CTP - Chapter 11 - Working Capital Metrics

Accounts Receivable (A/R) Balance Pattern

An A/ R balance pattern is used to monitor customer payment timing. An A/ R balance pattern specifies the percentage of credit sales during a time period (e.g., one month) that remain outstanding at the end of the current and each subsequent time period. A firm's collection history determines the normal balance pattern. Management evaluates any changes by comparing current patterns with historical norms. Balance patterns can also be used to project A/ R at the end of a period, measure collection efficiency, and forecast future cash collections.

Accounts Receivable (A/R) Aging Schedule

An aging schedule separates A/ R into current and past-due receivables using set periods (typically, 30-day increments). An aging schedule provides helpful information on working capital efficiency as the likelihood of the account being uncollected increases with the age of the account. Managers can apply an aging schedule to aggregate receivables or on a customer-by-customer basis. As compared to the DSO approach, an aging schedule is more indicative of trends as it illustrates a pattern of distribution, rather than just providing a single number representing an average.

Write-offs

A rise in write-offs could indicate the deterioration of A/ R quality.

Monitoring A/R at an Aggregate Level

A/ R should also be monitored on an aggregate level to identify the impact on overall firm liquidity and to determine the required level of external financing. Further, the analysis of aggregate receivables serves as the basis for forecasting future cash receipts.

Cash Conversion Cycle (CCC) Formula

Cash Conversion Cycle = Days' Inventory + Days' Receivables - Days' Payables

Cash Turnover Ratio Formula

Cash Turnover = 365 / Cash Conversion Cycle

Current Ratio Formula

Current Ratio = Total Current Assets / Total Current Liabilities

Days' Inventory (DI)

DI is calculated using inventory and cost of goods sold (COGS), which are taken from the balance sheet and income statement, respectively. Ending inventory is used here, although an average inventory figure is also commonly used. The COGS, rather than sales, is used in this formula because inventory is valued on the balance sheet at its purchase or manufacturing cost rather than at its selling price. The value indicates the average days it took the firm to sell its inventory. All else constant, a shorter DI is preferred.

Days' Payable (DP) Formula

DP = (Accounts Payable / Cost of Goods Sold) * 365

Days' Payable (DP)

DP is calculated as A/ P divided by COGS, and the result is then multiplied by 365 days. COGS is used in the denominator as A/ P reflects the cost paid for inventory. Year-end A/ P is used here, but some users average the A/ P balance from the two most recent fiscal periods. This value indicates the average days the firm carried COGS in A/P. That is, the average days it took the firm to repay A/P. To ensure that prudent payment practices are being used, the DP value should be compared to the trade credit terms provided by suppliers.

Days' Receivables (DR) Formula

DR = (Accounts Receivable / Revenues) * 365

Days' Receivables (DR)

DR represents the number of days of sales held in the form of A/ R. Accordingly, the period's ending value for A/ R is divided by revenues, and the result is then multiplied by 365. Note that revenues are used rather than COGS because A/ R is carried on the balance sheet based on the selling price. Year-end A/ R is used here, but some users average the A/ R balance from the two most recent fiscal periods. The value indicates the average days the firm held A/R during the period in question. This value for DR can be interpreted as the number of days required to convert a sale into a cash inflow.

Days' Sales Outstanding (DSO) Formula

DSO = Accounts Receivable / Average Daily Credit Sales for Period Accounts receivable is the balance at the end of the specific accounting period (e.g., 30 days, 90 days, 365 days). Daily credit sales is calculated by dividing total credit sales during the accounting period by the number of days in the accounting period.

Days' Inventory (DI) Formula

Days' Inventory = (Inventory / Cost of Goods Sold) *365

Days' Sales Outstanding (DSO)

Is one metric for measuring the quality of A/ R. DSO is calculated by dividing A/ R outstanding at the end of a fiscal period by the average daily credit sales for that period. This differs from DR, which is calculated using total sales rather than credit sales. Note that if there are no cash sales, then the two numbers are identical. DSO can be compared to stated credit terms, historic trends, or industry norms to indicate a company's overall collection efficiency. It may, however, be distorted by changing trends in sales volume or by strong sales seasonality.

Monitoring Individual A/R Accounts

It is important to monitor individual accounts in order to identify: 1. Errors or delays in the invoicing or payment process that are slowing collections 2. Customers that are intentionally delaying payment until follow-up is initiated 3. A change in financial condition that may alter a customer's ability to make timely payments, which might require the curtailment of future credit sales.

