Ignacio Lezaun

English edition
2021

Fundamentals of Finance

1
 2

Contents of the course

1. The role of the Chief Financial Officer

2. Statement of cash flows
3. Working capital management
4. Short-term finance instruments
5. The time value of money
6. Conclusions

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Unit 3: Working Capital 3

Management UNIT 3

OBJECTIVES
1. Background
2. Managing and Measuring Liquidity
3. Managing Accounts Receivable
4. Managing Accounts Payable
5. Managing Inventory
6. Working Capital Management
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Operating and cash cycles of a
firm UNIT 3

+ Manufacturing
 UNIT 3

3.5 Inventory
 What do you prefer?

TEMA 3: Gestión del Circulante I 6

 Advantages and disadvantages of having
high levels of inventory
Advantages
Lower purchase prices?
Prevents from being out-of-stock
Optimizes manufacturing process
Guarantees delivery time to
customer
TEMA 3: Gestión del Circulante I
Disadvantages
Obsolescence risk
Requires high investment
Higher maintenance cost
Any investment requires financing
7
Inventory Management -
Different perspectives in the UNIT 3
company
Purchasing Production Commercial Finance

Purpose Guarantee Optimize Serve client Cut costs related

sourcing and processes and to obsolescence,
delivery at lowest production cost maintenance and
cost financing

Criteria Keep safety stock Stable Meet delivery due Reduce

Buy high manufacturing dates investment
quantities flows Avoid being out-of Minimize risks
Avoid surprises Avoid downtime stock related to stock
due to material
shortage

Stock High High High Low

 Inventory UNIT 3

• Inventory management aims to make sure that the firm keeps an

adequate level of inventory to deal with ordinary operations and
fluctuations in demand without investing too much capital in the asset
• Purpose of management:
• An excessive level of inventory means that an excessive amount
of capital is tied to it
• It also increases the risk of unsold inventory and potential
obsolescence eroding the value of inventory
• A shortage of inventory should also be avoided, as it would
determine lost sales for the company
• Methods of management:
1. Inventory turnover
2. Number of days of inventory
 Inventory turnover UNIT 3

INVENTORY TURNOVER = COST OF GOODS SOLD ÷ AVERAGE INVENTORY

• Measures how many times, on average, inventory is sold over a period

• It refers to a company’s efficiency in managing its stock of goods
• Benchmark vs. sector:
• A ratio that is too high may imply a firm has too little stock, which
might hurt sales
• A ratio that is too low implies a firm has too much liquidity tied up
in inventory (maybe because it has become obsolete)
 Number of days of inventory UNIT 3

NUMBER OF DAYS OF INVENTORY = INVENTORY÷ (COST OF GOODS SOLD/365)

• Also known as DIO (Days Inventory Outstanding)

• This tells us the length of the period that inventory remains with firm
before being sold
• It is desirable to have a ratio close to industry standards
• What about VAT?
Operating and cash cycles of a
firm UNIT 3

DIO DSO

DPO

Cash Cycle = DIO + DSO - DPO

Apple case: 8,74 + 21,43 - 91,07 = - 60,9

-61
9 21

91 11/20/2021
 UNIT 3

3.6 Working capital management

3.6.1 Cash Conversion Cycle
Cash (conversion) cycle UNIT 3

Cash Cycle: The cash cycle is the time period between

when a business pays cash to its suppliers for inventory
and receives cash from its customers.

Also known as: Cash to cash cycle; cash conversion cycle

Key concept used to determine the financing

requirements of a company, the amount of cash needed
to fund ongoing operations.

# Days of Inventory DIO Days Inventory Outstanding

# Days of Receivables DSO Days Sales Outstanding

# Days of Payables DPO Days Payables Outstanding

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Exercise UNIT 3

The ALFALUSA company distributes household appliances. The stock as of December 31, 2020 was as follows (in million €):

01/01/2020 31/12/2020
Stock 45.500 38.200

During 2020 the following transactions were recorded (in million €):
Stock purchases 210.000
Sales 600.000
Accounts Receivable balance 31.12.20 42.500
Accounts Payable balance 31.12.20 8.600

100% of the operations of the Company are domestic and subject to 21% VAT

Calculate the Operating Cycle and the Cash Cycle of the Company (for DIO – consider the average stock)

11/20/2021
Exercise UNIT 3

Initial Purchases Consumption Final

stock + (inputs) - (outputs) = Stock

Stocks can be physical or monetary, but it is always true that what exists corresponds to
what was before plus what goes in minus what goes out.

