Short Term Financial Management - Page 26-78 - Page 11-53

CHAPTER

2Analysis of the

Working Capital Cycle

Inventory Accounts receivable Collection float

Time

Accounts payable Disbursement float

Paymentsent

Cashdisbursed

Orderplaced Sale

Inventoryreceived

Paymentsent

Cashreceived

27

O B J E C T I V E S

After studying this chapter, you should be able to:

distinguish between solvency and liquidity.

diff erentiate between solvency ratios and the cash conversion period.

calculate and interpret the cash conversion period.

determine the change in shareholder wealth attributable to changes in the cash conversion period.

F unds invested in working capital con-stantly shift among the various balance sheet accounts. To illustrate, a credit sale results in an accounts receivable. Th e eventual collection of the receivable yields increased cash and a reduced receivable bal-ance. During the operating cycle payments are made to various parties, as refl ected in accounts payable and accruals. Th e continuous ebb and fl ow of cash infl ows and outfl ows from produc-tion and revenue generation is referred to as the cash cycle. Th e length of this cycle directly infl uences fi rm liquidity; hence, it is important to monitor working capital behavior via the cash cycle.

Th is chapter discusses techniques used to quantify working capital management. Th e analysis begins with a review and critique of traditional measures used to assess working capital practices. A major focus of the chapter is to distinguish solvency from liquidity. Th e former concerns whether assets exceed liabili-ties, whereas liquidity refers to the fi rms ability to meet short-term obligations with cash while remaining a going-concern.1 Th e major empha-

1 Th e going-concern principle involves the fi rms ability to remain as a viable business. Hence, solvency violates the going-concern principle as selling off assets to repay

sis of the chapter centers on the cash conversion period, which is the length of time it takes to turn an inventoried product into a cash infl ow.

FINANCIAL DILEMMAWhat Happened?

Apple, Inc. is a multinational fi rm that designs and sells consumer electronics, personal computers, and related soft ware. Most indi-viduals probably associate the Apple brand with immense commercial success, but the fi rm has experienced periodic fi nancial diffi culties. Th e introduction of new products during the 2000s led to tremendous revenue growth, solidifying Apple as the world-wide leader in consumer technology. Chapter 1 illustrated how even profi table fi rms with growing revenues can be illiquid. How was Apple able to grow so rapidly yet maintain liquidity?

liabilities would impair the ability to remain a viable business.

28 | Short-Term Financial Management

TRADITIONAL WORKING CAPITAL MEASURESTh is section discusses traditional measures used in assessing working capital management. Th ese traditional measures include net working capital, working capital requirements, and the current and quick ratios. Example calculations and interpretations for these measures are calculated using Mas-Con, Inc.s fi nancial statements (provided in Appendix A).

Net Working Capital Net working capital (NWC) is the diff erence in current assets and current liabilities. Positive NWC indicates that long-term funds fi nance current assets. Meanwhile, negative NWC implies that the fi rm fi nances long-term assets with current liabilities. Larger values for the NWC may indicate adequate solvency and low default risk, as current assets exceed current liabilities. One problem with NWC is that it is an absolute measure, making comparisons across fi rms diffi cult. Th us, as one would expect, the absolute value of NWC will always be higher for larger fi rms. An intuitive solution to this problem of scale is to standardize NWC by assets or revenues.

Mas-Cons 2012 NWC calculation and the fi ve-year trend in this variable are shown below.

= + + + + =NWC (25 3,000 2,500)- (1,226 280 1,550) $2,4692012

2008 2009 2010 2011 2012NWC (millions) $615 $695 $498 $2,032 $2,469

With the exception of fi scal year 2010, NWC increased annually over the 2008 to 2012 period. In fact, the investment in NWC increased by 301% over the endpoints of the period in question. From these values we infer that the managers of Mas-Con increasingly fund current assets with long-term fi nancing.

Working Capital RequirementsTh e working capital requirement ( WCR) is the diff erence between current operating assets (i.e., non-cash current assets) and current operating liabilities (e.g., accounts payable and operating accruals). Th ese accounts represent spontaneous uses and sources of funds generated over the working capital cycle. Th e WCR is useful because the traditional NWC fi gure includes accounts that are not directly related to the operating component of the working capital cycle. Specifi cally, cash holdings and notes payable result from internal fi nancial decisions or policies enacted by management. Decomposing the NWC into operating and fi nancial components can be useful to management when assessing working capital policies.2

2 Shulman and Cox (1985) fi rst presented the WCR concept. Th e authors also defi ned the short-term fi nancial analog to the WCR, which is known as the net liquid balance (NLB). Th e NLB is loosely defi ned as the diff erence between cash and notes payable, as discussed in Chapter 3.

Analysis of the Working Capital Cycle | 29

All other factors constant, an increased WCR implies that the working capital cycle requires additional fi nancing. A negative WCR implies that the working capital cycle provides fi nancing for long-term assets, positively impacting solvency. Th e WCR for Mas-Con, Inc. is given below.

= + + =WCR (3,000 2,500) (1, 226 280) $3,9942012

2008 2009 2010 2011 2012WCR (millions) $640 $895 $1,490 $2,580 $3,994

Th e trend in the WCR indicates a substantial increase in net operating working capital. For each year, the observed WCR shows that more funds are tied up in receivables and inventory than is provided by spontaneous fi nancing. For example, the WCR in 2012 implies that Mas-Con, Inc. will need either internal or external funding in the amount of $3,994 to cover the gap in operating work-ing capital.

Current RatioTh e current ratio is one of the oldest fi nancial ratios, with its origin tracing back to the early 1900s. Th is ratio is calculated as current assets divided by current liabilities, indicating the level of coverage provided to short-term creditors with respect to the level of current assets. Values exceeding 1 imply that current assets exceed current liabilities. Note the relationship between the current ratio and NWC: Positive NWC means that the current ratio exceeds 1, and a negative NWC implies a current ratio of less than 1. Th e current ratio will equal 1 only if NWC is $0. Similar to the interpretation of the NWC, increased values for the current ratio traditionally imply improved solvency and reduced default risk. Despite this interpretation, keep in mind that higher receivables and inventory, while increasing the current ratio, also reduce operating cash fl ow.

Mas-Cons current ratio as well as the trend in this ratio are shown below.

=

+ +

+ +=Current Ratio (25 3,000 2,500)

(1,226 280 1,550)1.812012

2008 2009 2010 2011 2012Current Ratio 3.37 2.20 1.31 2.43 1.81

Values for the current ratio show wide variation over the horizon in question. Although it is diffi cult to discern a pattern, the data consistently show that current assets exceed current liabilities. During 2012, $1.81 in current assets was held for each $1 in current liabilities, a large reduction in solvency relative to the current ratio in 2008 (3.37).

Quick RatioA variation of the current ratio is the quick ratio, also referred to as the acid-test ratio. Th e diff er-ence between the current and quick ratio is that the latter ignores inventory, the least liquid current operating asset. Values for Mas-Cons quick ratio are shown below.


=

+

+ +=Quick Ratio 25 3,000

1,226 280 1,5500.992012

2008 2009 2010 2011 2012Quick Ratio 1.83 1.34 0.81 1.45 0.99

Similar to the current ratio, the quick ratio exhibits wide variation over the fi ve-year period. Not surprisingly, this ratio is less than the current ratio for each year. For 2012, the quick ratio indicates that the fi rm carried $0.99 of non-inventory current assets for each $1 of current liabilities. Solvency has decreased substantially since 2008.

Shortcomings of Traditional Working Capital MeasuresGauging liquidity and working capital effi ciency with NWC, WCR, and the current and quick ratios can be problematic for a couple of reasons. First, although typically referred to as measures of liquidity, the ratios presented earlier are more properly classifi ed as solvency measures. Solvency demonstrates the degree to which current liabilities are covered if current assets are liquidated at their present balance sheet values. Th us, a shortcoming of the solvency concept is that it ignores the going concern assumption, in which liquidation disrupts the operating cycle.

A second problem is the static nature of the aforementioned measures as the various balance sheet accounts are assumed to have equal time-to-cash conversion rates. For example, $100 in cash is considered just as liquid as $100 in inventory. Th us, two fi rms may have identical current ratios yet have vastly diff erent degrees of liquidity. Th is problem could lead to sub-optimal decisions made by treasury managers or lenders that are evaluating the default risk of a prospective borrower.

A third shortcoming concerns interpretation of the current and quick ratios, as changes in cur-rent assets and/or current liabilities can have counterintuitive impacts depending on the ratios initial level. Suppose a fi rm repaid a $50 trade credit obligation with cash. If the fi rms current ratio (prior to the transaction) equaled 1.5, then the current ratio would increase following the transaction. Although the fi rm now has less cash on hand, the increased current ratio would indicate improved solvency. Note that the transaction would have caused the current ratio to move in the opposite direction if the initial level of the current ratio was less than 1.

