Class 2 – September 11th - Analysis of Working Capital Management – Traditional analysis

Lesson 2:

1) Traditional W/C Measures

The following ratios measures are generally referred to as liquidity measures but in fact, they
measure solvency.

a. Current Ratio

Indicates the degree of coverage provided to short-term creditors if ST assets were to be liquidated.
Its use is limiting based on the components (firm might have a high ratio due to large balance of
uncollectible receivables and/or obsolete inventory)

A ratio of 2, indicates that the firm has $2.00 of current assets for $1.00 of current liabilities.

Current Assets: Cash, marketable securities, AR, prepaid expenses, inventory

Current Liabilities: Accounts payable, accrued expenses, notes payable, payroll deductions etc…

Short-term portion of long-term debt: if a debt is called short-term but is being rolled over yoy, then it is
not considered a short-term. Not included in calculating current ratio
Deferred Taxes: the timing difference between CCA and tax depreciation. Not included in calculating
current ratio

b. Quick Ratio

Also known as the acid-test ratio, it excludes inventory in the numerator since inventory is the least
liquid current asset. Prepaid expenses are commonly excluded.

Inventory could be obsolete, incomplete, worn (damaged), or non-saleable

c. Net W/C

NWC is a dollar-based solvency measure. same as current ratio, instead its measured in $.

The larger the amount, the more solvent the firm.

Too much working capital is considered a drag on performance.
Some analysts exclude cash from the ratio to measure the amount of cash tied up in the operating cycle.
 d. W/C requirement (WCR)

NWC commingles operating and financial accounts

A variation separates NWC into 2 pieces:

*WCR = operating CA – operating CL
(AR + Inventory + Prepaid) – AP
difference between WCR and NWC – WCR answers the question of true survival based on the business
alone and not on any stored assets. Does the business generated enough for the company to survive.

*NLB (Net Liquid Balance) = Financial CA – Financial CL

Weaknesses of WCR

1) Focus on Solvency
2) Assumes the same liquidity
3) Interpretation
cash 350
ap 100
payroll 75
Current Ratio = 2

Solvency vs. Liquidity

A firm is solvent when its assets exceed its liabilities. This is based on book, not market values.
A firm is liquid when it can pay its bills on time without undue costs.
Solvency is a bankruptcy concept
Liquidity is a going concern

 Weaknesses of Solvency
o Ignores the going concern assumption

Differences in time-to-cash conversion

e. Cash Conversion Period (non-traditional)

Revenue cycle: this is not good, because it sucks up cash. We need cash to finance inventory and
receivables.
Disbursement cycle: good cycle because the supplier is financing us. Inventory received (accounts
payable)
SEE CHART IN TEXTBOOK.

1. Turnover Ratio = COGS / Inventory  Convert to days inventory/COGS x 365

2. AR Turnover = Revenues / AR  Convert to days AR/Revenues x 365
3. AP Turnover = COGS / AP  Convert to days AP/COGS x 365
 And then to convert into
1. DIH – Days Inventory Held = 365 / Inventory Turnover
2. DSO – Days Sales Outstanding = 365 / AR Turnover
3. DPO – Days Payable Outstanding = 365 / AP Turnover

CCP = is the difference between the revenue cycle and the disbursement cycle

CCP = DIH + DSO – DPO

We want low or if possible NO CCP

How to minimize CCP, which will also maximize the value of the firm (NPV)
Sell Faster
Collect Faster
Pay Slower

2) Advanced tools
a. Cash holdings
b. CCE
c. Cash ratio
d. Days cash held
e. Net liquidity balance
f. Current liquidity index
g. Lambda
h. Cash management
i. Baumol
ii. Miller-Orr
iii. Stone