The Firm’s Operating Cycle and Its Effect on the Firm’s Balance Sheet

What level of net investments must a firm make to support its operating cycle?
Simply, its Working Capital Requirements, WCR

The Firm’s Operating Cycle, Showing Cash-to-Cash Period

The Two Components of Capital Employed

What is the best combination of equity capital and debt capital?

What proportion of borrowed funds should be in the form of long-term debt
and what proportion in the form of short-term debt?

Structure of the Managerial Balance Sheet

 31-Dec-08 31-Dec-09
Invested capital or net assets
Cash $6 5% $12
Working Capital requirements 59 49% 63
Net fixed assets 56 46% 51
Total Invested Capital or net assets $121 $126
Capital employed
Short term debt $15 12% $22
Long term financing
Long term debt 42 34
Owner's equity 64 106 88% 70 104
Total Capital employed $121 $126

The Matching Strategy - its relevance

The matching strategy suggests that by matching the life of an asset with the duration of its
financing source, a firm can minimize the risk of not being able to finance the asset over its entire
useful life
Interest-rate risk and funding risk
However, a maturity matching strategy may not be optimal for every firm at all times
Is the working capital requirement a short- or long-term investment?
perating cycle?

Solvency Vs.
Liquidity
 31-Dec-10

10% $8 6%
50% 77 56%
40% 53 38%
$138

17% $23 17%

38
83% 77 115 83%
$138

uration of its
set over its entire
 Balance Sheet

31-Dec-13 31-Dec-14 31-Dec-15

Assets
Current Assets
Cash $6 $12 $8
Accounts receivables 44 48 56
Inventories
52 57 72
Prepaid Expenses
2 2 1
Total Current Assets $104 $119 $137

Non current assets

Financial assets & intangibles 0 0 0

Property, plant & equipment
Gross value 90 90 93
less depreciation -34 -39 -40
Total non current assets 56 51 53
Total assets $160 $170 $190

Managerial Balance Sheet

31-Dec-13
Invested Capital or Net Assets
a Cash $6
b Working Capital requirements 59
c Net fixed assets 56
Total Invested Capital or Net Assets $121
Capital employed
d Short term debt $15
Long term financing
e Long term debt 42
f Owner's equity 64 106
Total Capital employed $121
 Balance Sheet

31-Dec-13 31-Dec-14 31-Dec-15

Liabilities & owner's equity
Current liabilities
Short term debt $15 $22 $23
Owed to banks 7 14 15
Current portion of 8
long term debt
8 8
Accounts payable 37 40 48
Accrued expenses 2 4 4
Total current
liabilities
$54 $66 $75
Non current liabilities
Long term debt 42 34 38
Total non current liabilities 42 34 38
Owner's equity 64 70 77
Total liabilities $160 $170 $190

anagerial Balance Sheet

31-Dec-14 31-Dec-15

$12 $8
63 77
51 53
$126 $138

$22 $23

34 38
70 104 77 115
$126 $138
 Structure of the Managerial Balance Sheet

31-Dec-13 31-Dec-14
Invested capital or net assets
Cash $6 5%
Working Capital requirements 59 49%
Net fixed assets 56 46%
Total Invested Capital or net assets $121
Capital employed
Short term debt $15 12%
Long term financing
Long term debt 42 34
Owner's equity 64 106 88% 70
Total Capital employed $121

How much long term finance is used to fund the firm's working capital requirement?

Net Long term Financing (NLF) = Long-term financing – Net fixed assets

How much short term finance is used to fund the firm's working capital requirement?

The amount of short-term debt in excess of cash is called net short-term financing or NSF

Net Short term Financing (NSF) = Short-term debt – Cash

The ratio of NLF to WCR is the firm’s liquidity ratio

Normally, the higher the proportion of WCR financed with long-term funds, the more liq

31-Dec-13 31-Dec-14
Working Capital requirements 59 63

Net long term financing 50 53

Net short term financing 9 10

Liquidity Net long term financing /

84.75% 84.13%
Ratio Working Capital requirements

Net short term financing / 15.25% 15.87%

Working Capital requirements
ance Sheet

31-Dec-14 31-Dec-15

$12 10% $8 6%
63 50% 77 56%
51 40% 53 38%
$126 $138

$22 17% $23 17%

38
104 83% 77 115 83%
$126 $138

capital requirement?

g capital requirement?

ort-term financing or NSF

-term funds, the more liquid the firm

31-Dec-14 31-Dec-15
77

62
15

80.52%

19.48%