Corporate Finance, Second Edition

7. Cash Flow Cycle
The cash flow cycle is a crucial part of understanding how a business functions because it gives managers an awareness of the dynamics of working capital management
The cash flow cycle can be used to help managers determine the impact of changes in variables on the cash account:
Examples:
Increasing sales requires additional investment in inventory
Increasing accounts receivable reduces cash
Delaying the payment of payables preserves cash
Speeding up collections of receivables improves the cash position
Booth/Cleary Introduction to Corporate Finance, Second Edition

8. Increasing and Decreasing Cash
Activities that Increase Cash
Increasing long-term debt
Increasing equity
Increasing current liabilities
Decreasing current assets other than cash
Decreasing fixed assets
Activities that Decrease Cash
Decreasing long-term debt
Decreasing equity
Decreasing current liabilities
Increasing current assets other than cash
Increasing fixed assets
Paying cash dividends
Booth/Cleary Introduction to Corporate Finance, Second Edition

9. The Cash Budget
The monthly cash budget is a management tool for forecasting the timing, magnitude and duration of both cash surpluses and deficits and their cumulative impact over time
Booth/Cleary Introduction to Corporate Finance, Second Edition

10. The Cash Budget
Management can change plans before they are implemented to produce a more favourable cash result
Management can choose the best investment option for forecast cash surpluses, and arrange financing solutions for forecast cash deficits
Investing Forecast Surpluses
Small surpluses (i.e., less than $100,000) available for short periods of time (i.e., 30 to 90 days) can be kept in a current account
Small surpluses available for longer periods of time can be paid out as a cash dividend or used to retire debt obligations
Large surpluses (i.e., greater than $100,000) available for short periods of time (i.e., 30 to 90 days) can be invested in marketable securities with minimal risk like Treasury bills
Large surpluses available for longer periods of time can be used to pay cash dividends, or to invest in longer-maturity, higher-yielding investments
Booth/Cleary Introduction to Corporate Finance, Second Edition

11. The Cash Budget Financing Forecast Deficits
Small deficits (i.e., less than $100,000) lasting for short periods of time (i.e., 30 to 90 days) can be resolved by delaying purchases, speeding up collections or trying to better synchronize cash flows. An operating line of credit could also be negotiated with a financial institution.
Small deficits lasting for longer periods of time must be financed by more permanent solutions to under-funding
Large deficits (i.e., greater than $100,000) lasting for short periods of time (i.e., 30 to 90 days) can be resolved with operating lines of credit or other longer-term permanent capital solutions, particularly if large cash flow deficits are likely to reoccur
Large deficits lasting for longer periods of time must be financed with permanent increases in capital in the form of debt and/or equity
Booth/Cleary Introduction to Corporate Finance, Second Edition

12. Analyzing Cash Inflows and Outflows
Equation 23-1 analyzes the impact of sales growth on the firm’s cash position:
where:
g = monthly sales growth
b = the cash production cost and (1 – b) = unit contribution margin
St – 1 = Sales in the previous time period
The sensitivity of cash to sales growth is strongly related to the firm’s inventory and accounts receivable policies.
Booth/Cleary Introduction to Corporate Finance, Second Edition

13. Analyzing Cash Inflows and Outflows
Equation 23-2 shows that the change in cash each month depends on credit, inventory management and payables policies:
where:
α = the proportion of sales collected this month (credit policy)
1 – α = the proportion of sales collected next month (only two periods)
β = the proportion of this month’s production costs paid this month
1 - β = the proportion of production costs paid next month
γ = the proportion of the firm’s monthly sales tied up in inventory
Booth/Cleary Introduction to Corporate Finance, Second Edition

14. Analyzing Cash Inflows and Outflows
We can simplify Equation 23-2 into Equation 23-3 by including the sales growth rate and removing the different sales levels:
Equation 23-4 solves Equation 23-3 for the sales growth rate at which the firm can grow without either needing or generating cash:
A firm can grow faster if:
It has a higher gross margin (1 – b)
It lowers production costs b
It collects receivables more quickly α
It pays its bills more slowly β
It has less inventory γ
Booth/Cleary Introduction to Corporate Finance, Second Edition

15. Analyzing Cash Inflows and Outflows
The slope of the line is determined by the firm’s credit, inventory and payables policies
A shallower slope reduces the sensitivity of cash to changes in sales
A shallower slope can be achieved by: collecting AR more quickly, delaying AP payments, and increasing inventory turnover.
Booth/Cleary Introduction to Corporate Finance, Second Edition

16. Working Capital Management
Ratios are commonly used to assess or summarize a firm’s working capital management, focusing on:
Liquidity management
Asset utilization
Current liability management
Liquidity Ratios
The current ratio and the quick ratio assess a firm’s liquidity
Excessive liquidity reduces ROI and ROE, and can also indicate credit policy is too lenient or excess inventories
Booth/Cleary Introduction to Corporate Finance, Second Edition

17. Working Capital Management
Working Capital Ratios – Accounts Receivable
Changes in receivables turnover and average collection period can indicate deteriorating or improving collection efforts
The shorter the collection period, the less sensitive cash balances are to changes in sales
Booth/Cleary Introduction to Corporate Finance, Second Edition

18. Working Capital Management
Working Capital Ratios – Inventory
Cost of goods sold is unlikely to be comparable across firms, so an alternative is to use sales revenue in the numerator
The higher the inventory turnover, the less sensitive cash is to changes in sales
Booth/Cleary Introduction to Corporate Finance, Second Edition

19. Working Capital Management
Working Capital Ratios – Accounts Payable
Payables turnover shows how many times per year, on average, a firm pays its suppliers
ADSP shows how long, in days, a firm defers payments to its suppliers
Booth/Cleary Introduction to Corporate Finance, Second Edition

20. Operating Cycle and Cash Conversion Cycle
The operating cycle is the time period between the acquisition of inventory and the collection of cash from receivables, and is defined by Equation 23-14:
The operating cycle is the sum of average days sales in inventory and the average collection period
The cash conversion cycle is the time between cash disbursement and cash collection, or an estimate of the average time between when a firm pays cash for its inventory purchases and when it receives cash for its sales.
The cash conversion cycle is the average number of days of sales that must be financed outside the use of trade credit, and is defined by Equation 23-15:
Booth/Cleary Introduction to Corporate Finance, Second Edition

21. Importance of the Cash Conversion Cycle
Management of the cash cycle can make an important difference in the amount of financing required, assets employed to generate a given level of sales … and therefore can affect ROA and ROE
Booth/Cleary Introduction to Corporate Finance, Second Edition

22. Copyright
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Booth/Cleary Introduction to Corporate Finance, Second Edition