From the discussion above, it should be clear that while liquidity encompasses solvency, the aforementioned solvency measures provide an incomplete measure of liquidity. To assess liquidity, additional information is needed regarding the time needed to convert current operating assets into cash fl ow.3

THE CASH CONVERSION PERIOD

Th e cash conversion period ( CCP) provides a useful framework to examine the effi ciency and eff ec-tiveness of working capital policies.4 Conceptually, the CCP represents the time needed to convert $1 of disbursements into $1 of cash receipts. In contrast with the traditional liquidation value approach, the fl ow approach of the CCP quantifi es liquidity from a going-concern perspective by blending data

3 Liquidity assessment also involves knowledge of the cash position and access to short-term debt fi nancing. Th ese aspects are addressed in later chapters.4 Th e CCP, also commonly referred to as the cash conversion cycle, was developed by Richards and Laughlin (1980). Gentry, Vaidyanathan, and Lee (1990) further refi ne the CCP concept by proposing a weighted CCP.


from the balance sheet and income statement. Specifi cally, the CCP incorporates the frequency of turnover in the operating working capital accounts, thereby accounting for diff erences in time-to-cash conversion rates. Calculation of the CCP involves three measures, including days inventory held (DIH), days sales outstanding (DSO), and days payables outstanding (DPO). Each component is illustrated in Exhibit 2-1 and is discussed in turn. Th e exhibit shows that the fi rst step in calculating the CCP involves determining the DIH, defi ned as ending inventory scaled by daily cost of goods sold (COGS).5 Conceptually, the DIH represents the delay between acquisition of inventory and selling the item to a customer (i.e., the average number of days inventory sits idle). Also, given that COGS represents inventory production costs, the DIH can be interpreted as the number of days of inventory held on the balance sheet at a given point in time. Th e DIH for Mas-Con in 2012 equals

= =

=DIHInventory

COGS365

$2,500$4,500

365

202.78 days2012

Th e DIH can also be considered in terms of inventory turnover, where COGS is divided by inven-tory. Since inventory turnover yields the frequency with which inventory is converted into revenues, rapid inventory turnover indicates effi cient inventory management. In this example, inventory is turned over or sold 1.8 (4,500/2,500) times per year. As you may have already realized, the transi-tion from inventory turnover to DIH is straightforward: Divide 365 by the inventory turnover. Th is step leads to a DIH of 202.78 days (365/1.8). Th e implication is that quicker inventory turnover reduces the number of days of inventory carried on the balance sheet. Purchasing, production, and distribution policies that minimize the inventory required to generate each $1 of sales results in more frequent turnover and a lower DIH. Th e other components of the CCP are similarly related to the turnover analogs.

Th e second component of the CCP is the DSO, defi ned as end-of-period receivables divided by average daily sales. DSO represents the average number of days it takes for a supplier to collect on credit sales, which refl ects the effi ciency of the credit and collections department. Subsequently,

5 Th e average age of inventory held during the period may be used in place of ending inventory.

EXHIBIT 2-1. THE CASH CONVERSION PERIOD

DIH

DPO

DSO

Cashconversion

period

Time

Paymentsent

Orderplaced Sale

Inventoryreceived

Paymentreceived


DSO is also referred to as the average collection period and it is common to compare the DSO to the trade credit terms off ered by suppliers. Th e DSO obtained for the fi rm in 2012 is calculated as

= =

=DSO A/RSales365

$3,000$9,000

365

121.67 days2012

Th e measure above understates the true DSO, in that credit sales should be used in the denominator. Credit sales are not always observable from fi nancial statements; however, treasury staff members can easily obtain their fi rms credit sales.

Th e third and fi nal component of the CCP accounts for the spontaneous fi nancing received during the working capital cycle. DPO is the elapsed time between receipt of inputs and when payments are made to suppliers. Th is ratio equals the ending accounts payable balance scaled by average daily COGS.6 Th e calculation for the fi rms DPO in 2012 is shown below:

= =

=DPO A/PCOGS365

$1, 226$4,500

365

99.44 days2012

Referring back to Exhibit 2-1, note the upper half of the timeline that extends from the point at which the order is received until payment is received. Th is period is referred to as the operating cycle (OC) and represents the normal fl ow of funds throughout the various current asset accounts for non-service providers. Th e OC equals the sum of DIH and DSO. Th e CCP is arrived at by subtract-ing DPO from the OC.

In practice, the CCP represents the length of time over which management must arrange for non-spontaneous fi nancing. Longer CCPs require increased fi nancial resources, reducing fi rm liquidity. Below, the calculations for Mas-Cons operating cycle and CCP are shown.

= +

= +

=OCInventory

COGS365

A/RSales365

$2,500$4,500

365

$3,000$9,000

365

324.44 days2012

= =

=CCP OC A/PCOGS365

324.44 $1,226$4,500365

225.00 days2012 2012

As is the case for most fi rms, Mas-Con, Inc. has a positive CCP, which implies that additional fi nancing is needed to fund the cash cycle. Specifi cally, the calculated CCP suggests that it takes this fi rm 225 days to turn a disbursement of cash into a cash infl ow. Although Mas-Cons positive CCP is

6 Purchases can be used instead of COGS. Purchases can be estimated using the following accounting relationship: Ending Inventory = Beginning Inventory + Purchases COGS. While the use of purchases is more accurate, COGS is used in this chapter to parallel the approach used when calculating industry averages for benchmarking purposes.


consistent with the working capital cycles of most fi rms, it is instructive to note that a negative CCP occurs when the trade credit period received exceeds the operating cycle. A negative CCP implies that suppliers provide fi nancing for the fi rms working capital cycle and for non-operating working capital assets. Firms that tend to have a negative CCP include Apple and Wal-Mart. Th is desirable working capital position is attributable to the strong demand for both fi rms products (short inventory holding periods), quick repayment by customers (to retain a favorable relationship), and generous trade credit terms received from suppliers. Th e fi ve-year trend for Mas-Cons CCP is shown below.

2008 2009 2010 2011 2012DIH 194.67 162.22 155.73 185.82 202.78DSO 109.50 113.56 116.80 132.73 121.67OC 304.17 275.78 272.53 318.55 324.45 DPO 48.67 64.89 77.87 92.91 99.44CCP 255.50 210.89 194.66 225.64 225.01

Each component of the CCP exhibits substantial variation within the sample period. In terms of the endpoints of the sample period, however, only DPO changed by a meaningful amount; the number of days of trade fi nancing more than doubled from 2008 to 2012. Th is increase in DPO coupled with only a small increase in the OC caused the CCP to decrease by 11.93% from 2008 to 2012.

Since the primary determinant of the reduced CCP is the length of time for which supplier fi nancing is received, it is important to note that over-extending terms received from suppliers is clearly not a signal of increased liquidity. Th us, the causation of changes in the CCP should be determined. Quicker turnover of accounts receivable and inventory indicates increased effi ciency and enhanced cash fl ow. Careful study of the CCPs components should reveal whether effi ciency has changed or whether policies have evolved.7 Overall, the CCP provides helpful information to the treasury department.

Unlocking Cash Flow from the CCPAs discussed, a longer CCP implies reduced liquidity. Evaluating changes in the individual com-ponents of the CCP can evidence the improvements in liquidity that result from reducing the cash cycle. Suppose that a fi rm currently has a CCP of 87 days and DIH equals 50 days. Management would like to reduce the CCP by 5 days through changes in inventory policy. Th at is, the extension and use of trade credit policies will remain unchanged. With this goal in mind, and assuming that the fi rm has annual revenues of $500M with COGS representing 40% of revenues, the treasury department can estimate the implied reduction in inventory and the subsequent increase in cash fl ow

7 While the CCP may facilitate helpful comparisons across fi rms in an industry or for a given fi rm over time, a few caveats are in order. First, calculating the CCP using annual data may lead to incorrect inferences. Th is may be due to seasonal variation that results in lower or higher values for the working capital accounts than are typical throughout the year. Th e toy industry is a nice example. Also, fi rms are notorious for window dressing their end of year fi nancial statements, employing tight collection practices, stretching payments to suppliers, and delaying inventory purchases, all to maximize cash fl ow. Clearly these problems are negligible for internal employees analyzing the underpinnings of their fi rms working capital policies. Second, like all fi nancial ratios, the CCP is a static, backward looking measure that may not be relevant in future periods.


that accompanies a 5 day reduction in the DIH. Th e steps involved include solving for the current and target inventory levels implied by the current and target values for the DIH, respectively. Next, subtract the target inventory from the current inventory. Th ese steps follow.

= = =

50Inventory$200,000,000

365

50 $200,000,000365

Inventory $27,397,260.27

Current

Current

= = =

= =

45Inventory$200,000,000

365

45 $200,000,000365

Inventory $24,657,534.25

Reduced Investment in Inventory $27,397,260.27-$24,657.534.25 $2,739,726.02

Target

Target

Th e implication is that a 5 day reduction in the DIH frees up over $2.7M in cash fl ow, providing for additional investment in long-term assets, distributions to shareholders, or amortization of debt. Changes in cash fl ow realized from altering the DSO and DPO can be similarly calculated. Th e following Focus on Practice provides practical insight on the art of unlocking cash fl ow through changes in the cash cycle.

