short term financial management
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
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
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.