Chapter 1 The Role of Working Capital Answers to Questions:

1. The cash cycle refers to a continual flow of resources through different working capital accounts, which may occur for a firm due to differences in the timing of cash receipts and cash disbursements. As an example consider the case of a manufacturing firm. Over a production cycle, raw materials are purchased from suppliers and converted into finished goods, which are then sold to customers. During the production cycle, the firm may have to maintain inventories of raw materials, work-in-process, and finished goods. An immediate cash outflow may be required if the raw materials are purchased on a cash basis. If they are purchased on credit, the cash outflow is postponed and creates an accounts payable. Depending on the timing of the payments, the same may be paid by drawing on liquid reserves, or by borrowing, or, out of cash from sales. Other outflows may also be required for payments towards wages and salaries, utilities etc. which could result in the creation of working capital accounts such as accruals, deferrals etc. Usually cash inflows from sales occur later - the earliest being at the time of the sale if the finished goods are sold on a cash basis. However, quite often the finished goods are sold on credit, thus generating an accounts receivable, and resulting in a delayed cash inflow when the receivables are collected for cash. {Reference: Pages 14 and 15}. Cash flow diverges from profit primarily due to two reasons. First, profit is calculated after accounting for non-cash charges such as depreciation and amortization. Second, calculations of profit are usually on an accrual basis i.e. revenues are recognized at the time of sale and expenditures are recognized at the time of purchases of goods and/or services resulting in changes in working capital accounts. Thus, cash flow will be the same as profit only when noncash charges are zero, and, when there are no changes in the working capital accounts (or, rarely, the changes in the working capital accounts on a net basis are zero). {Reference: Page 8}. There are two basic aspects to managing the operations of a firm. First, a profitable operation must be ensured which implies mainly, for the working capital manager, managing the cost structure. Second, working capital accounts must be managed from a cash flow perspective to ensure a proper level of liquidity. {Reference: Pages 9 and 19}. Managers often use the five Cs to manage the accounts receivable which is created when customers are sold goods on credit. The five C's are: Character, Capacity to pay, Collateral, Capital, and, business Conditions. These help

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the credit manager in determining: who to give credit to, how much credit to give, and, the terms of credit. {Reference: Page 15}. 5. Collection float is the time from when a payment is sent to the firm and the time the firm finally receives cash from the payment. The existence of collection float slows down the receipt of cash by the firm. For example, if a check is mailed from Seattle to the firm in Miami, a long delay may occur due to the transit time in the post. Further, a delay may occur in getting the check cleared after it is deposited in the bank. {Reference: Pages 5 and 15}. Inventories usually consist of raw materials, work-in-process, and, finished goods. Generally, these inventory balances act as shock absorbers for various steps in a production cycle. Take finished goods inventory as an example. These inventory items are goods ready for sale. A firm may have a policy for determining the amount of inventory based on forecasted sales and concerns about product shortages at the retail level if sales are under-forecasted. Having extra stock can allow the firm to draw upon the inventory until the production can catch up to the higher than expected sales level. {Reference: Pages 15}. Disbursement float works impacts the cash cycle by delaying the time at which the cash actually leaves a firms bank account. Thus, disbursement float works in favor of the payer viz. the firm in this case. For example, if the firm mails a check from Boston, and drawn on a Boston bank, to a supplier (the payee) in Los Angeles (LA), the firm will not have to expend actual cash immediately. First, a certain amount of time will be taken in the mail for the check to reach the supplier in LA. The check has to be processed by the supplier and then deposited in the suppliers bank account in LA. The LA bank then routes the check back to the bank in Boston on which it is drawn. Only on the day that the check is presented to the Boston bank does the firm actually have to have cash in the bank account to cover the check. So, the firm could keep the cash invested until it is needed to cover the check. {Reference: Page 5}. If, on a cash flow timeline, the date that cash is disbursed comes before the date that cash is received on the cash flow time, there are various options available to the financial manager for funding the disbursement. First, the financial manager may have cash reserves available from raised capital or earlier operational cycles. Second, the financial manager might have accumulated a pool of short-term investments that could be liquidated to cover the disbursement. Third, the financial manager might have arranged for a credit line, or other short-term borrowings, so the borrowed funds could be used to meet the disbursement need. {Reference: Page 14}. Firms have working capital for various reasons. Some firms have held inventory as a shock absorber for inefficiencies in the production areas as well as for an inability to forecast supply of raw materials or sales of finished goods. Some firms hold receivables due to credit offered to buyers to make it convenient for customers to purchase products. Payables exist for a similar reason if a firm accepts credit from a supplier. {Reference: Pages 5 to 8}. A profitable firm can go bankrupt by not managing its operating cash flows properly so as to maintain enough liquidity. A deficit cash flow may occur due to due to a mismanaged working capital cycle such as one in which too many resources are tied up in inventory and/or if accounts receivables are not collected

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timely. Thus, cash resources may not be available to cover necessary disbursements. {Reference: Pages 5, 9, 13 and 14}.

