Chapter 1 – Role of W/C

Net working capital = Current Assets – Inventory – Current Liabilities ---- Optimal level = 0 | Most companies = 2:1 | Retail = 4-6:1 | Utilities = 1:1
Matching Principal: Accrual - Revenue: recorded when earned (even if $ not received) || Expenses: recorded when goods are services are received (even if $ not yet paid)

Chapter 2 – Analysis of W/C

Solvency vs. Liquidity ---- Liquidity risk is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price.

Solvency Liquidity
A firm is solvent when its assets exceed its liabilities. A firm is liquid when it can pay its bills on time without undue cost.
Solvency is a Bankruptcy Concept A liquid firm has enough financial resources to cover its financial obligations in a timely manner with minimal cost.
Weaknesses of Solvency Elements of liquidity include several dimensions:
– Ignores the going concern assumption. 1) Time: The amount of time to convert an asset to cash. The quicker, the more liquid the firm.
– Differences in time-to-cash conversion. 2) Cost / Loss of Value: Assets can be quickly converted to cash with little/no cost.
3) Amount: The firm’s capacity to meet its ST obligations.
Solvency Ratios
Current Ratio = Current assets Indicates the degree of coverage provided to short-term creditors if ST assets were to be liquidated.
Current liabilities Its use is limiting based on the components (firm might have a high ratio due to large balance of uncollectible receivables and/or obsolete inventory)
A ratio of 2, indicates that the firm has $2.00 of current assets for $1.00 of current liabilities.
Current Assets: Cash, marketable securities, AR, prepaid expenses, inventory
Current Liabilities: Accounts payable, accrued expenses, notes payable, payroll deductions etc…
Short-term portion of long-term debt: if a debt is called short-term but is being rolled over yoy, then it is not considered a short-term. Not
included in calculating current ratio
Deferred Taxes: the timing difference between CCA and tax depreciation. Not included in calculating current ratio
Quick Ratio = current assets - 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 Also known as the acid-test ratio, it excludes inventory in the numerator since inventory is the least liquid current asset. Prepaid expenses are
current liabilities commonly excluded.
Inventory could be obsolete, incomplete, worn (damaged), or non-saleable
Net W/C NWC is a dollar-based solvency measure. same as current ratio, instead its measured in $.
Working Capital Requirements Net Working Capital commingles operating and financial accounts.
two pieces: Weaknesses:
1) Working Capital Requirements 1) focuses on solvency
= Operating CA – Operating CL 2) Assumes same liquidity
= (AR + Inventory + Prepaid) – ( Accruals +AP) 3) interpretation
2) Net Liquid Balance (NLB) Difference between WCR and NWC – WCR answers the question of true survival based on the business alone and not on any stored assets. Does the
= Financial CA – Financial CL business generated enough for the company to survive.
Cash Conversion Period is the difference between the revenue Revenue Cycle - this is not good, because it sucks up cash. We need cash to finance inventory and receivables.
cycle and the disbursement cycle
CCP = DIH + DSO – DPO

How to minimize CCP, which will also maximize the value of

the firm (NPV)
Sell Faster
Collect Faster
Pay Slower
Disbursement Cycle - good cycle because the supplier is financing us. Inventory received (accounts payable)
Turnover Measure
Inventory Turnover = COGS / Inventory Receivables Turnover = Revenues / AR AP Turnover = COGS/AP
Days Inventory Held = 365 / Inventory Turnover Days Sales Outstanding = 365 / AR Turnover Days Payable Outstanding = 365 / AP Turnover
END GOAL IS TO MAXIMIZE NPV
NPV = −𝐶𝑂𝐺𝑆 + 𝑆𝑎𝑙𝑒𝑠
[1+ 𝑖 365 𝐷𝑃𝑂 ] [1+ 𝑖 365 𝐷𝐼𝐻 𝐷𝑆𝑂 ]

Chapter 3 – Analysis of Working Capital Advanced tools

Cash Holdings 1- Moderate approach (maturity matching)

