short term financial management

Topics: Inventory, Balance sheet, Net present value Pages: 43 (17867 words) Published: October 28, 2014
CHAPTER

2
Analysis of the
Working Capital Cycle

Order
placed

Inventory
received

Payment
sent

Sale
Inventory

Accounts receivable

Cash
received

Collection float

Time
Accounts payable

Disbursement float
Payment
sent

Cash
disbursed

OBJECTIVES
After studying this chapter, you should be able to:
• distinguish between solvency and liquidity.
• differentiate between solvency ratios and the cash conversion period. • calculate and interpret the cash conversion period.
• determine the change in shareholder wealth attributable to changes in the cash conversion period.

F

unds invested in working capital constantly shift among the various balance sheet accounts. To illustrate, a credit
sale results in an accounts receivable.
The eventual collection of the receivable yields
increased cash and a reduced receivable balance. During the operating cycle payments are made to various parties, as reflected in accounts
payable and accruals. The continuous ebb and
flow of cash inflows and outflows from production and revenue generation is referred to as the cash cycle. The length of this cycle directly
influences firm liquidity; hence, it is important
to monitor working capital behavior via the
cash cycle.
This chapter discusses techniques used to
quantify working capital management. The
analysis begins with a review and critique of
traditional measures used to assess working
capital practices. A major focus of the chapter
is to distinguish solvency from liquidity. The
former concerns whether assets exceed liabilities, whereas liquidity refers to the firm’s ability to meet short-term obligations with cash while
remaining a going-concern.1 The major empha1 The going-concern principle involves the firm’s ability to remain as a viable business. Hence, solvency violates
the going-concern principle as selling off assets to repay

sis of the chapter centers on the cash conversion
period, which is the length of time it takes to turn
an inventoried product into a cash inflow.

FINANCIAL DILEMMA
What Happened?
Apple, Inc. is a multinational firm that designs
and sells consumer electronics, personal
computers, and related software. Most individuals probably associate the Apple brand with immense commercial success, but the firm has
experienced periodic financial difficulties. The
introduction of new products during the 2000’s
led to tremendous revenue growth, solidifying
Apple as the world-wide leader in consumer
technology. Chapter 1 illustrated how even
profitable firms with growing revenues can be
illiquid. How was Apple able to grow so rapidly
yet maintain liquidity?

liabilities would impair the ability to remain a viable
business.

27

28 | Short-Term Financial Management

TRADITIONAL WORKING CAPITAL MEASURES
This section discusses traditional measures used in assessing working capital management. These traditional measures include net working capital, working capital requirements, and the current and quick ratios. Example calculations and interpretations for these measures are calculated using Mas-Con, Inc.’s financial statements (provided in Appendix A).

Net Working Capital
Net working capital (NWC) is the difference in current assets and current liabilities. Positive NWC indicates that long-term funds finance current assets. Meanwhile, negative NWC implies that the firm finances long-term assets with current liabilities. Larger values for the NWC may indicate adequate solvency and low default risk, as current assets exceed current liabilities. One problem with NWC is that it is an absolute measure, making comparisons across firms difficult. Thus, as one would expect, the absolute value of NWC will always be higher for larger firms. An intuitive solution to this problem of scale is to standardize NWC by assets or revenues. Mas-Con’s 2012 NWC calculation and the five-year trend in this variable are shown below.

NWC 2012 = (25 + 3,000 +...

References: Heitor Almeida, Murillo Campello, and Dirk Hackbarth. 2011. Liquidity Mergers. Journal of Financial
Economics 102
James S. Ang. 1991. The corporate-slack controversy. In Yong Kim and Venkat Srinivasan, V., (eds): Advances
in Working Capital Management, vol
Thomas W. Bates, Kathleen M. Kahle, and Rene M. Stulz. 2009. Why Do U.S. Firms Hold So Much More Cash
than They Used To?
William J. Baumol. 1952. The Transactions Demand for Cash: An Inventory Theoretic Approach. The Quarterly
Journal of Economics 66:4, 1952, 545–556.
Bruce D. Bagamery. 1987. On the correspondence between the Baumol-Tobin and Miller-Orr optimal cash
balance models
Hans G. Daellenbach. 1974. Are cash management optimization models worthwhile? Journal of Financial and
Quantitative Analysis September:607–626.
Amy Dittmar and Jan Mahrt-Smith. 2007. Corporate Governance and the Value of Cash Holdings, Journal of
Financial Economics 83, 599–634.
Gary W. Emery. 1984. Measuring Short-Term Liquidity. Journal of Cash Management, July-August: 25–32.
Gary W. Emery and Kenneth O. Cogger. 1982. The Measurement of Liquidity. Journal of Accounting Research,
Autumn: 290–303.
Michael Faulkender and Rong Wang. 2006. Corporate Financial Policy and the Value of Cash, Journal of
Finance 61, 1957–1990.
Laurent Fresard. 2010. Financial Strength and Product Market Behavior: The Real Effects of Corporate Cash
Holdings
Fritz C. Foley, Jay Hartzell, Sheridan Titman, and Garry J. Twite. 2007. Why Do Firms Hold So Much Cash? A
Tax-Based Explanation, Journal of Finance 86, 579–607.
Jarrad Harford, Sattar Masni, and William Maxwell. 2008. Corporate Governance and a Firm’s Cash Holdings,
Journal of Financial Economics 87, 535–555.
Michael Jensen. 1986. Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers, American Economic
Review 76, 323–329.
John Maynard Keynes, 1936. The General Theory of Employment, Interest and Money, London: Macmillan.
Chang-Soo Kim, David C. Mauer, and Ann E. Sherman. 1998. The determinants of corporate liquidity: Theory
and evidence
Sandy Klasa, William F. Maxwell, and Hernan Ortiz-Molina, 2009. The Strategic Use of Corporate Cash
Holdings in Collective Bargaining with Labor Unions
Karl Lins, Henri Servaes, and Peter Tufano, “What Drives Corporate Liquidity? An International Survey of
Cash Holdings and Lines of Credit,” Journal of Financial Economics 98, 160–176, 2010.
Wayne Mikkelson and Megan Partch. 2003. Do Persistent Large Cash Reserves Hinder Performance? Journal
of Financial Quantitative Analysis 38, 275–294.
Continue Reading

Please join StudyMode to read the full document

You May Also Find These Documents Helpful

  • Short Term Financial Policies Essay
  • Essay on Financial Management
  • Financial Management Essay
  • short term cheat sheet Research Paper
  • Financial Management Essay
  • Financial Management Essay
  • FINANCIAL MANAGEMENT Essay
  • financial management Essay

Become a StudyMode Member

Sign Up - It's Free