THE FINANCIAL DILEMMA REVISITEDSo what can be gathered from Apples experience? Apple was able to sustain an enormous revenue growth rate of 65.96% during 2011 by using the working capital cycle as a source of funding. Th e fi rms CCP equaled 60.39 days in 2011, suggesting that inventory was converted into cash before payments were made to suppliers. Effi cient working capital management coupled with profi tability has allowed managers to create substantial value for Apple shareholders. In fact, Apples treasury management department has stated that monitoring the CCP and maintaining a tight control of the working capital cycle has allowed the fi rm to more quickly turn receivables and inventory into cash, which has led to a larger investment portfolio.8

8 Cashing in on ControlHow Apple Maximizes Treasury Effi ciency. GTNews.com/article/5205.cfm (October 16, 2003).


The Cash Conversion Period and Firm ValueTh e CCP directly impacts the value of the fi rm as the gap between the operating cycle and the DPO can be fi nanced with either debt or equity.9 Th at is, fi rms can borrow or internally fi nance the length of time that funds are tied up in the working capital cycle. Th is section quantifi es the impact on shareholder wealth attributable to changes in the CCP using both methods of fi nancing.

Th e tie between fi rm value and the use of debt to fi nance the CCP is straightforward: An increased cash cycle implies increased interest expense. As an example, suppose that the management of Washam, Inc. made a strategic change in the fi rms trade credit policy, lengthening the credit period (or DSO) from 30 to 35 days. Furthermore, assume that the fi rm has an average daily receivables balance of $150M and the cost of short-term debt is 3%. Th ese values imply an increased fi nancing cost of $22.5M [$150M*0.03*5 days] attributable to the given change in trade credit policy.

Interdependencies in the working capital cycle suggest that a liberalized trade credit policy will reduce the length of time that Washam, Inc. holds inventory, thereby reducing the interest expense incurred from fi nancing inventory held. Suppose that the fi rms DIH drops from 45 to 42 days and that the average daily inventory equals $180M. Th e change in trade credit policy reduces the inven-tory fi nancing cost by [$180M*0.03*3 days] $16.2M. Th is cost savings should be considered when quantifying the marginal costs associated with the change in trade credit policy.

Another approach to estimate the fi nancing costs associated with the CCP involves backing out the changes in the balance sheet accounts that occur due to increases/decreases in the individual components of the cash cycle (similar to that shown earlier in the section titled Unlocking Cash Flow from Changes in the CCP). Th ese changes are then multiplied by the cost of debt and the appropriate component of the CCP to arrive at the change in borrowing costs. Each component must be handled separately because of diff erences in the denominators of the CCPs components.10

While fi nancing the CCP externally results in a traceable or direct cost, it should be emphasized that the decision to internally fi nance the cash cycle is not costless. To visualize this, recall a basic principle from fi nance: time value of money. In general, fi rms prefer to receive cash infl ows sooner rather than later because the funds can be invested at the companys opportunity cost. Due to the same principle, fi rms also prefer to delay cash outfl ows. Since the CCP represents the length of time that funds are tied up in the working capital cycle, opportunity cost is an important factor to consider when estimating the impact of changes in working capital policies on shareholder wealth. Th e net present value (NPV) method is applied for fi rms that fi nance the CCP with equity. In addition to the upfront marginal costs associated with new investment, the NPV model accounts for opportunity costs by discounting the future cash fl ows that are expected to result from a given investment. In terms of working capital, fi rms invest in human capital and raw materials to produce goods, which are then sold. Th e general NPV framework applied to working capital decisions is shown below.11

9 In this section a positive CCP is assumed, implying that the working capital cycle requires additional fi nancing.10 Th e authors have seen this issue handled in various ways in practitioner articles and fi nance textbooks. Note, however, that the use of the Net Trade Cycle (NTC) mitigates complications in making inferences with respect to fi nancing costs that are attributable to changes in working capital policies. Th is is because the NTC scales the pertinent balance sheet accounts by revenues. Th at is, the NTC equals [(Inventory + Receivables Payables)/Revenues]*365. Th is metric eases the calculation for the increased fi nancing cost associated with a 5 day increase in the NTC that triggers a $50M increase in revenues. Assuming an interest rate of 2.5%, this implies that the cost of fi nancing the given increase in revenues is $6.25M [$50M*0.025*5 days]. 11 Compounded interest is ignored throughout the text. Th e short-term nature of the scenarios used in the problems implies only minor diff erences in present values calculated with and without compounded interest.


( ) ( )=

+

+

+ +

NPVCOGSi DPO

Salesi DIH DSO

DD D

1365

1365

in which:

COGSD = daily cost of goods sold SalesD = daily sales i = annual opportunity costDPO = days payable outstandingDIH = days inventory heldDSO = days sales outstanding.

Th e equation shows that the individual components of the CCP infl uence fi rm value in two ways. First, the delay in paying (DPO) for goods or services reduces the present value of cash outfl ows. Second, the length of time that funds are tied up in the operating cycle (DIH+DSO) reduces the present value of cash infl ows. Th e NPV model implies that fi rms can increase shareholder wealth by extending DPO and reducing the sum of DIH and DSO. Potential problems associated with these strategies are discussed in subsequent chapters.

Since the cash infl ow and outfl ow measures are assumed to occur daily (SalesD and COGSD), the model provides the daily change in fi rm value attributable to the CCP (NPVD). Assuming that the fi rm will indefi nitely remain a going concern, the perpetuity approach is the appropriate discounted cash fl ow technique used to calculate the aggregate NPV from NPVD.

= NPV

NPViPerp

D

365

Th e following example illustrates the impact on shareholder wealth that accompanies a change in the CCP for a fi rm that internally fi nances the working capital cycle. Suppose that DigiView, a maker of digital video disk players, is considering increasing its credit terms from net 30 to net 60. DigiView believes the relaxing of terms would stimulate sales, particularly at the present time when many electronics retailers are fi nancially constrained due to increased competition. To evaluate the fi nan-cial impact of this change in working capital policy, DigiViews fi nancial analysts need the relevant decision variables that will aff ect cash fl ows. Currently, DigiViews daily sales equal $100,000 and COGS represent 65% of sales. Th e fi rms credit analysts estimate the aforementioned change in credit terms will lead to a 3% increase in sales. DigiViews DIH and DPO will be invariant to the change in policy and equal 40 and 30 days, respectively. Further, assume the fi rms annual opportunity cost is 10%. Th e following exhibits display timelines of the cash fl ows associated with the present and proposed changes in credit terms, respectively.

Th e perpetual NPVs from both the present and proposed terms are needed to obtain the diff er-ence in shareholder wealth occurring due to the change in trade credit terms. Th e fi rst step involves solving for the daily NPV of the present terms, by subtracting the present value of the cash outfl ow made on day 30 from the present value of the cash infl ow received on day 70. Next, the daily NPV is


discounted by the daily opportunity cost to arrive at the aggregate NPV (NPVPerp). Th e calculations are shown below.

( ) ( )=

+

+

+ +

=

= =

NPV

NPV

D

Perp

$65,000

1 0.10365

30

$100,000

1 0.10365

40 30$33,648.17

$33,648.170.10365

$122,815,818.90

While the undiscounted net benefi t from the transaction is $35,000, note that the delayed payment terms erode value from the profi t margin earned on the sale. Still, repeating this transaction daily yields substantial value to shareholders.

Th e same procedure from above is implemented using the proposed terms. Note that the pro-posed terms involve an extended trade credit period, which boosts sales and cost of goods sold.

EXHIBIT 2-2. DIGIVIEWS CASH FLOW TIMELINE, PRESENT CREDIT TERMS

Sales proceedsreceived$100,000

Goodsproduced,raw materialspaid for

Raw materialspurchased

Productsold

0 30 40 70

($65,000)

DAY


( ) ( )=

+

+

+ +

=

= =

NPV

NPV

D

Perp

$66,950

1 0.10365

30

$103,000

1 0.10365

40 60$33,849.12

$33,849.120.10365

$123,549,300.20

Th e decision rule is to select the alternative with the highest NPV. Th e calculations suggest that the proposed terms provide the most value to shareholders, hence the change in trade credit policy is recommended.

As with any capital budgeting problem, management should consider the model assumptions before drawing inferences. Th e fi rst assumption involves the opportunity cost associated with the internal funds used to fi nance the CCP. Careful consideration should be used when choosing the opportu-nity cost to apply to the cash fl ows. Management faces a dilemma in evaluating short-term fi nancial management decisions with the fi rms overall opportunity cost, commonly referred to as the weighted average cost of capital, or with the rate of return earned on cash and short-term investments. Th e latter is a viable candidate because cash holdings are likely the source of equity used to fi nance the CCP. Another issue related to the choice of opportunity cost relates to the valuation horizon. Th e discount rate used is linked to fi rm risk before a change in working capital policy. Th us, if fi rm risk subsequently increases (decreases) due to the change in policy, the discount rate should be increased (decreased).

EXHIBIT 2-3. DIGIVIEWS CASH FLOW TIMELINE, PROPOSED CREDIT TERMS, ASSUMING SALES INCREASE

Sales proceedsreceived$103,000

Goodsproduced,raw materialspaid for

Raw materialspurchased

Productsold

0 30 40 100

($66,950)

DAY


Another model assumption that warrants attention is duration. If the cash fl ow eff ect associated with a change in working capital policy will not last indefi nitely, then the perpetuity approach is inappropriate. Lastly, great care should be used when selecting the growth in sales used to calculate the diff erent NPVs. In practice, it is diffi cult to estimate quantity demanded. If growth in sales is less than expected, then switching terms might not be optimal. A relatively straight-forward approach in mitigating the likelihood of making a sub-optimal switch would be to solve for the break-even growth in sales that results in a positive NPV. More formally, one could use simulation analysis in which probability distributions for revenues and expenses are combined in a quantitative model to determine an entire distribution of NPVs for a proposed change. Th is approach is beyond the scope of this text.

