short term financial management

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

Analysis of the
Working Capital Cycle





Accounts receivable


Collection float

Accounts payable

Disbursement float


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.


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.

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


28 | Short-Term Financial Management

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 +...

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