Financial Statement Analysis

Session 3: The Working Capital

Growing your company to the ground

Formal Definition of Working Capital

The excess of current assets over current

liabilities

Current assets: Assets expected to be sold, used

up, or otherwise realized in cash within one year or
one operating cycle of the business
Current liabilities: Liabilities expected to be
settled within one year or within one operating
cycle of the business

Economic Concept of Working Capital

1.

Timing: Result of the firm cash cycle

2.

Lubricant for the companys wheels

3.

Ordinary investment needed for growth

4.

Determinant of liquidity risk

Very counter-intuitive set of variables

A Company is like an Oil Pipe

Firms spend money (buying raw materials,

paying employees, etc.) in the hope that
somewhere down the line (through sales, etc.)
money will be generated (in the form of CFs)
Working Capital is the oil needed to first fill the
pipe (or grow it)
Growth has to be financed by Long Term Capital
WK acts counter-intuitively in the generation of
Cash Flows
Negative Working Capital firms (Carrefour)
actually make money off of growing sales

Cash Conversion Cycle

A/
P
Buy
inputs

Sell
product
s

Pay for
inputs

A/
P

Days Receivable
A/R

Increase
LHS

Days of Inventory

Invento
ry

Get paid
for sales

Days of Working Capital

Days Payable

COG
S

A/R

Increase
RHS

Invento
ry
Sale
s

The Daily Issue

How to calculate payment terms based on B/S info?

IF sales occur uniformly, then the percentage of sales
done on credit represents payment terms in days

Days Receivable: A/R(10) / Sales(120) x

360 = 30 days

+10

+10

+10

A/
R
10

A/
R
20

A/
R
30

-10
+1
0
A/
R
30

Days Rec.: A/R(30) / Sales(120) x

360 = 90d

A/
R
10
-10
+10

-10
+10

90 day
credit

+10

A/
R
10
-10
+10

30 day
credit

A/
R
10

A/
R
30

Calculating the Cash Conversion Cycle

Note that both Inventories and Purchases are

valued at cost (COGS), not sale price
And Purchases both take into account the cost
of units sold and those bought and left in
Inventory

Working Capital is an Investment

First you spend the money in inputs

You get paid for your sales later

What forms part of WK?

Net short term investments needed to operate

Differences in timing between profits and cash flow
from operations

Determined by Industry conventions

Difficult to influence Operations Management
Determined by Sales dynamics

Why do we care?
Investment

Growth

Return

Risk

Nonpayment

Liquidity

WORKING CAPITAL

Accounts involved
Current Assets:
Accounts
Receivable
Allowance for
doubtful
receivables
Inventories
Pre-paid income
Not (all) cash
Cash Flow Statement:
Increase in Working
Capital

Income Statement:
Sales
Cost of Goods Sold
Bad debt expense
Current Liabilities:
Accounts Payable
Notes Payable
Accrued Expenses
Not Short term
portion of long term
loans

Common types of Current liabilities

Trade

payables, also known as accounts payable:

Amounts that a company owes its vendors for purchases of goods and
services
In other words, the unpaid amounts of the companys purchases on
credit as of the balance sheet date

Notes

payable:

Financial liabilities owed by a company to creditors, including trade

creditors and banks, through a formal loan agreement

Accrued

expenses (also called accrued expenses payable,

accrued liabilities, and other nonfinancial liabilities)

Expenses that have been recognized but that have not yet been paid
as of the balance sheet date

Deferred

income (also called deferred revenue and

unearned revenue)

Arises when a company receives payment in advance of delivery of the

goods and services associated with the payment

Items that are in economic WK

The principle is that:
If it is inherent for the firms day-to-day operations
AND it is cash it should be in WK
Cash balances Some industries need cash on site
to operate (think retail). For these, at least a part of
cash should be considered WK: operating cash
Notes Payable and ST Debt If it is debt that is
taken on for the purpose of financing (reducing) WK
is a way to obscure true WK requirements

It has a cost interest payments & increased liquidity risk

It has a benefit frees cash for other purposes
Whether it is a good or bad idea is a valuation issue

Working Capitals Role

Forecasting Working Capital

Unless interested in changes in specific

components, best to forecast and analyze as one
single figure
Driven by sales
Effects of inventory and payables mediated by
margin multiplier
Effect of payables mediated by difference between
purchases and COGS

Purchases = COGS + Increase in Inventory

WKs role in returns

Fixed
Assets

Sales

Net
Income

CFFO

Level

Working
Capital

Invested
Capital

Increas
e

Cash
Return
(ROIC)