From the Ivory Tower: Empirical Evidence on Working Capital Management

Working capital management is a growing area of interest for academic research. Hawawini, Viallet, and Vora (1986) fi nd that industry affi liation is a primary factor that drives working capital practices. To put this fi nding into perspective, consider the diff erences in the working capital cycles for manu-facturing fi rms versus service fi rms (the latter carries no inventory). Hill, Kelly, and Highfi eld (2010) fi nd that industry affi liation, macroeconomic conditions, and operating and fi nancing frictions are important factors that infl uence fi rms working capital behavior.

In addition to examining the determinants of working capital, researchers also study the link between fi rm value and working capital policies. Shin and Soenen (1998) fi nd a signifi cant and nega-tive relation between U.S. fi rms operating performance and the length of time funds are invested in the cash cycle. Deloof (2003) fi nds similar results for a sample of Belgian fi rms. Kieschnick, Moussawi, and LaPlante (2012) show that excess stock returns are related to changes in operating working capital. Specifi cally, the market value impact of a $1 change in operating working capital results in a less than $1 change in market value of equity, which is consistent with the costs concomitant with carrying operating working capital. Other studies examine the relation between performance and individual components of operating and fi nancial working capital, which we will discuss in subsequent chapters. Overall, the implication is that the effi cient use of working capital via the cash cycle delivers tangible benefi ts to fi rms.

Trends in Working Capital ManagementWe next discuss trends in corporate working capital behavior via the CCP. Exhibit 2-4 displays annual median values of the CCP for all publicly-traded U.S. fi rms over the 1980 to 2011 period.12 Examining the endpoints of the sample period, we observe that the median CCP in 1980 is 91.18 days, which drops to 57.55 days in 2011. Th e lower CCP represents a 37% decrease in the length of time that funds are tied up in working capital and implies reduced interest expense and overall improved liquidity. Note that the minimum CCP over the sample occurs in 2008. Findings displayed in Exhibit 2-4 indicate that managers of publicly-traded fi rms have become much more adept at shortening the cash cycle. Trends in the individual components of the CCP are discussed in future chapters. Th e following Focus on Practice discusses a tool that managers can use to benchmark their fi rms CCP.

12 Th e sample consists of non-regulated U.S. fi rms covered by Compustat, a database that provides accounting informa-tion for publicly-traded fi rms. Th e data is trimmed at the 1% level of both tails of the distribution for each component of the CCP (DIH, DSO, and DPO). Median values are presented to further mitigate the infl uence of outliers.


EXHIBIT 2-4. TRENDS IN CASH CONVERSION PERIOD (CCP)

01980 1985 1990 1995

Years

CC

P (

# o

f day

s)

2000 2005 2010

10

20

30

40

50

60

70

80

90

100

CCPCCP

MedianMaxMin

70.88 days91.8355.17

198091.18 days

201157.55 days

SUMMARY

Th e chapter provides various calculations used to assess solvency and fi rm liquidity. Solvency is an accounting concept that compares assets to liabilities and is an appropriate measure used to assess the degree of coverage provided by current assets in the event of liquidation. Liquidity is more of a tactical concept related to the fi rms ability to pay for its current obligations in a timely fashion with minimal cost. Payment can be made either through current period cash fl ow or by drawing down a stock of liquid resources.

Along with calculations and interpretations, the strengths and weaknesses of each measure are discussed. A large portion of the chapter concerns the CCP, which is the most appropriate measure to use when assessing the effi ciency of fi rms operating working capital strategies. In addition, we show how to apply NPV concepts to changes in the CCP. Th ese calculations illustrate how to quan-tify incremental contributions to shareholder wealth caused by gaining a tighter grip on the working capital cycle.

Useful Web SitesSource for relevant practitioner articles: www.cfo.com and www.afponline.orgSource for corporate fi nancial statements: www.sec.gov/edgar.shtml

Questions1. What is liquidity and how does it diff er from solvency?2. How might a balance sheet measure of solvency be converted into a liquidity measure?3. Interpret a current ratio of 2.00. 4. Describe why the CCP is considered a liquidity measure.


ProblemsJ. WASHAM CALCULATORS

ASSUMPTIONS BALANCE SHEETS(current assets shaded) 2007 2008 2009 2010 2011 Cash & Equivalents $75 $75 $90 $100 $100 Accounts Receivable 300 400 600 550 500 Inventory 150 250 350 250 250 Net Fixed Assets 525 575 610 540 465 Total Assets $1,050 $1,300 $1,650 $1,440 $1,315

(current liabilities shaded)Accounts Payable $125 $175 $250 $225 $200 Notes Payable 165 162 178 136 99 Accrued Operating Exp. 60 161 165 89 76 Long-Term Debt 500 400 300 100 50 Shareholders Equity 200 402 757.2 890.2 890.2 Total Liabilities & NW $1,050 $1,300 $1,650 $1,440 $1,315

F O C U S O N P R A C T I C EBenchmarking Working Capital Policies

Given the importance of effi ciently managing the cash cycle, a relevant question is how does the treasury staff determine whether their rms operating working capital strategies are effi cient enough? Each year REL Consultancy publishes a Working Capital Scorecard. This publication presents various summary statistics on various industries annual CCP behavior. This scorecard provides a way for rms to benchmark their working capital policies against the most effi cient industry competitors. A note of caution is in order, however. While intra-industry comparisons are certainly helpful, this approach falls short in taking account of the various frictions that motivate the extension of trade credit and investment in inventory; these frictions are discussed in detail in subsequent chapters. For more details on REL Consultancys Working Capital Scorecard see www.cfo.com.

5. Is it possible for a fi rm to have high (low) solvency ratios but a low (high) CCP? 6. Discuss the implications of a negative CCP.7. Discuss the observed trend in the CCP for publicly-traded fi rms.


INCOME STATEMENTSRevenues (Sales) $1,500 $2,250 $3,000 $2,000 $1,500 Cost of Goods Sold 600 900 1,200 800 600 Operating Expenses 600 797 895 750 725 Depreciation 35 50 65 70 75 Interest 30 33 28 25 10 Taxes 94 188 325 142 36 Net Profi t 141 282 487.2 213 54 Dividends 40 80 132 80 54

1. Use the information contained in J. Washams fi nancial statements to solve the following problems.a. Calculate the current ratio, quick ratio, net working capital, and working capital require-

ments for each of the fi ve years. Discuss and interpret the trends observed.b. Calculate the cash conversion period for each year and interpret the trend.

2. Suppose a fi rm pays a $50,000 trade credit obligation to a supplier in cash. a. What impact does this transaction have on the fi rms current ratio if the initial current

ratio equaled 1? b. What impact does this transaction have on the fi rms current ratio if the initial current

ratio is 0.5? c. What impact does this transaction have on the fi rms current ratio if the initial current

ratio equaled 1.7?3. Suppose that last year a fi rm had a DSO of 35 days and annual revenues equal to $10,000,000.

Th e treasury department has made it a goal to reduce the DSO to 30 days, while holding constant revenues. If this reduction is realized, then calculate the following:a. Th e dollar change in receivables. b. Th e implied reduced fi nancing cost of the receivables held (assume a borrowing rate of

2.5%)c. Th e change in the OC and CCP given that next years DIH and DPO are expected to equal

45 days and 75 days, respectively. 4. Mississippi Delta, Inc. has been selling switching equipment to computer companies on net-

30 terms, in which payment is expected by 30 days from the invoice date. Concerned about deteriorating collection patterns, the credit manager has divided customers into two groups for examination purposes:

Prompt payors and laggards. Prompt payors (80 percent of Mississippi Deltas custom-ers) pay, on average, in 35 days, versus a 72-day average for the laggards. Th e manager wonders if the credit terms should be modifi ed to include a 2 percent cash discount on invoices paid within 10 days. Th e average invoice is the same for both groups, roughly $4,000. Th e manager expects 50 percent of the prompt payors to pay in exactly 10 days and the average on the other half to slip to 40 days. He thinks that 20 percent of the laggards will pay in 10 days and the average on the others will slip to 80 days. Given these forecasts, he is not sure that the lost revenue from discount takers (who


would then pay only 98 percent of the invoiced dollar amount) justifi es the improved collection. Th e companys annual cost of capital is 11 percent.

a. Using NPV calculations, show the present value of the present collection experience.b. Calculate the NPV of the proposed 2/10, net-30 terms.c. Based on your net-present-value analysis, should Mississippi Delta Inc. adopt the cash

discount?d. What other factors should be taken into account before Mississippi Delta Inc. makes a

switch, assuming such is justifi able on an NPV basis?e. Sensitivity analysis involves varying the key assumptions, one at a time, and observing the

eff ect on the key decision criterionsuch as profi ts or NPV. In the NPV analysis above, how could one carry out sensitivity analysis? (If you have a fi nancial spreadsheet available, conduct a sensitivity analysis that varies the number of prompt payors who will pay in exactly 10 days and report your fi ndings.)

REFERENCES

Marc Deloof, Does Working Capital Management Aff ect Profi tability of Belgian Firms?, Journal of Business Finance and Accounting 30, 2003, 573587.

