Chapter 1 - Controllership

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 III Corporate Cash Management
Part IV Forecasting & Planning
Part V Short-Term Investing &
Financing
Part VI Special Topics
2
Part I - Introduction to Liquidity
Chapters
Covered
Chapter 1
The Role of Working Capital
Chapter 2
Analysis of the Working Capital Cycle
Chapter 3
Cash Holdings

3
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.
identify the basic issues involved in managing
working capital.

After studying this chapter, you should be
able to:

4
THE ROLE OF WORKING CAPITAL
Chapter 1 Agenda
5

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
6

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.

The Importance of Cash

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 decision-making.
Therefore, firms must manage cash flows and profits.

7
Financial Statements
8
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
9

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
10
The balance sheet is a snapshot of the financial accounts of a
firm as of a particular date.
Assets
11
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.
building) or intangible (e.g.
patent).

Liabilities & Owners Equity
12
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
13

The relationship between current assets and current
liabilities is critical to the ongoing operations of the
firm.
Current Assets
14
Cash & equivalents
Cash and highly-liquid investments.
Short-term 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,
W-I-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
15
Accounts payable
Amounts owed to suppliers
for purchases.
Accruals
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
16

(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.

Long-Term Assets & Liabilities
17
Long-term assets represent the investments made by the
firm.

Long-term liabilities (LTD) represent the long-term financing
sources for those investments.
The residual interest in assets after deducting
liabilities.

Includes Common Stock (at par), Additional Paid-In-
Capital, Retained Earnings, and Treasury Stock.
Retained Earnings is not idle cash; rather reinvested
earnings.
Stockholders Equity
18
Sources & Uses of Cash
Buy inventory on credit
Sell inventory for cash
Collect receivables
Borrow short-term debt
Borrow long-term debt
Sell fixed assets
Sell common stock
Liquidate investments
Buy inventory with cash
Make sales on credit
Pay suppliers (A/P)
Repay short-term loan
Retire long-term debt
Buy fixed assets
Repurchase stock
Pay dividends / taxes
Make new investments
19
Sources (Inflows) Uses (Outflows)
On the balance sheet, there are both short and long-term sources
and uses of cash; they are the opposite of each other.
The Income Statement
20
The income statement measures financial performance over
a period of time.
Income,
earnings, and
profit are used
interchangeably.

The Income Statement
21
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
22
Earnings quality is
affected by:
Accounting choices,
methods, and
assumptions.
Discretionary
expenditures.
Non-recurring
transactions.
Non-operating gains and
losses.

Profits vs. Cash
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.

23
Cash Flow Timeline Example
24
A brand new
firm is
created.
The owner
puts in half
the money
and borrows
the other
half.
Cash 1,000 $ Debt 500 $
Stock 500 $
Total 1,000 $ Total 1,000 $
Balance Sheet - Day 1
Assets Liabilities & Net Worth
25
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.
Cash 1,000 $ Debt 500 $
Stock 500 $
Total 1,000 $ Total 1,000 $
Cash 400 $ Accounts Payable 300 $
Inventory 300 $ Debt 500 $
Fixed Assets 600 $ Stock 500 $
Total 1,300 $ Total 1,300 $
26
Buying the
inventory on
credit creates
the liability,
accounts
payable.
The size of
the firm
increases by
$300.
Cash 1,000 $ Debt 500 $
Stock 500 $
Total 1,000 $ Total 1,000 $
Inventory 300 $ Debt 500 $
Total 1,300 $ Total 1,300 $
27
Heres where
we are at
month-end.
The firm
offers credit
sales to
customers,
creating a
receivable
and depleting
inventory.
Accounts Receivable 700 $ Accruals 200 $
Inventory - $ Debt 500 $
(Accumulated Depreciation) (100) $ Retained Earnings 25 $
Total 1,525 $ Total 1,525 $
Balance Sheet - End of Month
Sales 700 $
Cost of Goods Sold 300 $
Gross Profit 400 $
Operating Expenses
Salaries, Advertising, Etc. 200 $
Depreciation 100 $
Operating Profit 100 $
Interest 50 $
Taxes 25 $
Net Profit 25 $
Income Statement - End of Month
28
As the firm
operates, it
incurs
expenses
(salaries,
utilities, rent,
etc.), which
are accrued
until paid.
Total 1,525 $ Total 1,525 $
Sales 700 $
Gross Profit 400 $
Operating Expenses
Depreciation 100 $
Interest 50 $
Taxes 25 $
Net Profit 25 $
29
Depreciation,
a non-cash
charge, is
expensed.
Total 1,525 $ Total 1,525 $
Sales 700 $
Gross Profit 400 $
Operating Expenses
Depreciation 100 $
Interest 50 $
Taxes 25 $
Net Profit 25 $
30
Cash is used
to pay
interest and
taxes.
Total 1,525 $ Total 1,525 $
Sales 700 $
Gross Profit 400 $
Operating Expenses
Depreciation 100 $
Interest 50 $
Taxes 25 $
Net Profit 25 $
31
Profits are
added to the
balance sheet
as retained
earnings.
Total 1,525 $ Total 1,525 $
Sales 700 $
Gross Profit 400 $
Operating Expenses
Depreciation 100 $
Interest 50 $
Taxes 25 $
Net Profit 25 $
32
At the
beginning of
the next
month, the
bills for the
accruals are
paid with
cash.

