Lecture 6 - Working Capital Management

Lucas S. Macoris

Decomposing Asset Turnover

In this lecture, we’ll focus on the Asset Turnover component:

\[ \small ROE=\dfrac{\text{Net Income}}{\text{Sales}}\times \underbrace{\dfrac{\text{Sales}}{\text{Assets}}}_{\text{Asset Turnover}}\times \dfrac{\text{Assets}}{\text{Equity}} \]

  • Since firms invest considerable resources in their assets, using them productively is critical to overall profitability.

  • There are two primary areas of investment management that are relevant to Asset Turnover:

    1. Working capital Management
    2. Management of long-term assets

  • In this lecture, we’ll extensively follow (Berk and DeMarzo 2019) to study Working Capital Management

Working Capital Management

  • Definition: working capital is the difference between a firm’s current assets and current liabilities. It does not distinguish between operating and financing components:
    1. Operating: Accounts Receivable, Inventory, and Accounts Payable, Cash (excluding non-excess cash), etc
    2. Financing components: Excess Cash, Marketable securities, and Notes Payable.

Why Working Capital is so important?

  • Our general definition for Net Working Capital is Current Assets - Current Liabilities

  • If this number is positive, is this good or bad? It depends!

    1. Having current assets higher than current liabilities tells us something about the firm’s liquidity…
    2. However, within these accounts, we’ll see items such as Cash, Inventories, and Accounts Receivable…

  • Notably, there are opportunity costs associated with investing in inventories and accounts receivable, and from holding cash

    1. For example, excess funds invested in these accounts could instead be used to pay down debt or returned to shareholders in the form of a dividend or share repurchase.

    2. To this point, Working Capital Management aims to manage working capital efficiently and thereby minimize these opportunity costs!

Why Working Capital is so important? An example…

  • Let’s get back to the pizza vendor example that we had in our first class…

    1. We know that, to run a food-business like this, we need fixed investments on Equipments, Machinerys, Buildings, etc
    2. But after these are set in place, we need to worry about the flow of the operations!

  • Examples:

    1. We need money to buy the core ingredients and to make up some inventory
    2. We also need to have a cushion to pay salaries for delivery/production/waiter workers
    3. There will also be electric, water, sewage bills, along with other fixed costs that we’ll need to cushion

  • Note that the operation cannot generate cash if we don’t have these assets in place

  • These are certain expenditures that we will continuously have as the operation flows – hence working capital

Working Capital, another example

  • A certain amount of investment in working capital is generally necessary for the firm to run its normal operations

  • To make this point clear, think about any mass retailer, such as Arezzo (ticker: ARZZ3):

  1. To ensure that consumers are buying, retailers might need to provide a flexible payment method \(\rightarrow\) increased investment on Accounts Receivable
  2. To ensure that the goods are delivered on time, we might need to have inventories in place \(\rightarrow\) increased investment on Inventories
  3. However, as ARZZ3 is a big retailer, it also may have good contracting terms with its suppliers to pay its inventory later \(\rightarrow\) increased Accounts Payable
  • Often, the interaction between these three accounts yields an important part of operating working capital needed for the business!

The Cash and Operating Cycle

  • The level of working capital reflects the length of time between when cash goes out of a firm at the beginning of the production process and when it comes back in:
  1. A company first buys inventory from its suppliers, in the form of either raw materials or finished goods
  2. After receiving the inventory, even if the inventory is in the form of finished goods, it may sit on the shelf for some time.
  3. Finally, when the inventory is ultimately sold, the firm may extend credit to its customers, delaying when it will receive the cash.
  • The main components of net working capital are cash, inventory, receivables, and payables. To that matter, we can use the most important parts of a firm’s net working capital to define the cash and operating cycle

Cash and Operating Cycle Dynamics

Definition: A firm’s cash cycle is the length of time between when the firm pays cash to purchase its initial inventory and when it receives cash from the sale of the output produced from that inventory

Cash Cycle Dynamics, continued

  • The longer the firm’s cash cycle, the more working capital it has, and the more cash it needs to carry to conduct its daily operations

  • Because of the characteristics of different industries, working capital levels vary significantly

Policies that increase the firm’s Cash Cycle:

  1. If a firm extends the credit terms to its clients from 30 to 60 days \(\rightarrow\) increased investment in Accounts Receivable

  2. If the firm takes more time to produce its finished goods \(\rightarrow\) the higher is the time that inventories are stocked \(\rightarrow\) increased investment in Inventories

Policies that decrease the firm’s Cash Cycle:

  1. If a firm receives more time to pay for its raw materials \(\rightarrow\) increased liabilities in Accounts Payable

Cash Conversion Cycles by Industry

Company

Industry

Receivable Days

InventoryDays

Payable Days

Cash Conversion Cycle

Coca-Cola

Beverages

43

81

297

-173

T-Mobile

Telecommunications

36

24

155

-95

Sirius XM

Cable and Satellite

14

2

108

-92

Molson Coors Brewing

Brewing

26

34

143

-83

Apple

Computer Hardware

24

19

106

-63

Amazon.com

Internet Retail

11

43

76

-22

Southwest Airlines

Airlines

12

11

31

-8

Chipotle Mexican Grill

Restaurants

2

2

11

-7

Walmart

Superstores

4

42

44

2

Kroger

Grocery Stores

5

25

23

6

Microsoft

Software

66

22

72

17

Macy's

Department Stores

4

140

124

21

Starbucks

Restaurants

12

29

19

23

FedEx

Air Freight

46

4

23

27

Nordstrom

Department Stores

4

83

57

30

Bristol-Myers Squibb

Pharmaceuticals

88

70

101

57

Nike

Footwear

34

90

37

88

ONE Gas

Gas Utilities

73

47

30

90

Lennar Corporation

Homebuilding

5

376

21

359

Tiffany & Co.