11/20/2021
Exercise UNIT 3

1. Consumption

Consumption:
- Retail companies: Cost of Goods Sold
- Manufacturing cos: Consumption of raw materials =

(+) Initial stocks

(+) Purchases
(-) Ending stocks

Cost of Goods Sold = 45.500 + 210.000 – 38.200 = 217.300

a) Purchasing ≠ Consumption.
b) Purchases are not cost until consumed.
c) Until then they are an asset (stocks in Current Assets)
d) When they are consumed they are sold or incorporated into the product.

11/20/2021
 Exercise UNIT 3

• Inventory Turnover (times) = (cost of goods sold) / (average stock)

217,300 / 41,850 = 5.19

• Number of days of inventory (days) = 365 / (stock rotation)

365 / 5.19 = 70.3

11/20/2021
Exercise UNIT 3

4. Average collection period

• Average Collection Period (days) = (Accounts Receivable) / (Sales + VAT) x 365

(42,500) / (600,000 + VAT) x 365 = 21,367

5.- Average payment period

• Average Payment Period (days) = (Accounts Payable) / (Purchases + VAT) x 365

(8,600) / (210,000 + VAT) x 365 = 12,353

11/20/2021
Exercise UNIT 3

Stock
Selling Collection
purchasing

DSO 21.4
DIO 70.3 days
days

DPO 12.4 days

Payment

OPERATING CYCLE = 91.7 days

  79.3 days
=

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Cash Conversion Cycle (CCC)
UNIT 3
(also known as Cash Cycle)
 Measures how fast a company can convert cash on hand into
inventory and accounts payable, through sales and accounts
receivable, and then back into cash
 It's a measure of business efficiency, and it's calculated with the
following simple formula:

CCC = Days Inventory Outstanding + Days Sales Outstanding -

Days Payables Outstanding = DIO+DSO-DPO

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Cash conversion cycle
Automotive company UNIT 3

 NOTICE: Tesla has a relatively quick cash conversion cycle because of:
 Very quick accounts receivable collection cycle
 Very favorable accounts payable cycle

 Tesla's (TSLA) cash conversion cycle is superior to those of traditional auto manufacturers, and this will
prove especially useful for the company in the coming quarters. Other companies have enjoyed this
advantage throughout their hyper-growth phases.

Source: Tesla's Unusual Source Of Cash (NASDAQ:TSLA) | Seeking Alpha

CCC of automotive companies
UNIT 3

 The following graph presents the cash conversion cycle for Tesla (TSLA) and its automotive peers: 

 Tesla has a relatively quick cash conversion cycle versus its peers, which is in-line with what
management stated in the most recent earnings call, but there's more to this observation than meets the
eye, so let's dig one level deeper, and break the cash conversion cycle to its three components: Days
Inventory Outstanding ("DIO"), Days Sales Outstanding ("DSO"), and Days Payables Outstanding
("DPO").
Source: Tesla's Unusual Source Of Cash (NASDAQ:TSLA) | Seeking Alpha
CCC of automotive companies
DIO
UNIT 3

Days Inventory Outstanding

The following graph illustrates the DIO component of the CCC. Note that the higher the DIO, the worse a
company's CCC gets, as higher DIO means the inventory sits in the warehouse longer before it's delivered
to customers. Notice two things:
• Tesla's DIO is seemingly the worst among its peers,
which leads to a worse CCC for the company than it
would have been otherwise. This is misleading,
however, because Tesla sells direct-to-consumer as
opposed to its peers whose inventory sits at third-party
dealerships; therefore, the above graph is not an
apples-to-apples comparison.
• Tesla's DIO increased temporarily in 2H15, which is
when the company was gearing up for the Model X
production. This is normal as parts arrive before the
cars are assembled and sold (naturally), so there is
bound to be a temporary quarter or two when the
inventory balance jumps on the balance sheet before
higher revenue (and cost of goods sold) follow on the
income statement. I expect this to happen in the next
two quarters as well.
Since we established that a usual DIO comparison between Tesla and its peers is not meaningful due to
their different business models, let's compare the companies directly in the other two components.