Gabriel Hawawini, Claude Viallet, and Ashok Vora, Industrial Infl uence on Corporate Working Capital Decisions, Sloan Management Review, 1986 27(4), pp. 1524.

James A. Gentry, R. Vaidyanathan, and Hei Wai Lee, A Weighted Cash Conversion Cycle, Financial Management, 1990, pp. 9099.

Matthew D. Hill, G.W. Kelly, and Michael J. Highfi eld, Net Operating Working Capital Behavior: A First Look, Financial Management 39:12, 2010, 783805.

Robert L. Kieschnick, Mark LaPlante, and Rabih Moussawi, Working Capital Management and Shareholder Wealth, Review of Finance, 2012, Forthcoming.

V.D. Richards and E.J. Laughlin, A Cash Conversion Cycle Approach to Liquidity Analysis, Financial Management (Spring 1980), pp. 3238.

Hyun-Han Shin and Luc A. Soenen, Effi ciency of Working Capital Management and Corporate Profi tability, Financial Practice and Education 8, 1990, 3745.

Joel M. Shulman and Raymond A.K. Cox, An Integrative Approach to Working Capital Management, Journal of Cash Management, 1985 5(6), pp. 6467.

Anne Bacher Cashing in on ControlHow Apple Maximises Treasury Effi ciency, GTNews.com/article/5205.cfm (October 16, 2003).

CHAPTER

3Cash Holdings

45

O B J E C T I V E S

After studying this chapter, you should be able to:

identify the bene ts and costs associated with corporate cash holdings.

discuss motives for holding cash.

assess corporate liquidity using cash-based nancial ratios.

explain and use cash management models.

T he previous chapter examined cor-porate liquidity from the perspective of the cash conversion period ( CCP). While the length of time needed to turn a cash disbursement into a cash infl ow is an important aspect of liquidity, the CCP is of limited use in determining whether the fi rm can withstand cash fl ow shocks that result from unexpected events (i.e., losing a major customer, litigation, etc.). Subsequently, this chapter focuses on the role of cash in managing liquidity.

In the past, cash was primarily held because of unsynchronized cash receipts and disburse-ments; hence, analysts largely viewed cash as an idle short-term asset earning a low rate of return. Heightened fi nancing frictions dur-ing the recent fi nancial crisis helped cause a paradigm shift in the way that cash is viewed. Consequently, the cash allocation decision is acknowledged as a critical determinant of maxi-mizing shareholder wealth. Cash policy impacts various strategic areas of corporate fi nance, including capital structure, dividend policy, and investment strategies.

Th e chapter begins with a discussion of the tradeoff s associated with cash holdings. Next,

quantitative measures are covered that can aid treasury managers in assessing the target cash position. Th e chapter closes with an exhibit showing trends in corporate cash holdings over the last three decades.

FINANCIAL DILEMMAHow Much Cash is Too Much?

At the end of fi scal year 2011, Apple, Inc. held $81.57 billion collectively in cash, equivalents, and marketable securities, comprising 70.01% of the fi rms asset base. Th is ample liquid reserve was a consequence of strong operating cash fl ow and non-existent dividend distributions to shareholders (per Steve Jobs). Continued revenue growth and robust operating margins coupled with Apples access to private and public capital markets caused certain analysts and inves-tors to question whether the fi rms cash position was in the best interest of shareholders.


CORPORATE CASH HOLDINGS

Cash holdings represent the most liquid asset, which explains the common phrase cash is king. Th e evolving safety of funds held in corporate transaction accounts and forthcoming changes in money market instruments warrant a clear delineation between cash holdings and short-term marketable securities. In this chapter, cash holdings refer to transaction account balances. Marketable securities represent short-term instruments owned by fi rms that mature in less than a year and have relatively low risk and cheap liquidation costs. Subsequently, these short-term investments provide liquidity in addition to cash holdings.

Typically, determining the proportion of assets held in cash is one of the fi rst investment decisions that management faces. Th e fi rms overall risk posture, as refl ected in current macroeconomic condi-tions and competition in product markets, infl uences the cash position. Further, the availability of other liquidity sources should be considered before adopting a particular cash strategy; non-cash items can provide liquidity if the stock of cash and current cash infl ow is insuffi cient to cover obligations. For example, fi nished goods inventory can be discounted for quick turnover while receivables can be factored. Th e ability to access private debt via lines of credit or borrowing through the commercial paper market also infl uences the appropriate cash position. Th ese additional sources of liquidity are discussed in later chapters.

Managers may choose a low, moderate, or high- liquidity strategy when deciding on the appropri-ate cash level. A low-liquidity strategy entails a minimal investment in cash. Th is strategy allows managers to internally fi nance increased investment in net operating working capital or fi xed assets.1 A disadvantage of the low-liquidity strategy is increased default and bankruptcy risk because of an impaired ability to weather unexpected contingencies. Certain fi rms may be able to justify the low-liquidity strategy on the basis of predictable cash fl ows and spare debt capacity. Benefi ts accom-panying reduced cash holdings include a higher return on assets and lower agency costs. Relative to the low-cash strategy, the moderate-liquidity strategy involves a greater investment in cash with correspondingly less risk. Th is strategy may be premised on a matching philosophy: increased near-term fi nancial obligations imply a heightened need to invest in cash. Last, the high-liquidity strategy prescribes a relatively large cash-to-assets ratio. Default and bankruptcy risks are reduced because of the greater liquidity reserve. However, profi tability is lower as well since a greater propor-tion of assets is allocated to low-yielding cash. Companies with signifi cant business or fi nancial risk might implement such a strategy. For years, automakers and Microsoft justifi ed large cash positions because of unknown future capital investment opportunities, such as plant expansions or newly-developed technologies.

Costs and Bene ts of Holding Cash Th e costs and benefi ts of holding cash infl uence the optimal cash level. A key marginal cost of cash holdings is opportunity costs. By investing in cash, managers lose the opportunity to pay down debt or invest in higher yielding projects or securities. Th e opportunity cost of cash and near-cash invest-ments should not be dismissed as trivial, given the current lower yields on transaction accounts off ered by fi nancial institutions. Another important consideration is the agency costs associated with cash. Jensens (1986) theory on the agency costs of cash posits that excess liquidity provides avenues

1 Fixed asset investments are generally property, plant, and equipment expenditures made in support of new products and market expansion, which presumably have positive net present value, thus enhancing shareholder value.

Cash Holdings | 47

through which managers can extract private benefi ts from the fi rm to the detriment of sharehold-ers. Examples of agency confl icts include managerial entrenchment and perquisite consumption. In terms of the former, cash holdings can help shield underperforming managers from capital market monitoring, prolonging their ability to manage fi rms. Cash also provides an unmonitored funding mechanism for perquisites, such as compensation packages, company planes, and entertainment.

Despite the marginal costs of liquid assets, many managers view cash as a necessary evil because of the accompanying benefi ts. Keynes (1936) states that cash holdings result from transactions, precautionary, and speculative motives. Managers have a transactions motive to hold cash when expenses are unsynchronized with cash infl ows. In this case cash provides a medium to ful-fi ll payments in lieu of liquidating long-term assets. Th us, cash can reduce transaction costs and opportunity costs that stem from lost returns due to early liquidation. Th e transactions motive for holding cash is important for fi rms with unsynchronized cash infl ows and outfl ows. Managers may hold cash for precautionary purposes because cash can buff er against unexpected contingencies or cash fl ow shortages; realized cash infl ows may be less than expected. Precautionary cash holdings provide funding for purchases and repayment of debt, which are even more critical during tight credit periods when external capital is more diffi cult to acquire. Managers also have a speculative motive because cash holdings allow for the acquisition of positive net present value investments, where examples include strategic mergers or acquisitions. In these specifi c instances cash allows the buyer to move quickly, thereby avoiding a potential bidding war. Th e following Focus on Practice illustrates Apples speculative motive for holding cash.

Th e rationales for holding cash have been developed further since Keynes treatise on cash. Newer motives include tax policy and agency problems. Th e tax motive for cash is largely an outcome from the globalization of trade, wherein large multinational corporations maintain foreign operations and subsidiaries. Because of high repatriation tax rates, managers of U.S. multinationals are motivated to accumulate cash overseas.2 In terms of agency problems, it was mentioned earlier that agency costs represent one of the negative aspects associated with holding cash. Nevertheless, agency problems may cause managers to hold more cash.

2 Th is accumulation of international cash holdings is oft en cited as a reason to lower repatriation taxes. Presumably, lower repatriation rates would increase liquidity in U.S. capital markets.

F O C U S O N P R A C T I C E

With regards to Apples cash position, a high-ranking manager recently remarked that, Cash gives us tremendous exibility. When you take risks and jump in the air, its nice to know the ground is still there. At another point, he hinted that the company could use the money for a big acquisition, despite the companys history of sticking to deals worth well under $100 million, with a few notable exceptions, including Jobs former company, Next. You never know what opportunity is going to be right around the corner. When we need to acquire a piece of the puzzle, we can write a check.

Source: Apple Hoarding Dough For Acquisition, Rainy Day? by Ken Spencer Brown Thu., Feb. 25, 10 4:03 PM ET

Source: http://blogs.investors.com/click/index.php/home/60-tech/1154-apple-hoarding-dough-for-acquisition-rainy-day Accessed: 2/26/10.