Luxury Goods

20

532

58

494

Brown-Forman

Distillers and Vintners

83

548

122

509

U.S. Firms

-

50

70

79

41

Determining the Cash Cycle

  • Some practitioners measure the cash cycle by calculating the cash conversion cycle. The cash conversion cycle (CCC) is defined as

\[ \small CCC= \text{Accounts Receivable Days}+\text{Inventory Days}- \text{Accounts Payable Days} \] Where:

\[ \small \text{Accounts Receivable Days}= \dfrac{\text{Accounts Receivable}}{\text{Average Daily Sales}} \]

\[ \small \text{Inventory Days}= \dfrac{\text{Inventory}}{\text{Average Daily COGS}} \]

\[ \small \text{Accounts Payable Days}= \dfrac{\text{Accounts Payable}}{\text{Average Daily COGS}} \]

Estimating the Cash Conversion Cycle

  • Suppose that a firm has $100,000 in account receivables, $50,000 in inventory, and $25,000 in accounts payable. It has reported sales of about $1MM and its Cost of Goods Sold (COGS) represent 40% of total revenues. Calculate the Cash Conversion Cycle. Assume a 365-day year.

  • Now, we’ll calculate the Cash Conversion Cycle of the firm by looking at its individual components

Step 1: Inventory Days

  • The firm has $50,000 in Inventory
  • It had reported COGS of \(40\% \times 1,000,0000=400,000\)
  • The Inventory Conversion is then:

\[ \small IC=\dfrac{Inventory}{\dfrac{COGS}{365}}\rightarrow \dfrac{50,000}{\dfrac{400,000}{365}}\rightarrow \dfrac{50,000}{1,096}\approx \text{45.6 days} \]

  • Interpretation: if the firm had 400,000 in Inventory Costs yearly, this translates to a daily average of 1,096. If there’s 50,000 in Inventories, it means that it takes, on average, \(50,000/1,096=45.6\) days for Inventories to be finished.

Step 2: Accounts Receivable Days

  • The firm has $100,000 in Receivables
  • It had reported Sales of \(1,000,0000\)
  • The Accounts Receivable Conversion is then:

\[ \small ACC=\dfrac{Receivables}{\dfrac{Sales}{365}}\rightarrow \dfrac{100,000}{\dfrac{1,000,000}{365}}\rightarrow \dfrac{100,000}{2,739}\approx \text{36.5 days} \]

  • Interpretation: if the firm had 1,000,000 in Sales yearly, this translates to a daily average of 2,739. If there’s 100,000 in Receivables, it means that it takes, on average, \(100,000/2,739=36.5\) days for a given client to pay the firm, after it has bought the product.

Step 3: Accounts Payable Days

  • The firm has $25,000 in Receivables
  • It had reported COGS of \(40\% \times 1,000,0000=400,000\)
  • The Accounts Payable Conversion is then:

\[ \small APC=\dfrac{Payables}{\dfrac{COGS}{365}}\rightarrow \dfrac{25,000}{\dfrac{400,000}{365}}\rightarrow \dfrac{25,000}{1,096}\approx \text{22.8 days} \]

  • Interpretation: if the firm had 400,000 in COGS yearly, this translates to a daily average of 1,096 If there’s 25,000 in Receivables, it means that it takes, on average, \(25,000/1,096=22.8\) days for the firm to pay its suppliers, after it bought the Inventory.

Step 3: putting all together

  • Recall tha the Cash Conversion Cycle is defined as:

\[ \small CCC= \text{Accounts Receivable Days}+\text{Inventory Days}- \text{Accounts Payable Days} \]

  • Using our formula, we have:

\[ \small CCC= \text{36.5}+\text{45.6}- \text{22.8}\approx \text{59.3 days} \]

  • It means that, on average, it takes roughly 60 days for the firm to receive from its clients after it paid for its inventories.

    1. If CCC>0 \(\rightarrow\) the firm needs to invest in Working Capital to be able to pay its obligations before receiving from clients
    2. If CCC<0 \(\rightarrow\) the firm receives from clients before it actually had to pay its suppliers

Changing the Accounts Payable

  • Suppose that the firm has made an arrangement with its suppliers to be able to pay in 40 days. What is the effect of this policy?

  1. First, we can see that the new CCC is \(36.5+45.6-40\approx 42.1\) days. Why is this important? Because it reduces the net working capital requirement!

  2. In order to see that, recall that, on average, the firm pays \(\$400,000/365\approx \$1,096\) to its suppliers on a daily basis. Therefore, as there’s an increase from 22.8 \(\rightarrow\) 40 days, the new level of accounts payable is:

\[ \small APC=\dfrac{Payables}{\dfrac{COGS}{365}}\rightarrow 40=\dfrac{Payables}{1,096}\rightarrow Payables= 43,835 \]

Changing the Accounts Payable, continued

  • Therefore, the change in the Net Working Capital is simply given by the difference in Accounts Payable:

\[ \small \Delta Payables=43,835-25,000=18,835 \]

  1. The company was able to free-up $18,835 of resources that can be either paid off to shareholders as dividends or reinvested in other activities or even financial instruments

  2. Also, if we distributed this value, as we’re keeping the Sales numbers constant, but being able to do so with a lower level of assets, we are increasing the firms’s Operating Asset Turnover, and hence, the ROIC

Practical Example, Arezzo (ARZZ3)

References

Presented by Lucas S. Macoris

Berk, J., and P. DeMarzo. 2019. Corporate Finance, Global Edition. Global Edition / English Textbooks. Pearson. https://books.google.com.br/books?id=m78oEAAAQBAJ.