2- Aggressive approach
3- Conservative approach
CCE (Cash Conversion Efficiency) Operating CF = net income + depreciation (+noncash iteams) + interest + taxes
= Operating Cash Flow / Revenue Interpretation: how much cash is generated of $ of sales. The CCE should be positive
Cash ratio (if customer is under duress) Cash Ratio = Cash and Equivalents / Total Assets
Higher ratios improve firm liquidity and flexibility but come with an opportunity cost.
Days cash held DCH (Cash burn rate) is the number of days a firm can cover expenses with cash on hand.
DCH = Cash and Equivalents / (Cogs/365) * Operating expenses can be substituted for COGS or both can be included*
Net Liquidity Balance NWC = WCR + NLB
NWC = assets – liabilities A negative NLB indicates dependence on outside financing
WCR = (AR + Inventory + Prepaid) – (AP) *to see if the company is NLB = (Cash + Marketable Securities) – (N/P + CMLDTD)
self-sustaining by its own business
Current Liquidity Index CLI = Cash (t-1) + E (OCFt) / Noes Payable
ability for operations to pay ST financial debt t-1= present ----- t= future looking
Lambda λ • is Comprehensive liquidity measure designed to overcome shortcomings in other measures that:
Lambda = Cash + LOC + µCf / ϬCF – Ignore availability of liquidity provided by other sources
The numerator represents overall liquidity; – ignore the effect of volatile cash flow.
-Cash • λ has a coverage component similar to the Current Ratio,
-Unused credit lines (LOC) but also has a time (or flow) dimension.
-Next period’s expected daily OCF (µCf) • λ is dynamic and continuously accounts for
The denominator is historical cash flow volatility, measured as the standard – (1) the uncertainty of future cash inflows,
deviation of OCF – (2) current and expected liquidity, and
maybe put example of lambda from slides – (3) access to committed bank lines of credit.
Cash Management
Baumol: The goal of the Baumol is to choose the optimal cash amount (Z*) that minimizes the total costs from
liquidating securities during a given time period
The Baumol Model assumes:
• Periodic receipt of funds but a continuous and steady disbursement of monies F = fixed transaction cost per sale of security
• Certain cash needs TCN = total cash needed during period / annual cash disbursements
• When the cash balance reaches -, or the desired safety-stock” level, securities are sold so that the balance is U = per period opportunity cost
replenished to the initial cash balance, denoted as Z* Z = cash transfer account
Total Costs = Transaction Costs + Opportunity Costs Miller-Orr formula
Transaction Costs = # of Transaction x # of Trnscts. Period
Miller-Orr
•Like Baumol, Miller-Orr minimizes total costs
•Baumol assumes net cash flows are steady and predictable, whereas Miller-Orr does not assume a perfect cash
forecast Z* = optimal transfer amount
•Miller permits upward and downward changes to cash F = fixed transaction cost per sale of security
o^2 = variance of daily net cash flows
• The model includes two “trigger” points I = daily opportunity cost
-Upper Control Limit (UCL) – Triggers a purchase to return cash balance to the return point NOTE –
-Lower Control Limit (LCL) – Triggers a sale to return cash balance to the return point When cash is outside of the control limits, the firm mustreturn the cash balance to the Return
No transactions are made so long as the cash balance remains within the control limits (ranges) Point,
• investing only when cash reaches the UCL and liquidating investments at the LCL.
Chapter 5+6 – A/R Credit Policy and Collections
Components of Credit Policy
1. Credit Standards

a) 5 C’s b) Gathering info c) Credit Analysis (Ratios) Liquidity d) Risk Analysis

Character; reputation of the company credit reporting agencies Leverage ratios - current ratio
Capital credit interchange bureaus - TIE (Times Interest Earned) = - quick ratio
Capacity; earning power (do they have banks EBIT/Interest - cash ratio
the capacity to pay back) reference suppliers - Debt/Equity Profitability
Collateral financial statements and field data Asset Utilization (efficiency) - ROA = EBIT/assets avg.
Conditions -asst. turnover = sales/asst. avg. - ROE = NI / Equity avg.
-inventory turnover = see above - Margins
-days turnover Market Valuations

2. Credit Terms 3. Credit Limit 4. Collection Procedures

Period maximum dollar value 1. Mise en demeure 2. Action 3. Hearing 4. Judgement • with or
How many days of credit? exposure (What % of your assets does the A/R represent) || (What without legal fees • court fees 5. Write of seizure 6. Bailiff
Cash discount (2/10, n/30) % of their assets does the A/R represent)

NPV approach: Credit managers select the credit policy that combines mutually-exclusive alternatives such that NPV is maximized.

Z = PV of Sales To Discount Takers Single-Sale approach S= existing credit sales under present policy, per day
+ PV of Sales to Non-Discount Takers EXP = variable collection/credit administrations cost ratio under new policy
– Variable Operating Costs VCR = variable cost rate, per dollar of sales
– PV of Credit/Collection Costs i= daily interest rate, CP= average collection period of paying customers under new policy

Changing Credit Terms - DO THE EXAMPLES

Chapter 9 – Cash Collection and Concentration Systems

3 components of float How to make it faster – internally-collection system Cost of Collection Systems
Mail float (Usually 2 days ) 1) Company Processing Centers • Customers remit payments to the N= # of remittance
Processing float (internal) firm’s headquarter site (centralized) or to a field office processed
Clearing Float (by the bank) (decentralized). F= average face value
Treasury Management 2) Lockbox Systems • Customers remit payment to a bank lockbox of remittance
Services can improve all D = number of days it takes to clear the cheque
three. I = annual opportunity cost of funds
Other: Concentration Transfer Tool Wire transfer vs. ACH
• Offering trade credit to customers is the single longest delay in 1) Depository Transfer Check (DTC) • Non-negotiable check payable
converting sales to cash to a single bank account.
•expedite the delivery of the mail, 2) EDT (Electronic Depository Transfer; an ACH item) • The
•remittance processing ‘concentration bank’ initiates transfers from the gathering banks on a
next-day basis.
3) Wire Transfer • An immediate transfer of funds with immediate
availability. • Wires are expensive with an incoming and outgoing
charge. • Only collected funds can be transferred.

