WORKING CAPITAL MANAGEMENT

EFFICIENCY ANALYSIS

LECTURE
Liquidity Ratios
Liquidity means having enough money on hand to pay bills
when they are due and to take care of unexpected needs for
cash.

1. Current Ratio = Current Assets

Current Liabilities
Used to measure the short-term solvency of the firm’s ability
to meet its short term debts. Current liabilities must be
covered from cash or its equivalent, otherwise the firm will
need to borrow money to meet these obligations.

A ratio of 2:1 is favorable as it indicates that for every dollar of

debt, the company has $2 to cover for it. The higher the
ratio, the more liquid the company is, however, it indicates
lower profitability. Hence the ratio should be compared with
industry standards.
Liquidity Ratios…….cont…..
2. Quick Assets Ratio =
Current Assets – Inventories
Current Liabilities

Also known as the liquidity ratio and acid test ratio, gives a
more sensitive guide to immediate solvency. Inventory is
subtracted as it usually takes some time to realize and will
not be available to meet immediate debts. Normal ratio is 1:1
 Note the variation,
Quick ratio = Cash + Short-term investments + Accts. receivable
Quick Current liabilities
ratio*
Liquidity Ratios…….cont…..
3. Cash Ratio =
Cash
Current Liabilities

Measures liquidity more strictly. It shows

the number of dollars available in cash for
every dollar in current liabilities. What if
there is an immediate demand to pay off
liabilities and no time to convert other
current assets.
Management of Cash
 Cash is anything that is available to pay the immediate bills
and includes money in hand, in the bank, or anywhere the
business can retrieve it quickly.
 Most liquid asset and needs a tight control.
 Very susceptible to mis-management and fraud.
 As discussed earlier holding cash is unprofitable and must
be managed properly by investing in profitable ventures.
 It is the goal of the cash manager to minimize the amount of
cash the firm must hold for use in conducting its normal
business activities, yet at the same time have sufficient
cash to:
1. Take trade discounts
2. Maintain its credit rating
3. To meet unexpected cash needs, such as favorable
business opportunities, or emergencies such as
strikes, fire, etc.
Management of Cash…..cont…
 Reasons for Holding Cash:
1. Transaction – routine payments and collections

2. Compensation – banks require firms to leave a

certain balance of cash in their deposits for
providing loans and services.
3. Precaution – Cash reserves for random unforeseen
fluctuation sin inflows and outflows. (safety stock)
4. Speculation – Cash balances held by the firm to take
advantages of any bargain purchases that may
arise.
Cash Management Techniques
 Proper Management of inflows and outflows
which entail:
1. Synchronizing cash flows (cash receipts to coincide
with cash payments) leads to reduced cash balances
2. Using float (difference between our checkbook
balance and the balance on the bank’s books)
3. Accelerating collections
4. Getting available funds to where they are needed
5. Controlling disbursements
Cash Management Ratios
 Cash to Current Assets
Cash X 100
Current Assets
Shows cash as a percentage of total
assets
 Cash Turnover in Sales
Sales for Period X 100
Average Cash Balance
What percentage of cash is from
sales.
 Inventory Management
 Inventories tie up funds and brings in carrying costs,
however we need inventory for sales.
 Ideal stockholding policy minimizes the combination of
carrying and stock out costs. (matter of judgment over time)
 Inventory Turnover
= COGS
(Average) Inventory
Measures the rate at which inventory is used on an annual
basis.
 Average days’ Inventory on Hand (Inventory Turn-Days)
Days in Year
Inventory turnover
Converts the inventory turnover ratio into an “average days
inventory on hand” figure..
Inventory Control Systems
1. Red- Line Method – red line is drawn around the inside of
the bin to indicate the reorder level point.
2. Two-bin Method - Reorder when one of the two stocked
bins is empty
3. Computerized systems – keeps track of withdrawals and
when reorder point is reached, it automatically places the
orders.
4. Just-In Time Systems – production is coordinated with
suppliers so that raw materials arrive as and when needed
by production.
5. Out- Sourcing – The practice of purchasing components
rather than making them in house.
6. Production scheduling and inventory levels – whether to
produce the whole year or only when the sales are high
Management of Accounts Receivable
 We need to sell on credit for increased sales and more
profits.
 The firm needs to effectively control and minimize the
investment in Accounts Receivable.
 Receivables Turnover

Net Sales
(Average) Accounts Receivable
Measure the rate at which accounts receivable are being
collected on an annual basis
 Average Days Sales Uncollected (Average Collection
Period)
Days in Year
Receivable Turnover
Converts the accounts receivable turnover ratio into the
average number of days the firm must wait for its
accounts receivable to be paid.
Management of Accounts Receivable
 Debtors Aging Schedule:
 Breaks downs a firm’s receivables by age of
account.
 Developed from a firm’s accounts receivable ledger
 Credit Policy – A set of decisions that include a
firm’s:
1. Credit Period (length of time allowed for pmt)
2. Discounts (for early payment)
3. Credit Standards (required financial strength)
4. Collection Policy (toughness or laxity in attempting
to collect slow-paying accounts
Management of Accounts Payable
 Payables Turnover
COGS
Average Accounts Payable
Measures the rate at which accounts payable are being
paid on an annual basis.
 Average Days Payable (Average Payment Period)
Days in Year
Payables Turnover
Converts the accounts payable turnover ratio into the
average number of days a firm takes to pay its
accounts payable
Cash Conversion