Return Calculations
Margin:
NI / Sales

Unaffected

RoA (LT):
NI / LTA
Cash
Margin:
CFFO /
Sales

Increases in
WK
(changes)

ROIC:
NI / IC

Levels of
WK

Examples of dynamics of
Working Capital

Effect of WK on steady growth

Effect of WK on steady growth

12%

35
Salesgrowth

10%

34

8%
33

Daysof WK
(RHS)

6%

32

CFFO growth

4%

31

2%
0%

30
1

Effect of WK on (one off) higher growth

Effect of WK on (one off) higher growth

16%
14%

35
Salesgrowth

34

12%
10%

CFFOgrowth

33

8%
32

6%

Daysof WK
(RHS)

4%

31

2%
0%

30
1

Effect of WK on (sustained) higher growth

Effect of WK on (sustained) higher growth

16%
14%

35
Salesgrowth

34

12%
10%

CFFOgrowth

33

8%
32

6%

Daysof WK
(RHS)

4%

31

2%
0%

30
1

Effect of (one off) change in drivers of WK

Effect of (one off) change in drivers of WK

14%

35
CFFO growth

12%

Salesgrowth

34

10%
33

8%
6%

32
Daysof WK
(RHS)

4%
2%
0%

31
30

Effect of (sustained) change in drivers of

WK

Effect of (sustained) change in drivers of

WK
12%

35

Salesgrowth

10%

34
CFFO growth

8%

33
6%
32
4%
2%

31

Daysof WK
(RHS)

0%

30
1

Tricks of the trade

Changes in working capital are the main reason

changes in Sales growth rates do not flow straight
away into changes in Cash Flow growth rates

Use the 2/3-year rule to forecast Cash Flow

growth rates

Once there is a change in the growth rate in sales

Forecast cash flows for another two years
After that, cash flows will grow at the same rate as
sales
If the change is in the drivers of WK intensity (days
receivable, payable, etc.) you have to forecast for three
years

Liquidity: The great unknown

Killing two bird with one stone...

... Misses them both!

Difference between WK as an asset and as a
measure of liquidity

For liquidity purposes

No netting should be done

Cash & Marketable Securities should be considered
Short term portion of long term loans also
A high ratio is desirable

For operating purposes

WK should be as low as possible

More than one measure of WK

RECEIVABLES
PAYABLES

INVENTORY
ST PORTION OF
LT DEBT
CASH & MKT.
SECURITIES

OPERATING
WORKING
CAPITAL
TOTAL WORKING
CAPITAL

Balance sheet Ratios: liquidity ratios

Liquidity ratios indicate a companys ability to
meet current liabilities.
Ratio
Current

Calculation
Current assets /Current liabilities

Quick (acid
test)

(Cash + Marketable securities +

Receivables) / Current liabilities

Cash

(Cash + Marketable securities)

Current liabilities

Analyzing Working Capital

Common Size Balance Sheet Figures (%)

Ener.

Mat.

Ind.

Disc.

Stapl
.

Heal.

Fin.

IT

Tel.

Util.

Cash

4.3

4.5

5.9

5.9

4.1

11.6

7.4

26.1

2.9

1.7

Receivables

8.3

12.2

16.4

9.4

8.8

11.5

18.3

9.4

5.8

5.3

Inventory

3.3

12.1

8.7

15.2

12.8

6.1

---

3.2

0.3

2.3

19.9

35.1

35.7

41.2

30.1

39.4

31.1

49.6

8.9

13.8

Rank

5th

3rd

3rd

2nd

4th

2nd

4th

1st

Last

6th

Payables

6.1

6.3

6.4

7.8

7.9

3.6

9.4

3.2

2.1

3.5

15.8

17.6

24.6

26.4

26.3

17.9

24.0

22.6

10.7

13.5

Rank

5th

4th

2nd

1st

1st

4th

2nd

3rd

Last

6th

WK

4.1

17.5

11.1

14.8

3.8

11.5

7.1

27.0

-1.8

0.3

Rank

6th

2nd

4th

3rd

7th

4th

5th

1st

Last

8th

-0.2

13.0

5.2

8.9

-0.3

-0.1

-0.3

0.9

-4.7

-1.4

5th

1st

3rd

2nd

5th

5th

5th

4th

Last

6th

CA

CL

WK ex.
Cash

ian values for the S&P 500 grouped by MSCI Sector. Based on 2008 Compustat data

The Efficient Firm

The smaller the level of WK, the more efficient you are
The less costly (in investment terms) it is to grow

Liberates cash one-off

Famous negative WK subsectors

Favorite source of funding for corporate raiding operations

HBSs John M Case Case

Downstream squeezers: Carrefour

Paid in advance sweet talkers: Sirius XM and Comcast

Changing payment terms, inventory policy or

seasonality

Wheres the poop?

