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Level I CFA CF: Working Capital Management-Lecture 1 - YouTube
Channel: IFT
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working capital management this is a
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long reading in the curriculum there is
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a tremendous amount of detail you can
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obviously do the reading if you have
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time but what I will do in this lecture
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is focus on the seven learning
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objectives and emphasize the most
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testable points as you've learned in
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earlier readings working capital refers
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to a company's current assets and
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current liabilities which are used in
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the regular operations of a business the
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way this reading is organized there are
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a few high-level sections that give
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overview section one is an introduction
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section to talks about how do you manage
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and measure liquidity this is perhaps
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one of the most important aspects of
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this reading because it gives a lot of
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ratios for measuring liquidity managing
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liquidity over here is referred to at a
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high level almost all the ratios that
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you will see are ratios that you have
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covered in earlier readings so this is
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important we then get into the specific
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elements if you look at these items cash
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short-term funds accounts receivables
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these all are current assets on the
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balance sheet so we will talk about how
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to deal with each of these balance sheet
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elements inventory also is a current
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asset on the balance sheet then section
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seven and eight moved to the right side
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of the balance sheet we talked about how
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to manage accounts payable and how to
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manage short-term financing the
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introduction and the curriculum is
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extremely good it's just over one page
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and I would strongly encourage you to
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read the introduction because it sets
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the context very well here are the main
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points though working capital management
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involves managing the relationship
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between the firm's short-term assets and
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short-term liabilities
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the goal of effective working capital
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management is to ensure that a company
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has adequate ready access to the funds
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necessary for day-to-day operating
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expenses another way of looking at this
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is that a company will have short-term
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obligations such as paying bills paying
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salaries and so on the short term assets
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and liabilities need to be managed in
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such a way that the short term
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obligations are easily met different
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companies will have different working
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capital needs and we need to understand
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the factors that impact working capital
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needs this slide presents a list of
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internal factors and external factors
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let's go over the specific items company
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size and growth rates clearly companies
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that are large and companies that are
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growing fast will have relatively high
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working capital requirements
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organizational structure if you compare
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centralized companies versus
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decentralized companies decentralized
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companies will have higher working
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capital requirements because we're
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decentralized companies each business
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unit or division will try to manage its
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working capital whereas with a
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centralized organizational structure the
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cash management and receivables
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management and other aspects of working
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capital will be managed centrally which
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means that relative to a decentralized
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company the working capital requirement
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would be lower sophistication of working
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capital management a company that is
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using a sophisticated system such as sa
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P to manage working capital will be able
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to do a better job of keeping working
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capital relatively low while still
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meeting its short-term obligations
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borrowing and investing positions
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activities and capacities a company that
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can borrow relatively easily invest
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relatively easily liquid
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relatively easily will have relatively
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lower working capital requirements on
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the other hand a company that cannot
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borrow easily will try to play it a
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little safe and maintain relatively high
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working capital on the right we list the
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external factors banking services in
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economy where banking services are very
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well developed the working capital needs
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will be relatively low because it would
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be easy for companies to raise
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short-term funds interest rates if
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interest rates are relatively high then
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companies will maintain high working
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capital because the companies would not
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want to borrow at high interest rates
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new technologies and new products which
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make it easier to manage working capital
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would result in relatively lower working
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capital the impact of the economy on
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working capital depends on the industry
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and on the specific element for example
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when the economy is not doing well
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companies will cut down on inventory on
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the other hand companies might maintain
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higher cash balances because when the
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economy is not doing well then generally
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liquidity is impacted and it is harder
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to raise money through banks and other
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non bank
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sources in a highly competitive industry
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working capital requirements might be
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relatively high coming now to managing
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and measuring liquidity liquidity is the
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extent to which a company is able to
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meet its short-term obligations using
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assets that can be readily transformed
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into cash liquidity management refers to
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the ability of an organization to
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generate cash when and where needed we
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need to understand the primary sources
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of liquidity and the secondary sources
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here are the primary sources cash
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balance
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obviously a company can use its cash to
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pay off obligations trade credit this
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refers to accounts payable when the
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company purchases from suppliers if it
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is purchasing on credit that is a source
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of liquidity short term investment
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portfolio companies invest their money
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in tables and other short term
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investments if a company needs money it
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is easy to liquidate the short term
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investments and generate cash secondary
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sources of liquidity these are sources
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of liquidity that companies generally
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want to avoid negotiating debt contracts
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a company needs to make a large debt
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repayment but is having trouble
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generating sufficient cash so the
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company will try to renegotiate the debt
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contract liquidating assets again this
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is not a favorable position to be an if
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a company has to sell off its long term
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assets in order to pay off a loan that
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would be a negative sign filing for
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bankruptcy protection obviously is a
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last resort drags and pulls on liquidity
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cash receipts and disbursements affect a
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company's liquidity position we need to
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at a high level understand these two
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terms drag on liquidity and pull on
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liquidity we say that a company has a
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drag on liquidity when the receipts lag
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the disbursements for example if a
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company is slow at collecting
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receivables whereas the company is
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making its payments on time then this
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creates a drag on liquidity because the
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company is not collecting cash at a fast
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enough rate compared to paying bills
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obsolete inventory again creates a drag
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because the company is not selling its
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inventory but the company is still
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making its regular payments there are
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other examples also but what you need to
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remember is drag on liquidity means
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receipts lag
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disbursements a pull on liquidity
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represents the other scenario where
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disbursements are paid too quickly or
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trade credit is limited if a company is
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paying its suppliers very quickly
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relative to getting money from customers
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then we have a pull on liquidity reduced