 How fast can the organization converts all its

current assets into cash. (NET)
 Net Cash Conversion Cycle = number of
days in inventory + number of days in
accounts receivable – number of days in
accounts payable
Evaluating Cash Flow Adequacy

 Cash flows in a cycle into, around and out of a business. It is the

business's lifeline and every manager's primary task is to help
keep it flowing and to use the cash flow to generate profits.
 If this lifeline deteriorates, so does the company's ability to fund
operations, reinvest and meet capital requirements and
payments.
 Cash flow measures are closely related to liquidity and long-term
solvency because cash flows are needed to pay debts when they
fall due
 If a business is operating profitably, then it should, in theory,
generate cash surpluses. If it doesn't generate surpluses, the
business will eventually run out of cash and expire.
Cash Flows ……cont…..
 The faster a business expands, the more cash it will need for
working capital and investment.
 Good management of working capital will generate cash will help
improve profits and reduce risks.
 It can be tempting to pay cash, if available, for fixed assets e.g.
computers, plant, vehicles etc.
 If you do pay cash, remember that this is no longer available for
working capital.
 Therefore, if cash is tight, consider other ways of financing
capital investment - loans, equity, leasing etc.
 Similarly, if you pay dividends or increase drawings, these are
cash outflows and, like water flowing down a plug hole, they
remove liquidity from the business.
 Most Businesses Fail for Lack of Cash
Than for Want of Profits
WORKING CAPITAL MANAGEMENT
EFFICIENCY ANALYSIS

LECTURE
RECAP

 Liquidity Ratios
 Management of Cash
 Inventory Management
 Management of Accounts Receivables
 Management of Accounts Payable
 Cash Flows
 Cash Flow Ratios

1. Cash Flow Yield

Net Cash Flows from Operating Activities
Net Income
Measures the ability of the firm to generate operating cash
flows in relation to net income.
2. Cash Flows to Sales
Net Cash Flows from Operating Activities
Net Sales
Measures the ability of sales to generate operating cash
flows.
Ratios….cont…….

3. Cash Flows to Assets

Net Cash Flows from Operating Activities
Average Total Assets
Measures the ability of assets to generate operating
cash flows
4. Free Cash Flows
Net Cash Flows from Operating Activities –
Dividends – Net Capital Expenditures
A measure of cash generated or cash deficiency after
providing for commitments
EVALUATION OF
PROFITABILITY
 Profitability is important to business as is paying bills
on time
 Closely linked to liquidity because earnings produce
cash flows.
 Profitability is defined as the ability to earn a
satisfactory income
 Profitability competes with liquidity for management
attention
 Liquid assets (although important are not the best
profit producing resources
Measures of Profitability
1. Profit Margin
 Shows the percentage of each sales dollar that
results in net income
Net Income
Net Sales
2. Asset Turnover
- Measures how efficiently assets are used to produce
sales
Net Sales
Average Total Assets
Measures of Profitability…cont …
3. Return on Assets
- shows the income generated from each dollar invested in
assets
- shows income generating strength (profit margin) of the
company’s resources and how efficiently the company is using
all its assets (asset turnover).

Net Income = Net Income X Net Sales

Average Total Assets Net Sales Ave. Total Assets

Return On Assets = Profit Margin X Asset Turnover

- Management can improve overall profitability by increasing

profit margin, asset turnover or both.
Measures of Profitability…cont …
4. Debt to Equity Ratio
- shows the proportion of company financed by
creditors in comparison with that financed by
owners.
Total Liabilities
Owners Equity
This ratio can fall under both the liquidity (relates to
debt and repayment) and profitability (both the
owners and creditors are interested in the
profitability) categories.
Measures of Profitability…cont …
5. Return on Equity
- shows the return earned on the owners investment
in the business
Net Income
Average Owners Equity
Whether its an acceptable return depends on the
return earned previous year and the return earned
by the other companies in the same industry
Evaluating Long-Term Solvency
 Has to do with the company’s ability to survive for
many years.
 The aim is to detect early signs that a company is
headed for financial difficulty.
 Studies have indicated that financial ratios can show
as much as 5 years in advance that a company may
fail.
 Declining profitability and liquidity ratios are key
indicators of possible business failure.
Evaluating Long-Term Solvency…cont..

 Debt to Equity Ratio

 Measure capital structure and leverage by

showing the amount of assets provided by

creditors in relation to the amount provided by
stockholders.
Total Liabilities
Stockholder’s Equity
 Interest Coverage Ratio
 Measure the degree of protection creditors have

from a default on interest payments

Income Before Tax + Interest
Expense
Interest Expense
Some limitations of Using Ratio Analysis

Ratio analysis is useful but analysts should be aware of these

problems and make adjustments as necessary.