Levels of WK: How low can you go?

Dangers of Working Capital that is too low:

Hurting the top line:

Hurting the bottom line:

Turning away solvent clients because they cannot

pay cash
Lean inventory has the risk of leaving unforeseen
demand unfulfilled
Using expensive trade credit or working capital
loans

Increased risk:

Liquidity problems

The Hidden Cost of Trade Credit

Terms

Explanation

1/10 Net 30

1% discount if pay in 10 days, or pay in

30 days

18.2%

2/10 Net 30

2% discount if pay in 10 days, or pay in

30 days

36.7%

1/10 Net 60

1% discount if pay in 10 days, or pay in

7.3%
60 worth
days
is
it is a financing decision

Whether it

2/10
Net 60 is
What

Interes
t

discount if pay
10 days,
or pay in
14.7%
the2%
profitability
ofinthe
investment?
60 days
What is the extra risk equity holders incur in?

Is it a firm? Is it a bank? Its...

Lessons Learned

Working Capital is an investment needed for

growth
Counter-intuitive effect on cash flow

Difference analysis of Working Capital for

Growth
Liquidity

Less Working Capital is more efficient, but

runs risks

2/3 year rule

Leaving demand untapped

Costly financing
Liquidity

Book: Some Ch. 4 (COGS) and 5, Ch. 8

In our next episode

The Investment module

A.k.a. Is it a deal, or a steal?

Book

Some Ch. 4 (Depreciation), Ch 5.3 and a cursory

view of chapter 9

Exercises

Solutions available to homework 1

Optional: Receivables
Items of Special Interest I

Measurement of trade receivables

Trade receivables: Amounts owed to a company
by its customers for products and services already
delivered
Also referred to as accounts receivable
Typically reported at net realizable value, an
approximation of fair value, based on estimates
of collectability
Aspects of accounts receivable often relevant to an
analyst:
Level of accounts receivable relative to sales
Allowance for doubtful accounts (gross v. net level)
Concentration of credit risk

Bad debt
The principle of prudence again
Mainly have to do with the probability of
either:

Not being paid by customers

Suffering losses on inventory

Spanish accountants are world-renowned

experts here

Because in Spain nobody pays, ever

LOral Example
Based on the note below, what percentage of its
receivables did LOral estimate will be
uncollectible?

Answer:
For 2011, 46.2 divided by 3,042.3 = 1.52%.
For 2010, 48.1 divided by 2,733.4 = 1.76%.
For 2009, 50.2 divided by 2,493.5 = 2.01%.

Effect of Doubtful Accounts

ALLOWANCE
DOUBTFUL
ALLOWANCE
ACCOUNTS
DOUBTFUL
ACCOUNTS
RECEIVABLES

BAD DEBT
EXPENSE
NET
INCOME

SALES

Analysis of Receivables

Decreases in A/R could be more doubtful

clients, not more efficient operations
Decreases in valuation allowance may mean
final confirmation of non-payment, not better
credit conditions
Decreases in the percentage of doubtful
accounts may mean more stringent lending
conditions to clients that leaves potential
demand untapped
Analyzing concentration of trade credit is key

Optional: Inventory

Measurement basis of Inventory

Inventory Cost Flow
Beginning
Inventory
Goods
Purchased

Goods
Available
for
Sale

Balance Sheet

Ending
Inventory
Cost of
Goods Sold

Income Statement

Different bases in measuring inventory

U.S. GAAP
Lower of cost or market (LCM):
Market defined as
replacement cost with a floor
(Net realizable value, or
NRV, less normal profit
margin) and a ceiling (NRV).
NRV defined as estimated
selling price less estimated
costs of completion and sale.

Reversals of prior write-downs

are NOT allowed.

Permits last in, first out (LIFO).

IFRS
Lower of cost or net
realizable value (LCNRV):
NRV defined as estimated
selling price less estimated
costs of completion and
sale.

Reversals of prior writedowns can be made and

recognized in income.
Does not permit LIFO.