Source: Tesla's Unusual Source Of Cash (NASDAQ:TSLA) | Seeking Alpha

CCC of automotive companies
DSO
UNIT 3

Days Sales Outstanding

The following graph illustrates the DSO component of CCC. Note that the lower the DSO the better a
company's CCC gets, as lower DSO means the customers are enthusiastic about paying the company...
well, not exactly, but you get the point.
 Note that Tesla is seemingly in its own
league with its DSO of just ~15 days, but
this also is not exactly an apples-to-apples
comparison since Tesla naturally collects
its accounts receivable relatively quickly
as it sells directly to its customers as
opposed to its peers' dealership model.

 It's very important to note, however, that when DSO and DIO are combined to calculate the companies'
"Operating Cycle" (as illustrated in the first graph above), Tesla is in fact more efficient compared to all of
its peers, even if we exclude the days Tesla's peers' inventory sit on dealership lots. This is a key
distinction.
Source: Tesla's Unusual Source Of Cash (NASDAQ:TSLA) | Seeking Alpha
CCC of automotive companies
DPO
UNIT 3

Days Payables Outstanding

The following graph illustrates the DPO component of CCC. Note that the higher the DPO the better a
company's CCC gets, as higher DPO means the company has favorable (read: longer) payment terms with
its suppliers. We will discuss below why this is especially important for Tesla.

Source: Tesla's Unusual Source Of Cash (NASDAQ:TSLA) | Seeking Alpha

CCC of automotive companies
Growth
UNIT 3

Tesla's Unusual Source Of Cash

 One factor that differentiates Tesla from its peers is its triple-digit growth rate:

 Normally, such a high growth rate would require an immense amount of incremental investment in 
working capital in addition to incremental operating expenses. Such a scenario reduces the attractiveness
of an investment, because required incremental investment in working capital means lower free cash
flows that the company can use for other purposes.

 The opposite, however, will be the case with Tesla as it grows quickly in the near future with the Model 3,
and the following graph illustrates the reason:

Source: Tesla's Unusual Source Of Cash (NASDAQ:TSLA) | Seeking Alpha

CCC of automotive companies
Growth financing
UNIT 3

Unlike its peers, Tesla enjoys a very quick accounts receivable collection cycle combined with a very favorable
accounts payable cycle. This means, as Tesla's revenue growth accelerates even further in the coming quarters, Tesla's
operating cash inflows will precede its operating cash outflows. This is what Elon Musk meant by "Nirvana" in the
most recent earnings call:
... So obviously, the Nirvana is that we can make the car and get paid for the car before we have to pay
our suppliers, which then the faster you grow, the faster your cash position grows. Obviously, that's
like the – that's the promised land right there. And that's how – it's what we've aimed for. And I think we'll
achieve that maybe not immediately but pretty quickly.

Source: Tesla's Unusual Source Of Cash (NASDAQ:TSLA) | Seeking Alpha

CCC of automotive companies
Best in class
UNIT 3

This is unique to Tesla in the Automotive Industry

 As the above graphs illustrate, no automotive company other than Tesla enjoys this advantage, but
you know who else does? Some of the world's biggest companies such as Amazon (AMZN), Wal-
Mart (WMT), and Apple (AAPL), which enjoyed what Tesla is about to enjoy throughout their hyper-
growth periods.

Source: Tesla's Unusual Source Of Cash (NASDAQ:TSLA) | Seeking Alpha

 UNIT 3

3.6 Working capital management

3.6.2 Cash Management
 31

Cash management
◼ A key objective of cash management is to
manage the collection and payment
circuits to shorten the processes in order to
accelerate the collection of the income and
comply with the agreed conditions for
payments.

◼ The delay in entering, for example, a

check increases the balance of working
capital, which has to be financed with the
consequent financial cost.

◼ Collection delays increase investment and

financial expenses.