 Ratios are not useful in itself unless there is a comparison made

 Comparing prior years figures may not give a clear picture as
results may have been exceptionally good or bad due to good or
poor management.
 Ratios behaving in particular fashion may not itself be indicative
of good or poor performance
 Sometimes difficult to identify the industry category to which a
firm belongs to when engaged in multiple lines of business.
 It may be difficult to find appropriate companies against which
to measure your performance
 Data in balance sheets represent one date in the year and is not
indicative of performance for the whole year..
Limitations……..cont……..
7. Seasonality factor affecting business year ends
8. Calculation of averages distorts some results as we are not able
to calculate a true average and we can not have average for the
first year.
9. Different accounting methods used by different firms can lead to
different figures
10. Changes in Accounting policies may affect comparison of ratios
11. Most firms want to be better than average so just attaining
industry averages is not necessarily good
12. Inflation can significantly distort balance sheet figures.
13. “Window dressing techniques” employed by firms to make their
financial statements look stronger.
14. Some firms have both good and bad ratios making it difficult to
analyze the firms position.

In spite of their limitations, ratio analysis used intelligently and with

good judgment can provide useful insights into a firm’s
operations.
ACCOUNTING MODULE
WORKING CAPITAL MANAGEMENT
EFFICIENCY ANALYSIS

LECTURE
RECAP
 Cash Flow Ratios – Cash Flow Yield, Cash Flow to
Sales, Cash Flow to Assets, Free Cash Flows
 Evaluation of profitability
 Measure of profitability – the Profit Margin, Asset
Turnover, Return on Assets, Debt to Equity and
Return on Equity ratios.
 Long-term Solvency – Debt to Equity Ratio and
Interest Coverage Ratio
 Limitations of Ratio Analysis
Objective of WC Management
 to maintain the optimum balance of each of
the working capital components.
 includes making sure that funds are held as
cash in bank deposits for as long as and in
the largest amounts possible, thereby
maximizing the interest earned
 such cash may more appropriately be
"invested" in other assets or in reducing other
liabilities.
 Working capital management takes place on
two levels:
 Ratio analysis can be used to monitor overall
trends in working capital and to identify areas
requiring closer management
 The individual components of working capital
can be effectively managed by using various
techniques and strategies
 Managing working capital is a matter of
balance.
 A department must have sufficient cash on
hand to meet its immediate needs while
ensuring that idle cash is invested to the
organisation's best possible advantage.
 To avoid tipping the scale, it is necessary to
have clear and accurate reports on each of
the components of working capital and an
awareness of the potential impact of outside
influences
Remember
 Cash is king, especially at a time when fund raising
is harder than ever.
 Letting it slip away is an oversight that investors
should and would not forgive.
 Firms can manage cash in virtually all areas of
operations that involve the use of cash.
 The goal is to receive cash as soon as possible
while at the same time waiting to pay out cash as
long as possible.
 Cash flow can be a problem even when a
small business has numerous clients, offers a
superior product to its customers, and enjoys
a sterling reputation in its industry.
 Companies suffering from cash flow
problems have no margin of safety in case of
unanticipated expenses.
 They also may experience trouble in finding
the funds for innovation or expansion.
 Finally, poor cash flow makes it difficult to
hire and retain good employees.
Cash Management in Troubled Times
 Create a realistic cash flow budget that charts finances for both
the short term (30-60 days) and longer term (1-2 years).
 Redouble efforts to collect on outstanding payments owed to the
company.
 Offer small discounts for prompt payment.
 Consider compromising on some billing disputes with clients.
Closely monitor and prioritize all cash disbursements.
 Contact creditors (vendors, lenders, landlords) and attempt to
negotiate mutually satisfactory arrangements that will enable the
business to weather its cash shortage (provided it is a temporary
one).
 Liquidate superfluous inventory.
 Assess other areas where operational expenses may be cut
without permanently disabling the business, such as payroll or
goods/services with small profit margins.
Looking Beyond the Numbers

 Sound financial analysis involves more than

just calculating numbers
 Good analysis requires that certain
qualitative factors be considered when
evaluating a company.
 Some of the factors are summarized as
follows:
Factors to be considered
1. Are the company’s revenues tied to one key customer?
- If so, consider the effects on the performance if the customer
goes elsewhere
2. To what extent are the company’s revenues tied to one key
product?
- Lack of diversification increases risk. Consider the effects if
demand for that product goes down.
3. To what extent does the company rely on a single supplier?
- May lead to unanticipated shortages. What if something goes
wrong on the suppliers side?
Factors………cont……

4. What percentage of the company’s business is generated

overseas?
- Fluctuations in currency markets creates additional risks.
Potential stability of region is important
5. Competition
- Competition lowers prices and profit margins. Need to
consider the likely action of current competitors and new
entrants
6. Future Prospects- How much does the company invest in
R&D?
7. Legal and regulatory environment – changes in laws and
regulations have important implications for many industries
eg. Tobacco Industry, Banks, Telecommunications and
Electric Utilities.