Inventory Example
Inventory Purchases
First quarter 2,000 units at $40 per unit
Second quarter 1,500 units at $41 per unit
Third quarter
2,200 units at $43 per unit
Fourth quarter 1,900 units at $45 per unit
Total
7,600 units at a total cost of $321,600
Inventory sales during the year 5,600 units at $50 per unit.
Revenue and expense for these transactions during the year?

Solution with Weighted Average Costing

Revenue = $280,000
(5,600 units times $50 per unit)

Total available
for sale

Average cost per unit =

Total cost of goods available divided by total units available =
$321,600/7,600 units = $42.3158 per unit

Cost of goods sold =

5,600 units at $42.3158 per unit

$236,968

Ending inventory =
2,000 units at $42.3158 per unit

$84,632

Inventory Example
Inventory Purchases
First quarter 2,000 units at $40 per unit
Second quarter 1,500 units at $41 per unit
Third quarter
2,200 units at $43 per unit
Fourth quarter 1,900 units at $45 per unit
Total
7,600 units at a total cost of $321,600
Inventory sales during the year 5,600 units at $50 per unit.
Revenue and expense for these transactions during the year?

Solution with FIFO

Inventory Purchases
First quarter 2,000 units at $40 per unit
Second quarter 1,500 units at $41 per unit
Third quarter
2,200 units at $43 per unit
Fourth quarter 1,900 units at $45 per unit
Total
7,600 units at a total cost of $321,600
Using the FIFO method of inventory costing:
FIFO to determine COGS: 2,000 from 1st quarter at
$40 per unit + 1,500 from 2nd quarter at $41 per
unit + 2,100 from 3rd quarter at $43 per unit
COGS = $231,800

Inventory Example
Inventory Purchases
First quarter 2,000 units at $40 per unit
Second quarter 1,500 units at $41 per unit
Third quarter
2,200 units at $43 per unit
Fourth quarter 1,900 units at $45 per unit
Total
7,600 units at a total cost of $321,600
Inventory sales during the year 5,600 units at $50 per unit.
Revenue and expense for these transactions during the year?

Solution with LIFO

Inventory Purchases
First quarter 2,000 units at $40 per unit
Second quarter 1,500 units at $41 per unit
Third quarter
2,200 units at $43 per unit
Fourth quarter 1,900 units at $45 per unit
Total
7,600 units at a total cost of $321,600
Using the LIFO method of inventory costing:
LIFO to determine COGS: 1,900 from 4th quarter at
$45 per unit + 2,200 units at $43 per unit + 1,500
units at $41 per unit
COGS = $241,600

Inventory Costing Methods Summary

Method

FIFO

Description

COGS when
prices are
rising
relative to
the other
two
methods

Ending
Inventory
when prices
are rising
relative to the
other two
methods

Assumes that
earliest items
Lowest
Highest
purchased were
sold first
LIFO
Assumes most
recent items
Highest*
Lowest*
purchased were
sold first
sumes no LIFO layer liquidation. LIFO layer liquidation occurs when the volume of sales exceeds the
ume of Average
other purchasesAverages
in the period total
so that some sales are assumed to be from existing, relatively low
entoryCost
rather than from
more recent
costs
overpurchases.
total
Middle
Middle
units available

Inventory method: example disclosure

Inventory Valuation Inventories are valued at the lower of cost
or market value. Product related inventories are primarily
maintained on the first-in, first-out method. Minor amounts of
product inventories, including certain cosmetics and commodities,
are maintained on the last-in, first-out method. The cost of spare
part inventories is maintained using the average cost method.
Procter & Gamble (2011), Annual Report
Inventories are valued at the lower of cost or net realizable value.
Cost is calculated using the weighted average cost method.

LOreal Group (2011), Registration Document

Inventory method: example disclosure

Inventories. Inventories are stated at the lower of cost or market. The
cost of approximately 80% of inventories is determined using the firstin, first-out (FIFO) method. The cost of all other inventories,
predominantly in the U.S. and Mexico, is determined using the last-in,
first-out (LIFO) method.

Colgate-Palmolive (2011), Annual Report (Note

2)
Inventories valued under LIFO amounted to $271 and $263 at
December 31, 2011 and 2010, respectively. The excess of current cost
over LIFO cost at the end of each year was $30 and $52, respectively.
The liquidations of LIFO inventory quantities had no material effect on
income in 2011, 2010 and 2009.

Colgate-Palmolive (2011), Annual Report (Note

16)