From the Ivory Tower A growing body of academic literature examines corporate cash holdings. Many of these studies provide valuable insights into the factors that managers consider when setting corporate cash positions. Kim, Mauer, and Sherman (1998) and Opler, Pinkowitz, Stulz, and Williamson (1999) examine the determinants of corporate cash holdings for domestic fi rms using panel datasets that span several decades. Both studies fi nd support for Keynes motives for cash. Specifi cally, the studies report that cash holdings vary directly with fi nancial constraints, costs of external fi nancing, cash fl ow volatility (i.e., business risk), and growth opportunities. Results also indicate that cash policies vary signifi cantly by industry classifi cation. Overall, fi rms that are most likely to benefi t from cash holdings accumulate greater levels of internal liquidity. Supporting the tax motive for cash, Foley, Hartzell, Titman, and Twite (2007) show that U.S. multinationals with higher repatriation tax rates accumulate signifi cantly more cash abroad. For further discussion of the tax motive for holding cash, see the nearby Focus on Practice. Harford, Mansi, and Maxwell (2008) study the relation between cash levels and agency problems. Th eir results suggest that fi rms with weaker corporate governance structures (fi rms with greater agency confl icts) hold less cash than fi rms with stronger governance. Further tests reveal that this result is attributable to more weakly-governed fi rms quickly burning through cash. Th ese fi ndings support the agency motivation for holding cash. Both the tax and agency motives hold aft er controlling for the operating and fi nancial variables that Opler, Pinkowitz, Stulz, and Williamson (1999) show to impact cash holdings.

Recent studies show various ways that cash policy impacts overall fi rm strategy. Harford (1999) fi nds that cash-rich fi rms are more aggressive in attempting acquisitions. Building on this construct, Almeida, Campello, and Hackbarth (2011) discuss the benefi ts associated with liquid fi rms acquir-ing fi nancially distressed competitors, thereby reallocating cash to fi rms that need capital. Klasa, Maxwell, and Ortiz-Molina (2009) show that cash holdings represent an important variable in collec-tive bargaining agreements between managers and labor unions. Th eir evidence suggests that fi rms with higher unionization rates strategically hold less cash, which confers bargaining advantages to management. Lower cash levels weaken managers ability to meet union demands, reducing the likelihood of labor strikes.

Given the aforementioned fi ndings on the factors infl uencing cash levels, it is no surprise that a growing literature fi nds various ways that liquidity policy impacts fi rm value. Faulkender and Wang (2006) fi nd a direct and signifi cant relationship between excess stock returns and cash holdings. Th e authors report that the value of cash increases for fi rms with lower prior period cash levels, less leverage, and greater fi nancial constraints. Aft er accounting for prior period cash and leverage, Faulkender and Wang (2006) report that shareholders value an additional dollar of cash holdings at $0.94. Dittmar and Mahrt-Smith (2007) fi nd that shareholders mark up the value of cash for fi rms with stronger governance structures (fewer agency problems). In fact, their results indicate that the market value of an additional $1 in cash held by a well-governed fi rm is worth twice as much as $1 held by a poorly-governed fi rm. Studies also examine the eff ects associated with excess cash holdings. Mikkelson and Partch (2003) fi nd that fi rms persistently holding excess cash do not signifi cantly underperform matched cohort fi rms. Th is result is an important counter to the typical conventional wisdom that cash is a low-yielding asset that should be minimized. In a related vein, Simutin (2010) fi nds that future stock returns are directly related to current period excess cash. Importantly, Fresard (2010) shows that cash holdings lead to systematic future market share gains at the detriment of industry rivals.

Cash Holdings | 49

CASH-BASED LIQUIDITY MEASURES

Th is section presents fi nancial measures that gauge corporate liquidity from a cash perspective. Quantifying the cash position is important given the clear links between fi rm value and cash. Th e measures cover both stock and fl ow-based aspects of corporate liquidity. Specifi c measures include cash conversion effi ciency, cash ratio, cash burn rate, and net liquid balance. Each is discussed in turn. Similar to Chapter 2, example calculations for each metric are based on Mas-Con, Inc.s fi nan-cial statements provided in Appendix A (see page 490).

Cash Conversion Ef ciencyGenerating revenues is important, but converting revenues into operating cash fl ow (OCF) is essen-tial to maximizing shareholder wealth. Hence, the proportion of sales that yield operating cash fl ow, dubbed cash conversion effi ciency (CCE), is critical for fi rms long-term viability. Adequate CCE involves monitoring the fi nancial supply chain, including managing costs and operating working capital. As shown in Chapter 1, OCF is net income plus depreciation and aft er adjusting for changes in the working capital accounts. Th e calculation of Mas-Cons CCE in 2012 and the fi ve-year trend are shown below.

= =

= CCE OCFRevenues

3949,000

0.0442012

2008 2009 2010 2011 2012CCE (%) n/a 1.64 0.80 9.09 4.38

Th e CCE is negative for each year, which suggests problems in converting sales into cash fl ow. Many factors infl uence the CCE, including profi t margin and effi cient management of the working

F O C U S O N P R A C T I C EHolding Liquidity Overseas

Why would management hold cash overseas? Under current tax law, a multinational rm must pay taxes in the country in which the cash is earned and then pay taxes at U.S. rates upon repa-triation. This double taxation leads to international cash holdings. To assess a multinational rms liquidity, it is important to understand whether the rms cash is held domestically or internation-ally. This is because cash held overseas is less accessible in managing the working capital cycle. Subsequently, some rms carrying large amounts of cash must seek external nancing to fund their domestic operations. An article in the Wall Street Journal reports that General Electric and Microsoft hold only 33% and 13%, respectively, of their cash in the U.S.1 The ineffi ciency implied by the current double taxation of repatriated, retained cash ow is a clear example of a negative externality that often accompanies government interaction in the private sector.

1 Top U.S. Firms Are Cash-Rich Abroad but Poor at Home, Kate Linebaugh, Wall Street Journal, B6, December 2012.


capital cycle. Careful study of the fi nancial statements indicates that the negative values for the CCE result from a generous credit policy and large inventory holdings. In general, industry leaders have CCE values that exceed 10%. Examples of fi rms that convert a robust proportion of revenues into cash fl ow include Apple and Wal-Mart.

Cash RatioTh e cash ratio is defi ned as the stock of cash held on the balance sheet scaled by total assets. Recall from previous business courses that the observed cash level is a function of the prior period cash balance plus the change in cash provided by the statement of cash fl ows (i.e., the sum of cash fl ow from operations, net cash fl ow from investing activities, and net cash provided from fi nancing activi-ties). Since the cash ratio provides the proportion of assets held in cash, this metric is a key measure used to assess corporate liquidity. Higher cash ratios imply an improved ability to weather uncertain conditions in product markets and the broader economy. At the same time, high cash holdings increase agency and opportunity costs. Th e cash ratio calculation and the trend in Mas-Cons cash ratio are shown below.

= = =Cash Ratio CashTotal Assets

257,475

0.00332012

2008 2009 2010 2011 2012Cash Ratio (%) 1.49 3.70 3.08 1.10 0.33

In 2012, Mas-Cons cash comprises less than 1% of assets. Th e cash ratio reaches its minimum in 2012.

Cash Burn RateAnother helpful liquidity measure involves the number of days for which the fi rm can cover ongoing expenses with cash on hand. During a typical operating cycle fi rms need cash to, at a minimum, repay trade credit obligations and pay employees and miscellaneous bills. By combining stock and fl ow measures, insight can be gained concerning the length of time a fi rm can cover its day-to-day obligations without realizing additional cash infl ows. Th e cash burn rate equals current cash hold-ings scaled by average daily cost of goods sold. Subsequently, this metric provides the number of days of COGS that the fi rm can fund with cash without receiving additional cash infl ows or external fi nancing. Increased burn rates imply a reduced likelihood of illiquidity. Th e calculation for Mas-Cons burn rate is shown below.

= = =Cash Burn Rate CashCOGS365

254,500365

2.03 days2012

2008 2009 2010 2011 2012Cash Burn Rate (days) 12.17 24.33 19.47 6.64 2.03

Cash Holdings | 51

Th e cash burn rate in 2012 implies that there is only enough cash on hand to fund 2 days of COGS. Th e trend suggests that the fi rm depends on daily cash infl ows (via operations or external fi nancing) to cover COGS. A caveat is in order with respect to the calculation of the cash burn rate: Th e appropriate variable used in the denominator of this metric depends on the nature of the industry and/or product market. For example, managers of a service fi rm may be more concerned with operating expenses than COGS.3

Net Liquid BalanceTh e net liquid balance (NLB) is the sum of cash and short-term investments minus current nons-pontaneous fi nancial liabilities (i.e., arranged fi nancing) such as notes payable and current maturing debt. A negative NLB indicates dependence on outside fi nancing and suggests the minimum capac-ity needed from a credit line. While a negative NLB by itself does not mean that the fi rm will default on debt obligations, a negative NLB implies reduced liquidity.

Th e NLB equation along with the associated trend follow:

= = = NLB Cash Notes Payable 251550 $1,5252012

2008 2009 2010 2011 2012NLB (millions) $25 $200 $992 $548 $1,525

Consistent with the other cash metrics, values for the NLB suggest that the fi rm may face diffi culties in covering its short-term fi nancial obligations.