Chapter 11- Cash Forecasting

Cash forecasting is important because the future of a firm is uncertain, but we can plan for it. CFF assess the firm’s liquidity risk. It is the foundation of a firm’s short-term financial plan. It provides benchmark to assess
variances in future cash flows. Finally, large variances between actual and forecasted cash flows warrant corrective actions. Such as; 1) Timely payments and strengthened relationships with creditors/suppliers. 2)
Higher credit ratings and lower borrowing cost. 3) Improved control due to lower cash balances held in local transaction accounts. 4) Reduce opportunity costs
Sensitivity Analysis; can be used to determine the impact caused by variability in the model inputs (pessimistic, realistic and optimistic)
Statistical Methods applied to cash flow forecasting
Descriptive Time-series Regression Analysis
-Describe the location (mean, median and mode) and Moving-Average (MA); -Forecasts NCF based on the statistical relation between net cash flow and sales
variability for a given distribution -Using an averaging process over a rolling time prd. -Net cash flow: dependent variable
-Confidence levels (Standard deviation and %) -Discarding of data is attributable to the MA technique’s -Sales independent variable
Mean +- t-value* Standard error emphasis on the most recent net CF -Algebraic equation that leads to straightforward forecasts for net cash flows
Exponential Smoothing

Chapter 7 – Supplier Financing

PV(d) = (invoice price (1-d)) / (1+ (i/365)(days)) d is the discount percentage received if paid during the discount period
PVd; is the present value of the purchase paid on a specific day days represents the day on which the payment is made
Chapter 13 – S.T Financing
Asset based loans

Receivable financing Factoring - Inventory Financing

Pledging - sell the receivables to a factoring company. The factoring company will buy our receivables at a Floating Lien - Blanket coverage of assets
- collateral that the company gives to the discount on the basis that they will be able to collect more than the amount they paid us. Trust Receipts – Used when the invneotry is high value and there is a specific indicator
bank Warehouse Receipts – a warehouse that is pledged to the bank

Sources of money

1) Credit lines/ and revolving credit; both these credits are the same except that a revolving credit guarantees that the bank will always OUT OF POCKET EXPENSES 365
have the money for the owner. REVOLVING CREDIT Effective rate = ----------------------------------------- x -------
The benefits of a line of credit include: – Funding for working capital requirements – Bridge financing to quickly facilitate acquisition of USABLE FUNDS M
capital assets – Funds borrowed can be repaid with long-term capital – Liquidity insurance to cover adverse contingencies – Reduced
agency costs – Reduced opportunity costs, relative to cash holdings – Positive signaling to other creditors regarding borrower’s
creditworthiness
2) Letter of credit -Often a firm will extend credit to an unknown customer. Doing so involves (1) credit risk and (2) tying up cash as 3) Banker’s acceptance
goods are made, shipped and sold on credit . In such cases, the selling firm might require a bank letter of credit. A letter of credit is a Commonly used in international transactions. Here, a time-draft is issued by the importer’s bank drawn on the
promise made by the bank to make the payment to a third party upon presentation of the required documents (presentment), bank with payment guaranteed by the bank. The exporter can discount it through its own bank and receive
effectively substituting the credit-worthiness of the firm with that of the bank. The use of letters of credit is most common international payment prior to the delivery of the goods, freeing up cash that would have otherwise been tied up during the
trade sales cycle
5) Commercial paper; Commercial paper is a short-term promissory note issues for a pre-specified maturity at a discount from face value. CP is regularly issued by firms with low credit risk with no collateral. Use of CP
is restricted to funding working capital. Effective Cost of issuing CP = [(Discount+Commitment fee+Dealer fee+)/(usable funds raised)]*(365/M)
Financing Strategies
Aggressive strategy - Conservative strategy: Reliance on long-term financing to cover cash needs consistently even through cyclicality. The company does not take any risks with short-term financing and borrows long-term to cover the minimal and maximal cash
they need. This is costly because we are paying for borrowing without using it. Moderate strategy: draw line of credit to cover peak needs and keep it (short-term). saving money when we are borrowing short-term to cover short-term needs since the cost is lower.
saving interest cost at the cost of risk.
Short-term vs. Long-term •Long term is more expensive than short-term•Long-term carries higher risk since it is longer. Therefore it charges higher interest rate•Consumption; the longer we delay gratification, the greater the return. •Short term is riskier than
long term; if we have a business and borrow for 1 year, and business is not so good, then at the end of the 1 year, the bank will take back the loan if business is not good. •Match long term debt with long term financing, and short term debt with short term
financing!
Chapter 12 – Money Market Calculations
TEY Tax equivalent yield = nominal yield / (1-T) ----- Discount Yield = Face – P / Face x 360/n ---- Annual effective yield = ([1+ (face-P)/P]^ 365/n) - 1