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credit limits also creates a pull on
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liquidity this could refer to reduced
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credit limits from banks it could also
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refer to suppliers who are giving very
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tight credit terms again there are other
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examples but it's important to
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understand these concepts from a
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testability perspective coming now to
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measuring liquidity liquidity
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contributes to a company's
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creditworthiness creditworthiness is the
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perceived ability of the borrower to pay
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what is owed in a timely manner high
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creditworthiness allows a company to
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obtain lower borrowing costs obtain
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better terms for trade credit have
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greater flexibility and exploit
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profitable opportunities these are
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fairly self-evident a company with a
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high level of creditworthiness can
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borrow more easily at a lower rate a
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company with high working capital and
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high creditworthiness can also exploit
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profitable opportunities because this
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company can raise money relatively
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quickly in order to take advantage of
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opportunities liquidity ratios measure a
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company's ability to meet short-term
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obligations and before you go to the
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next slide I want you to write down all
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the liquidity ratios that you remember
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from earlier readings so here are some
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ratios that you should come up with
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perhaps the most important one is the
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current ratio which gives the current
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assets divided by the current
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liabilities if you recall from afar a we
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also have other ratios such
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the quick ratio and the cash ratio the
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quick ratio has the same denominator
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which is the current liabilities but in
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the numerator we do not include
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inventory because if for a given company
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the inventory is obsolete or it is not
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very liquid then we want a ratio that
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does not include inventory in some
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textbooks you will see the quick ratio
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written as current assets minus
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inventory and as we've discussed in Fr a
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there are no strict rules or formulas
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for ratios you just need to understand
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what ratio is being used based on the
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context we also have other ratios such
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as receivables turnover and payables
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turnover inventory turnover and so on in
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Fr a these were categorized as activity
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ratios but over here you need to
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recognize that receivables turnover
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inventory turnover also measure
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liquidity a company that has high
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receivables turnover is collecting money
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from customers relatively fast which is
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a positive sign from a liquidity
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perspective as we've seen before the
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receivables turnover is the credit sales
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divided by average receivables sometimes
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you might see only sales written over
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here it depends on what data you have
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but the important thing is when you are
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comparing the receivables turnover
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across different companies then you need
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to use the same formula the number of
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days of receivables is a measure of how
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many days on average it is taking to
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collect receivables and that is given by
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365 divided by receivables turnover the
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way the formulas are given in corporate
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finance is slightly different from the
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way the formulas are given in Fr a but
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just to help you remember this better I
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am using the same format that we used in
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Fr a because the answer will be the same
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regardless of whether you use the
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formulas shown here or the formulas
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shown in this particular reading
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inventory turnover is a measure of how
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quickly a company is selling inventory
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this is given by cogs divided by average
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inventory number of days of inventory
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tells you on average how many days of
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inventory a company has this is given by
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365 divided by the inventory turnover
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payables turnover is purchases divided
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by average trade payables it purchases
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data is not available then you can use
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cogs as approximation for purchases and
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the number of days of payables is 365
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divided by the payables turnover ratio
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when you are doing ratio analysis you
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need to cover two dimensions first you
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need to look at whether liquidity is
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improving for a given company over time
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that would be time series analysis you
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should also compare the liquidity ratios
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of companies with other companies in the
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industry or we can call them peer group
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companies you want to see whether these
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ratios are above or below the average
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this concept is covered well in example
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1 in the curriculum so I would encourage
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you to read and do this example net
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operating cycle here you need to
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understand the difference between the
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operating cycle and the net operating
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cycle and we have seen this in Fr a also
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the operating cycle refers to the days
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of inventory plus days of receivables
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the cash conversion cycle which is also
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the net operating cycle tells you how
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much time it takes between when you pay
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cash to when you receive cash and to
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calculate the net operating cycle you do
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the following average days of
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receivables plus average days of
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inventory - average days of payables let
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us consider a simple example say days of
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payables for a given company equals 20
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days of inventory is 30 and days of
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receivables as 15 if a company purchases
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inventory on day 0 days of
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equal to 30 means that it will sell the
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product after 30 days or on day 30 and
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if days of receivables is 15 then the
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company actually receives cash on day 45
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from 0 to 45 which is the time between
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when inventory was received an inventory
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sold that is 45 days days of inventory
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30 plus days of receivable 15 is equal
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to 45 this is the operating cycle with
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the net operating cycle we are looking
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at the time between when cash is paid to
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suppliers till the time when cash is
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received from customers so we take the
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overall operating cycle of 45 days which
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is days of receivables plus average days
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of inventory and then we subtract the
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days of payables so 45 minus 20 is equal
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to 25 that's this period over here this
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is the net operating cycle or the cash
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conversion cycle if you get a question
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in the exam make sure you are careful
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about whether or not the term net is
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being used when you seen it that means
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you need to subtract the average days of
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payables if you don't seen it then you
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are simply doing days of inventory plus
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days of receivables managing the cash
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position now we will talk about specific
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elements on the balance sheet the
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purpose of managing the firm's daily
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cash position is to make sure there is
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sufficient cash that sufficient amount
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of cash is called the target balance a
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company does not want cash balances to
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become negative because it is expensive
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to borrow cash on short notice
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companies also do not want high cash
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balances because that would be
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inefficient usage of funds companies
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should recognize
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the major sources of cash inflows and
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outflows in order to forecast and manage
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cash position clearly a company needs to
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recognize how much cash is coming in how
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much cash is going out only if there is
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a view on cash in and cash out will a
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company be able to effectively manage
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will a company be able to effectively
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manage its cash position the specific
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inflows and outflows will vary from
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company to company but at a high level
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here are the typical inflows and here
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are the typical outflows as an analyst
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you can figure out the inflows and
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outflows by studying the cash flow
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statement of a company
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you
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