To gain a better perspective of the importance of the NLB, note that net working capital (NWC) equals the sum of the working capital requirement ( WCR) and the NLB. To conceptualize how the NLB measures liquidity, consider the interaction between sales growth and the operating cycle. With growing sales the WCR will expand due to increased receivables and inventory. Th e increased invest-ment in WCR must either be fi nanced by drawing down the NLB or by raising fi nancing through the acquisition of additional long-term fi nancing. Th erefore, a greater NLB implies an increased amount of liquid resources available to fund the WCR. If the increase in WCR is seasonal, then drawing down the NLB is appropriate. However, if the increase in WCR is permanent because of a new higher level of operations, then the increase in WCR should be fi nanced with a permanent source of fi nanc-ing and contract as sales shrink (selling off of inventory and collection of receivables). As applied to Mas-Con, Inc., management must jointly consider the NLB and the WCR to improve liquidity.

Current Liquidity IndexTh e current liquidity index (CLI) quantifi es liquidity by scaling the sum of current cash and equiva-lents and the next periods expected operating cash fl ow by next periods short-term fi nancial liabili-ties.4 Reduced values for the CLI signal potential liquidity problems and vice versa. Assuming that next

3 Operating expenses represent fi xed costs incurred without regard for the production level. Analysts may augment the given cash burn rate equation by using the sum of operating expenses and cost of goods sold in the denominator.4 Th e CLI presented in the current edition of the textbook is a slight variant of that presented by Fraser (1983). Th e CLI presented here provides a forward-looking measure of liquidity.


years operating cash fl ow and notes payable are expected to equal $200 and $1,800, respectively, then Mas-Cons CLI at the end of 2012 equals:

=

+ = =

ECLI

Cash OCFNotes Payable

25-2001,800

-0.097220122012 2013

2013

Th is value suggests that internal liquidity will be insuffi cient to cover maturing fi nancial obliga-tions in 2013. Subsequently, managers will require external fi nancing to fund operations. However, if the CLI equaled 1.5, then $1.50 in liquid resources would be available for each $1 of fi nancial obligations.5

Recap on Mas-Con, Inc.s Liquidity PositionFrom the liquidity measures presented thus far, it appears that Mas-Con, Inc. has a defi cient cash position. However, the fi rm may still be able to fund daily operations because of access to lines of credit. Hence, an analyst might consider accounting for lines of credit in the aforementioned equa-tions. Another factor that should be considered is the variability in operating cash fl ow. Firms with more volatile cash fl ows should hold more cash as well as maintain access to credit lines. To put these elements into perspective, Mas-Con, Inc. may not carry much cash because of access to credit lines and reasonably certain cash fl ows. In-depth discussions of cash fl ow variability and credit lines are provided in later chapters. However, these inputs are incorporated in a liquidity measure referred to as lambda, which is discussed next.

Lambda ()Lambda () is a unique liquidity measure in that it accounts for the uncertainty of future cash infl ows along with access to lines of credit.6 Further, this measure provides the probability of a fi rm experiencing illiquidity. In a perfect world future cash fl ows are certain, allowing new investment to be fi nanced with cash infl ows. However, cash fl ows are variable, which may cause managers to forego positive net present value investments, thereby reducing shareholder wealth.7 Th e uncertainty of next periods cash infl ow heightens the importance of holding cash and maintaining access to credit lines.

Th e equation for is shown below.

=

Cash+ Unused Credit Lines + [ ]E OCF

OCF

Th e numerator for represents overall liquidity, encompassing cash, remaining credit line capacity, and the next periods expected infl ow of cash. Th e denominator is cash fl ow uncertainty, measured as the standard deviation of operating cash fl ow. Recall from basic statistics that the standard deviation of a variable equals the square root of the average sum of squared deviations from the mean. Assuming

5 Th e trend in the CLI is not shown because next periods operating cash fl ow is un known. 6 Th is measure was developed by Emery and Cogger (1982). See Emery (1984) for an applied summary of .7 Minton and Schrand (1999) show that fi rms with more volatile cash fl ows invest less.

Cash Holdings | 53

that future cash fl ows resemble past values, historical data can be used to calculate both the expected future cash fl ow and the variability in cash fl ow.

Within the context of a standard normal distribution, resembles a z-score. Specifi cally, the area under the normal distribution curve to the left of represents the probability of the fi rm having liquidity problems. Hence, higher values for imply a reduced probability of illiquidity and vice versa. In terms of mechanics, a standard normal distribution table (or Excel) is needed to fi nd the probability that associates with the calculated .

For brevity, Exhibit 3-1 provides the area under the standard normal curve to the left of selected values for . To illustrate, suppose a fi rm has a of 2.00. Th at is, the sum of cash holdings, unused lines of credit, and expected cash infl ow is double the standard deviation of operating cash fl ow. Th e exhibit shows that a probability of 2.25% associates with a of 2.00. With respect to the concept, the probability of 2.25% represents the likelihood that the fi rm will be illiquid over the given horizon. At the same time, a of 2.00 implies a 97.75% probability that the fi rm will not experience liquidity problems. In sum, larger values for imply reduced probabilities of illiquidity; this general inference is intuitive given the equation used to calculate .

Information that is not typically provided by fi nancial statements is needed to calculate . Specifi cally, access to unused credit lines represents off -balance sheet fi nancing and expected cash fl ow from operations is unknown. For purposes of illustration, suppose that you are charged with calculating Mas-Con, Inc.s for the end of the year 2012. From the fi nancial statements we observe cash holdings of $25 and annual operating cash fl ows of 37, 30, 500, and 394 for the years 2009 through 2012, respectively. We shall use the four-year average of past operating cash fl ows to proxy for the next years expected cash fl ow (OCF2013). Further, assume that this fi rm has unused line of credit capacity of $705. With this information we can now calculate .

[ ]= =

=

+ + +

=

=

=

+ =

E CF

OCF

O 37 30 500 3944

240.25

( 37 ( 240.25)) ( 30 ( 240.25)) ( 500 ( 240.25)) ( 394 ( 240.25))4

176,726.444

210.19

25 705 240.25210.19

2.33

OCF

2 2 2 2 1/2

1/2

Th e of 2.33 implies a 1% chance of running short of liquidity over the next year. Hence, it is unlikely that Mas-Con, Inc. will be illiquid. Th e probability of illiquidity can be reduced by increas-ing cash holdings, access to credit lines, cash infl ows, or by implementing procedures to smooth cash fl ows. Note that the treasury staff can choose the acceptable degree of liquidity risk and then determine the optimal liquidity reserve. Problem 5 (at the end of the chapter) addresses this issue.

Th e method is an appealing approach for determining liquidity risk because it can diff erentiate between fi rms with identical cash levels. For example, a fi rm with a relatively low liquidity reserve may have less illiquidity risk than a competitor with a larger liquid reserve. Th is would be the case if the former has dramatically reduced cash fl ow variability. In other words, liquidity is less benefi cial to fi rms with more stable cash fl ows. In closing this section, we emphasize the diffi culty in estimating as credit lines are off -balance sheet items and cash fl ow variability must be estimated. Th e latter


EXHIBIT 3-1. LAMBDA VALUES AND THEIR RELATED PROBABILITY VALUES

LAMBDAPROBABILITY IN LEFT TAIL LAMBDA

PROBABILITY IN LEFT TAIL

1.645 5.00% 2.108 1.75%

1.670 4.75 2.170 1.50

1.695 4.50 2.241 1.25

1.722 4.25 2.326 1.00

1.751 4.00 2.432 0.75

1.780 3.75 2.576 0.50

1.812 3.50 2.808 0.25

1.845 3.25 2.879 0.20

1.881 3.00 2.969 0.15

1.919 2.75 3.090 0.10

1.960 2.50 3.291 0.05

2.004 2.25

2.053 2.00

implies that the analyst must choose the relevant horizon over which to estimate the standard devia-tion of cash fl ow.

THE FINANCIAL DILEMMA REVISITEDIn the Spring of 2012, Apples management announced a strategic shift in cash policy. Apple investors were to receive cash distributions via dividends and a stock repurchase program was announced.8 Quarterly dividends were expected to be $2.65 per share beginning in its fi scal fourth quarter and a $10 billion share repurchase program should commence on September 30th, 2012. Management likely had many motives for returning this large amount of cash to its shareholders. In addition to basic explanations like the opportunity and agency costs of holding cash, Apple executives said that their decision was motivated by their desire to stimulate demand from a new breed of investors, namely certain equity funds that are restricted to invest in fi rms that pay dividends. Even with these distributions, Apple has enough internal fi nancial slack to fund multiple large acquisitions. Further, steady revenue growth and robust margins should allow the fi rm to accumulate additional cash in the future. Th is is already evidenced as the sum of Apples cash, equivalents, and marketable securi-ties equaled $121.251 billion at the end of fi scal year 2012.

CASH MANAGEMENT MODELS

As noted at the beginning of the chapter, managers must carefully weigh the costs and benefi ts of cash when setting liquidity policy. Consider the specifi c tradeoff s between holding cash in

8 Flush with Cash, Apple Plans Buyback and Dividend, Nick Wingfi eld, New York Times, March 19, 2012.

Cash Holdings | 55

transactions accounts versus investing cash in money market instruments (i.e. marketable securi-ties). Cash held in transactions accounts implies opportunity costs in the form of foregone invest-ment interest earned on marketable securities. Cash and marketable securities have essentially the same liquidity but in liquidating the latter, fi rms incur various transactions costs, including brokerage commissions, funds transfer fees, and the implicit costs of communicating transactions instructions and clerical time necessary for record keeping. Without these transactions costs and assuming no frictions in selling marketable securities, setting the cash position would simplify to cash balance minimization. Such a policy translates into holding the minimal balances in trans-actions accounts to pay a days disbursements. Th e money market, however, is characterized by imperfections. Consequently, management must carefully consider the tradeoff s between cash and marketable securities.