The balance
sheet
decreases in
size.
Total 1,525 $ Total 1,525 $
Accounts Receivable 700 $ Accruals - $
Total 1,325 $ Total 1,325 $
Balance Sheet - Beginning of Next Month
33
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.
Total 1,325 $ Total 1,325 $
Cash (175) $ Accounts Payable - $
Total 1,025 $ Total 1,025 $
Balance Sheet - Middle of Next Month
Balance Sheet - Beginning of Next Month
34
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).
Cash (175) $ Accounts Payable - $
Total 1,025 $ Total 1,025 $
Cash 525 $ Accounts Payable - $
Accounts Receivable - $ Accruals - $
Total 1,025 $ Total 1,025 $
Balance Sheet - Middle of Next Month
Balance Sheet - Final View
35

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
36

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
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.
37
Cash flows in a cycle into, around, and out of a businessit
is the lifeblood of the firm.
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
38
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.

Operating Versus Cash Cycle
39

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) is the elapsed
time between the firms payment to suppliers and receipt of
customer payments.
Here, the Cash Cycle is 75 days (105 30).

40
The Cash Cycle

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.
41
We need to isolate the cash component of the accrual-based
income statement entries:

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
42

Cash Collected From Customers
- Cash Paid To Suppliers
- Cash Paid For Operations
- Cash Paid To Creditors
- Cash Paid For Taxes
= Cash Flow From Operations

43
Cash Flow Statement
Income Statement Adjustment Cash Flow Account
Sales - A/R = Cash Collected
- A/P
+ Inv
- Op Accr
- Dep
Interest - Acc Int = Cash Paid to Creditors
- Accrued Txs
- Deferred Txs
Net Profit Operating Cash Flow
CGS
Operating Expenses
Taxes
= Cash Paid to Suppliers
= Cash Paid for Op Exps
= Cash Paid for Taxes
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
44
Cash Flow Statement
- A/P
+ Inv
- Op Accr
- Dep
- Accrued Txs
- Deferred Txs
CGS
Operating Expenses
Taxes
Assets
= Use
= Source

Liabilities
= Use
=Source
45
Cash Flow Statement
- A/P
+ Inv
- Op Accr
- Dep
- Accrued Txs
- Deferred Txs
CGS
Operating Expenses
Taxes
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
accrual-based
income statement.

If A/R decreased,
cash from prior
period sales was
collected.
46
Cash Flow Statement
- A/P
+ Inv
- Op Accr
- Dep
- Accrued Txs
- Deferred Txs
CGS
Operating Expenses
Taxes
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.

47
Cash Flow Statement
- A/P
+ Inv
- Op Accr
- Dep
- Accrued Txs
- Deferred Txs
CGS
Operating Expenses
Taxes
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.

48
Cash Flow Statement
- A/P
+ Inv
- Op Accr
- Dep
- Accrued Txs
- Deferred Txs
CGS
Operating Expenses
Taxes
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
expensed in a prior
period.
Accruals can be recorded as assets or liabilities. In either case, it is simply a matter of
timing; the transaction has occurred but 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.
49
Cash Flow Statement
- A/P
+ Inv
- Op Accr
- Dep
- Accrued Txs
- Deferred Txs
CGS
Operating Expenses
Taxes

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.
50
Cash Flow Statement
- A/P
+ Inv
- Op Accr
- Dep
- Accrued Txs
- Deferred Txs
CGS
Operating Expenses
Taxes
We are interested in current period depreciation. If using the income statement,
simply use the depreciation expensed 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 fixed assets during the
period that affected accumulated depreciation.
The income
statement includes
the non-cash
charge,
depreciation.