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Solutions to Odd-Numbered Problems: Chapter 1

1. Calculating cash received. Cash Received = Sales Change in Accounts Receivable = Sales (Ending Receivables Beginning Receivables) Sales less a. b. c. 3. $2,000 $5,000 $2,500 Change in equals Accounts Receivable ($500 - $0) = ($1,500 - $900) = ($750 - $1,000) = Cash Received $1,500 $4,400 $2,750

Rockwall Enterprises, Inc. - developing a cash flow statement. Balance Sheet Cash Accounts Receivable Inventory Fixed assets Less: Accumulated Depreciation Total Assets Accounts Payable Operating Accruals Debt Common Stock Retained Earnings Total Liabilities 12/31/03 $500 $750 $400 $1,000 ($400) $2,250 $200 $300 $1,000 $500 $250 $2,250 12/31/04 $500 $2,000 $600 $1,000 ($700) $3,400 $950 $275 $1,000 $500 $675 $3,400 Change - $1,250 Cash Flow $7,750 $3,950

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Income Statement 1/01/04 - 12/31/04 Sales - Cost of goods sold = Gross profit -

Cash Flow Adjustment $9,000 - A/R $4,500 $4,500 - A/P + Inv

- $750 + $200 = - $550

Gross cash margin = $3,800 - Op Acc - Dep - ($25) - $300 = -$275

Operating expenses: Salaries etc. $3,500 Depreciation $300 $700

$3,525 $275

= Operating profit

Cash operating margin =

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- Interest - Taxes = Net profit b.)

$100 $175 $425

- Acc Interest - Acc Taxes - Def Taxes

$0 $0 $0

$100 $175 $0

Profit does not equal cash mainly due to non-cash expenses and changes in working capital accounts. In this the difference in the net profit of $425 and cash flow of $0 occurs for several reasons. First, the companys revenue was $9,000, but it only collected $7,750 from its customers. Then, it expensed COGS of $4,500 but only paid out cash of $3,950 due primarily to an increase in accounts payable. Finally, it expensed $3,800 for operations but paid out only $3,525 due to $300 of the expenses being for depreciation and operating accruals falling by $25. Brothers, Inc. - developing a cash flow statement. Balance Sheet 12/31/01 Cash Accounts receivable Inventory Fixed assets Less: Accumulated depreciation Total Assets Accounts payable Operating accruals Accrued Interest Deferred Taxes Debt Common stock Retained earnings $1,000 $1,500 $1,750 $3,000 ($800) $6,450 $1,250 $450 $0 $0 $2,750 $1,000 $1,000 $6,450 $2,000 $6,450 Balance Sheet 12/31/02 ($100) $1,850 $2,100 $3,500 ($900) $6,450 $800 $500 $50 $100 $2,000 $1,000

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a.)

Developing the cash flow statement Income Statement 1/01/04 - 12/31/04 Sales - Cost of goods sold = Gross profit Cash Flow Adjustment $9,000 - A/R $4,000 - A/P + Inv Change - $350 - ($450) + $350 $3,850 Cash Flow $8,650 $4,800

$5,000 Gross cash margin = - Op Acc - Dep

Operating expenses: Salaries etc. $2,900 Depreciation $100

- $50 - $100 = -$150 $1,000

$2,850

= Operating profit - Interest - Taxes = Net profit b.)

$2,000 Cash operating margin = $200 $800 $1,000 - Acc Interest - $50 - Def Taxes - $100

$150 $700 $150

Brothers, Inc. generated revenues of $9,000 but only collected $8,650. It expensed $4,000 for cost of sales, but paid out $4,800 in cash payments. It expensed $3,000 for operations but only paid out $2,850 in cash due to an increase in accruals and depreciation. It expensed $1,000 for interest and taxes but only paid out $850 due to accruals and deferrals resulting in an operating cash flow of $150. The company then paid down debt by $750 [= $2,000 - $2,750 = -$750] and bought fixed assets of $500 [= $3,500-$3,000 = $500]. Thus net cash flow was a deficit of $1,100 [= -$750-$500+$150 = -$1,100]. This deficit added to the beginning cash balance of $1,000 results in an ending cash balance of ($100) i.e. a deficit of $100.