Higher Values Indicate

Overall, higher values for the current ratio, quick ratio, and NWC indicate that a firm has a stronger ability to cover its current obligations. However, it should be noted that it is not optimal for firms to have excessively high values for these metrics. This is because current assets earn a lower rate of return than fixed assets. Once the firm has an adequate base of current assets, additional investment in current assets lowers the overall return on assets, which translates into a lower profit per dollar of investment.

Past Due Date

The aging schedule should be calculated based on the "past-due date" (i.e., the date on which the payment actually becomes past due), not the invoice or mail date.

Quick Ratio (Acid Test Ratio)

is defined as the sum of cash, short-term investments, and accounts receivable, divided by total current liabilities. As with the current ratio, a higher value for the quick ratio implies less risk for creditors. The quick ratio is a more stringent measure of liquidity than the current ratio, as it excludes inventory due to that current asset's lower liquidity. The quick ratio also excludes prepaid expenses, which have little to no likelihood of converting to cash. By definition, the quick ratio will not exceed the current ratio.

Current Ratio

is defined as total current assets divided by total current liabilities. This measure is intended to represent the ratio of liquid (or current) assets that are expected to become cash in one year or less to short-term (or current) liabilities that are due in one year or less. That is, the ratio measures the degree to which a firm's current obligations are covered by current assets. A higher current ratio generally indicates less default risk for creditors.

Quick Ratio Formula

(Cash + Short-Term Investments + Accounts Receivable) / Total Current Liabilities

Annualized Cost of Trade Discount Formula

Annualized Cost of Trade Credit Discount = ((D / (100 - D)) * ((365 / (N - T)) D = Discount Percentage N = Net Period T = Discount Period The first term in the calculation, D/( 100 - D), represents the interest rate applicable to the discount period. The second term, 365/( N - T), annualizes the interest rate.

Average Past Due Formula

Average Past Due = DSO - Average Days of Credit Terms

Cash Turnover Ratio

Defined as the number of cash conversion cycles that a firm experiences per year.

Situations where it is economical to forgo the offered trade credit discount

If the buyer does not have cash available to take the discount, but has to borrow funds at an interest rate that exceeds the effective cost of the discount. If the buyer has enough operating cash to pay the A/ P by the discount date, but the buyer can earn a rate of return on its cash that exceeds the effective cost of the discount.

Net Working Capital

Is defined as current assets less current liabilities. NWC is not a ratio: it is an absolute measure of the dollar amount by which current assets exceed current liabilities.

Discount that would leave the seller indifference between the buyer's choice of payment timing

Indifferent Percentage = ((Credit Sale * (1 - D)) / 1 +((full days * (opportunity cost percentage / 365))

Net Working Capital Formula

NWC = Current Assets - Current Liabilities

Working Capital Management

Refers to the firm's use of current assets and current liabilities.

Net Benefit of Offering a Trade Credit Discount Calculations

Step 1: Discounted Amount = Credit Sale * (1 - Discount Amount) Step 2: i = Days in Discount Period * (Annual Interest / 365) Step 3: Present Value = Future Value / (1 + i) Step 4: Net Present Value = Present Value to the discount day power - Present Value to the non-discount day power

Improving the Cash Conversion Cycle (CCC)

The CCC can be improved by: 1. Shortening DI through careful purchasing and production scheduling, and by removing excess finished goods inventory. 2. Shortening DR by monitoring customer payment habits and reducing delinquencies. 3. Increasing DP by managing A/ P effectively through accepting supplier discounts only when it is economical (i.e., not paying earlier than is required).

Cash Conversion Cycle (CCC) Highlights

The CCC highlights the critical nature of monitoring the: Amount of time it takes to sell inventory Length of time between when a sale is made and when cash is collected Actual disbursement period.

Cash Conversion Cycle (CCC)

The CCC represents the time required to convert cash outflows associated with production into cash inflows through the collection of A/ R. In short, the CCC is calculated as the average age of inventory (days' inventory) plus the average age of A/ R (days' receivables) minus the average age of A/ P (days' payables).

Cost of offering a cash discount

The cost of offering a cash discount is the lower revenue per dollar of sales. This cost may be acceptable if the discount prompts increased sales. Regardless of sales growth, faster payments from customers allow the seller to more quickly reinvest the cash receipts.

Accounts Receivable Monitoring

To improve working capital efficiency, many firms actively monitor A/ R at both an individual account and aggregate level.

Fundamental Metrics

Used to assess the efficiency of working capital management. These include the current ratio, quick ration, and net working capital. These metrics collectively provide information regarding the firm's default risk (i.e., the risk of nonpayment by a borrower), which is why they are commonly referenced in debt covenants.