Adjust operating
expenses to
include current
period
depreciation, a
non-cash expense.
51
Cash Flow Statement
- A/P
+ Inv
- Op Accr
- Dep
- Accrued Txs
- Deferred Txs
CGS
Operating Expenses
Taxes
Deferred taxes
result from timing
(temporary)
differences.
Accrued taxes are
permanent
differences
between tax
returns and
financial
statements (e.g.:
depreciation
methods on fixed
assets).
A deferred expense has been incurred but not yet paid; an accrued expense has not yet
been incurred.

52
Cash Flow Statement
- A/P
+ Inv
- Op Accr
- Dep
- Accrued Txs
- Deferred Txs
CGS
Operating Expenses
Taxes
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 and
must liquidate
investments or
borrow.
Back To This Example
53
Presented are
two points in
timeDay 1
and the final
view.
Lets
reconcile the
change in
cash from
$1,000 to
$525.
Cash 1,000 $ Debt 500 $
Stock 500 $
Total 1,000 $ Total 1,000 $
Cash 525 $ Accounts Payable - $
Accounts Receivable - $ Accruals - $
Total 1,025 $ Total 1,025 $
Balance Sheet - Final View
54
Reconciliation of Cash
We will do a more complex
example in a minutefor
now, become acquainted with
the format.
Cash Flow Statement
Inccome Statement 2009 Adjustment Change Cash Flow LT Sources/Uses Change
Sales 700 $ - A/R - $ 700 $ - Fixed Assets 500 $
CGS 300 $ - A/P - $ - Depreciation 100 $
+ Inv - $ + Short-Term Debt - $
Operating Expenses 300 $ - Op Accr - $ + Long-Term Debt - $
- Dep 100 $ + Other Liabilities - $
Interest 50 $ - Acc Int - $ 50 $ - Dividends Paid - $
Taxes 25 $ - Def Txs - $ 25 $ LT Change in Cash (600) $
Net Profit 25 $ Operating Cash Flow 125 $
125 $
-$600
(475) $
1,000 $
(475) $
525 $
Beginning Cash
Total Change in Cash
Ending Cash
Cash Reconciliation
300 $
200 $
Operating Cash Flow
LT Change in Cash
Cash Flow Statement
Inccome Statement 2009 Adjustment Change Cash Flow LT Sources/Uses Change
Sales 700 $ - A/R - $ 700 $ - Fixed Assets 500 $
CGS 300 $ - A/P - $ - Depreciation 100 $
+ Inv - $ + Short-Term Debt - $
Operating Expenses 300 $ - Op Accr - $ + Long-Term Debt - $
- Dep 100 $ + Other Liabilities - $
Interest 50 $ - Acc Int - $ 50 $ - Dividends Paid - $
Taxes 25 $ - Def Txs - $ 25 $ LT Change in Cash (600) $
Net Profit 25 $ Operating Cash Flow 125 $
125 $
-$600
(475) $
1,000 $
(475) $
525 $
Beginning Cash
Ending Cash
Cash Reconciliation
300 $
200 $
Operating Cash Flow
LT Change in Cash
55
Reconciliation of Cash
IMPORTANT:
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.
2
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.

56
Managing the Cash Cycle
57
Managing The Cash Cycle
58

Managing the cash cycle includes:
Reducing idle inventory
Stretching payables
Aggressively managing receivables
Receivables and inventory
absorb cash; payables supply
cash.
Working Capital Management
59
The cheapest and best source of cash exists as
working capital within the business:
Managing The Cash Cycle
60
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 long-
term.
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
61
Value can be created from many short-term financial
management activities.
Inventory Cash Management
Level Amount & Timing of Collections
Mix Amount & Timing of Disbursements
Timing Amount & Timing of Concentration
Customer Integration Receivables Banking System
Supply Chain Integration Quality Information System Integration
Information System Integration Quantity
Collection Short-Term Investing & Borrowing
Payables Timing Vendors
Utilization Customer Integration Maturity
Timing Information System Integration Hedging
Supplier Negotiation Yield
Purchasing Integration Diversification
Information System Integration Liquidity
Information System Integration
Managing Inventory
62

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
63
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
64

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.
A Few Introductory
Thoughts
65
Short-Term Planning
66
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 six-months, it ran out of cash.
How Much WC Is Enough?
67

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
68

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.

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