With the aforementioned tradeoff in mind, a handful of models have been developed to opti-mize the mix between cash and marketable securities. Each model views cash as an inventoried asset in which the primary determinant of cash allocation is the transaction motive. Given the total disbursements for a period, the models specify the optimal number and timing of each transfer between investment security and cash that minimizes the sum of opportunity costs and transaction costs. Th ree cash management models, each with diff erent assumptions, are discussed below.

Baumol ModelWilliam Baumol fi rst developed a cash management model that provides the optimal cash level that minimizes the total costs associated with transferring funds out of securities into cash during a given time period.9 Total costs of setting the cash position include the transactions costs incurred to replenish cash by selling securities and the opportunity costs of foregone interest resulting from holding demand deposit balances.

Th e assumptions involved in using the Baumol model include:

Periodic receipt of funds but a continuous and steady disbursement of monies Certain cash needs (that is, the demand for cash is known) When the cash balance reaches $0, or the desired safety stock level, securities are sold so that

the balance is replenished to the initial cash balance, denoted as Z*.

Th e fi rst step in applying the Baumol model is to specify the cost function. Th e total cost of liquidating securities and carrying cash has two components: the transactions costs of selling securi-ties and the opportunity cost of holding cash. Th e total transactions cost equals the total number of transactions multiplied by the fi xed cost per transaction. Th e number of transactions is equivalent to total cash needed divided by the amount of cash raised per transaction. To arrive at the opportunity cost of carrying cash, the average cash balance held over the period is multiplied by the estimated periodic lost opportunity cost.10 Since it is assumed that the cash is dispersed at a constant rate and that fresh cash is received on the day that the existing cash stock is exhausted, the average cash balance equals the amount of cash raised via the sale of securities plus the ending cash balance of $0 divided by two. Th e total cost equation is modeled below:

9 Th e Baumol model, as developed in Baumol (1952), is a variant of the familiar EOQ model used to optimize inventory. 10 Th e assumed opportunity cost is the rate earned on the money market instrument minus the rate paid by the bank for funds held in the transactions account.


( ) ( )= + TC FTCN

Zi ZCash 2

,

where

TCCash = the total cost of the cash positionF = fi xed transaction cost per sale of security TCN = total cash needed during period Z = cash transfer amounti = per period opportunity cost.

Notice how a larger order cash balance reduces transaction costs by lowering the number of transac-tions. However, increased cash results in increased opportunity cost. Th is trade-off between transac-tion costs and opportunity costs presents an interesting challenge for management.

Th e optimal cash transfer level is found by diff erentiating the total cost equation with respect to Z and setting this derivative equal to 0 in order to locate the minimum point on the total cost curve. Th is optimization process results in the following equation:

( )( )( )=Z F TCN

i*

2

Th us, Z* is the optimal dollar amount of securities that should be sold to replenish cash when the disbursements account has been drawn down. It also can be thought of as the optimal return point for the cash balance. Based on Z*, the treasury manager can calculate the average cash balance, the frequency of transactions, and the total costs of carrying cash. Th e following example illustrates use of the Baumol model.

Joe Nevada, entrepreneur and one-time football great, recently started a business that is enjoy-ing unexpectedly rapid growth. Profi ts have been adequate, but Joe is concerned about maintain-ing adequate liquidity so that he is not tackled by his banker. Specifi cally, he is having trouble deciding how to allocate his liquid assets between cash and marketable securities. He fi gures that his company has disbursements of $1 million per year. His broker charges $65 per transaction (liquidating securities and depositing the funds into his cash disbursement account). Short-term interest rates on potential investments are now approximately 3% greater than the return earned by Joes disbursement account. Not having skill with numbers (other than calling signals at the line of scrimmage), Joe asks your advice. What should Joe do?

Given this information, the optimal cash transfer is calculated as

( ) ( )=Z* 2 ($65) $1,000,000

0.03 = $65,828.06

Th e cash transfer level that minimizes costs is roughly $65,828 per transaction. To further verify that this transfer amount minimizes costs, one can solve for the total cost (TCCash) at various levels of Z. Th is simulation exercise will indicate that $65,828 is the transfer amount that minimizes total costs.

Z* provides additional information that is helpful to the treasury staff . For example, the num-ber of transactions placed can be determined by dividing the total cash needed by the optimal

Cash Holdings | 57

cash transfer, which in this case suggests that Joe would need to request approximately 15.19 ($1,000,000/$65,828.06) security sales over the period. Th e average cash balance equals $32,914.03 ($65,828.06/2).

Th e major shortcoming of the Baumol model is that the user must make unrealistic assumptions, including known future disbursements and that transaction costs are fi xed when they might vary inversely with the dollar size of the transaction.11 Despite these unrealistic assumptions, results from the Baumol model can be instructive. First, the total cost equation shows the decision maker the extent of suboptimization when cash transfer is too low or too high. Exhibit 3-1 shows the costs of extreme cash positions. Second, re-calculating the model for shorter periods mitigates the assump-tion of lumpy receipts.

Whether or not a company uses Z* to establish the transaction cash balances, sensitivity analysis using the model can show how to revise the cash replenishment. For example, the transactions cost and the opportunity cost rate can be varied to calculate revised values for Z*. Such an analysis enables the manager to anticipate the revision to the cash balance necessary if and when either input changes.

Miller-Orr ModelTwo characteristics distinguish the model developed by Miller and Orr model (1966) from the Baumol model.12 First, the former allows for unpredictable fl uctuations in the cash balance instead of assuming a perfect forecast. Th e Miller-Orr model accomplishes this by incorporating the variance of the companys daily net cash fl ows. Second, it permits both upward and downward movements in

11 A model that assumes continuous cash receipts and lumpy disbursements was developed by William Beranek, (Analysis for Financial Decisions, Chapter 11, Homewood, IL: Richard D Irwin, 1963). In situations in which cash accrues and is then paid out in a lump sum (e.g., a quarterly dividend), this model would be appropriate. Th is model, like the Baumol model, assumes perfect certainty of future cash fl ows. In companies for which cash receipts are highly predictable, the Beranek model may be used to give guidance on how oft en to sweep monies from many collection accounts into a concentration account.12 Bagamery (1987) provides a helpful comparison of the Baumol and Miller-Orr cash models.

EXHIBIT 3-2. PERIOD COST WHEN VARYING LEVEL OF CASH

0

10

20

30

40

50

60

70

15

1015

2043.095

5080

110140

170200

230260

290320

350380

410440

470500

1000

(Thousands)Return level for cash (Z)

To

tal c

ost

for

the

peri

od

($)

(tho

usan

ds)

Transaction cost Forgone interest

Minimumperiod cost


the cash balance subsequent to replenishment, as opposed to the company experiencing a one-time periodic cash infusion that is subsequently depleted at a continuous rate. Th e model includes two trigger points that signal a purchase or sale of securities. Th e upper control limit (UCL) triggers a purchase of securities large enough to reduce excess cash balances to the return point Z*. When the cash balance dips down to the lower control limit (LCL), a sale of securities suffi cient to return the cash balance to Z* is initiated. Exhibit 3-2 illustrates the control limits. Notice that no transactions are initiated as long as the cash balance remains within the control limits. In such a case, the stream of cash receipts and disbursements would need to be moderately synchronized, but the Miller-Orr model assumes unpredictable cash fl ows meaning that next periods fl ows.

Th e formula underlying the Miller-Orr model is presented below:

Z* = Fi

34

23

where

Z* = optimal transfer amount F = fi xed transaction cost per sale of security 2 = variance of daily net cash fl ows i = daily opportunity cost.

Like the Baumol model, Z* minimizes the sum of transactions and foregone opportunity costs, except the Miller-Orr model accounts for the uncertainty in the future cash fl ows. Be careful interpreting Z*. If the company sets the LCL limit at any value other than $0, then Z* is no longer the return point for cash. Instead, the return point is Z* + LCL. Because this discussion focuses on the disbursement account balance, the company might need to set the LCL above $0 to meet loan covenants or other banking requirements. Alternatively, the LCL may represent a safety stock of liquidity, where the level is conditional on managements chosen risk posture. While the LCL equals $0 or some arbitrary low value, the optimal value of UCL (derived using stochastic calculus) is 3Z* + LCL. Th e average cash balance equals 4/3(Z*) + LCL and the return point is Z* + LCL. Th e Miller-Orr model can be applied to the example presented earlier.

Aft er being presented with your recommendations based on the Baumol model, Joe Nevada asks for some background information about the model and what it is based on. You warn Joe that the model assumes his forecasts of cash needs are perfectly accurate, at which point he becomes visibly uncomfortable. Our cash fl ows jump all over the place, he grumbles. Can we adjust the model? You reply that there might be a better way, as you think about the less demanding assumptions behind the Miller-Orr model, while hoping Joe will no

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