Module 2:

Managing Corporate Liquidity

Net Working Capital Components
CA CL
Cash
Mkt. Sec A/P
A/R N/P
Inventory CMLTD
Prepaid Accruals
CA CL
Cash
Mkt. Sec A/P
A/R N/P
Inventory CMLTD
Prepaid Accruals
CA CL
Cash
Mkt. Sec A/P
A/R N/P
Inventory CMLTD
Prepaid Accruals
NWC = CA - CL WCR = A/R + INV + Pre A/P - Accruals NLB = Cash + M/S N/P - CMLTD
Net Working Capital = Working Capital Requirements + Net Liquid Balance
Legend:
CA = Current Assets NWC = Net Working Capital
CL = Current Liabilities WCR = Working Capital Requirements
Mkt. Sec. = Marketable Securities Pre = Prepaid
A/R = Accounts Receivable NLB = Net Liquid Balance
A/P = Accounts Payable
N/P = Notes Payable
CMLTD = Current Maturing Long Term Debt
Net Working Capital Requirements
Index of working capital needs
Spontaneous uses/sources of funds over
operating cycle
Expands or contracts with sales
If seasonal , working capital is financed with
Net Liquid Balance (NLB) or short term
borrowings
Net Working Capital Requirements
If permanent due to growth, finance with long
term capital
Negative number means cash cycle is a source
of financing
Net Liquid Balance
Measure of liquidity rather than solvency
Current funds that are available to finance
short term needs
Negative number indicates need for external
financing which means reduced financial
flexibility
Cash Conversion Cycle
Dr. Pepper Manufacturing
Corp. is a diversified
manufacturing company.
Determine the companys
2013 operating cycle and the
cash cycle after computing
the appropriate ratios for
inventory, receivables and
payables.
Cash Conversion Period
Inventory Stocked Inventory Sold
Cash Received
Days Inventory Held
Days Sales Outstanding
Days Payable Outstanding Cash Conversion Period
Cash Disbursed
Cash Conversion Period = Days Inventory Held
+
Days Sales Outstanding
-
Days Payable Outstanding
Cash Conversion Cycle
2013 2012
Assets
Current Assets
Cash $ 500,000 $ 500,000
Marketable Securities (at cost) $ 500,000 $ 450,000
Accounts Receivable less allowance for bad
debts
$ 2,000,000 $ 1,600,000
Inventories $ 3,000,000 $ 2,000,000
Total current assets $ 6,000,000 $ 4,550,000
Dr. Pepper Manufacturing Corporation Balance Sheet
Cash Conversion Cycle
2013 2012
Liabilities
Current Liabilities
Accounts payable $ 1,000,000 $ 750,000
Notes payable $ 1,500,000 $ 500,000
Accrued expenses payable $ 250,000 $ 225,000
Taxes payable $ 250,000 $ 225,000
Total current liabilities $ 3,000,000 $ 1,700,000
Dr. Pepper Manufacturing Corporation Balance Sheet
Cash Conversion Cycle
2013 2012
Consolidated Income Statement
Net Sales $ 11,500,000 $ 10,700,000
Cost of sales and operating expenses:
Cost of goods sold $ 8,200,000 $ 7,684,000
Depreciation $ 300,000 $ 275,000
Selling and administrative expenses $ 1,400,000 $ 1,325,000
Operating profit $ 1,600,000 $ 1,416,000
Dr. Pepper Manufacturing Corporation Income Statement
Cash Conversion Cycle
Compute average inventory first
Ave. Inventory = $ 3 million + $ 2 million
2
= $ 2.5 million
Cash Conversion Cycle
2013 2012
Assets
Current Assets
Cash $ 500,000 $ 500,000
Marketable Securities (at cost) $ 500,000 $ 450,000
Accounts Receivable less allowance for bad debts $ 2,000,000 $ 1,600,000
Inventories $ 3,000,000 $ 2,000,000
Total current assets $ 6,000,000 $ 4,550,000
Dr. Pepper Manufacturing Corporation Balance Sheet
Cash Conversion Cycle
Compute Inventory Turnover Ratio
Inventory Turnover Ratio = Cost of Goods
Ave. Inventory
= $ 8.2 million
$ 2.5 million
= 3.3
This means an inventory cycle of 3.3 times per year
Cash Conversion Cycle
2013 2012
Consolidated Income Statement
Net Sales $ 11,500,000 $ 10,700,000
Cost of sales and operating expenses:
Cost of goods sold $ 8,200,000 $ 7,684,000
Depreciation $ 300,000 $ 275,000
Selling and administrative expenses $ 1,400,000 $ 1,325,000
Operating profit $ 1,600,000 $ 1,416,000
Dr. Pepper Manufacturing Corporation Income Statement
Cash Conversion Cycle
Compute for Days in Inventory
Days in Inventory = 365 days
Inventory Turnover Ratio
= 365 days
3.3
= 110.6 days
This means inventory cycle is around 110 days
Cash Conversion Cycle
Compute for Average Accounts Receivable and Average
Receivable Turnover
Ave. Accounts Receivable = $ 2.0 million + $ 1.6 million
2
= $ 1.8 million
Ave. Receivable Turnover = Credit Sales*
Ave. Accounts Receivable
= $ 11.5 million
$ 1.8 million
= 6.4
*Assumes company has no cash sales
Cash Conversion Cycle
2013 2012
Assets
Current Assets
Cash $ 500,000 $ 500,000
Marketable Securities (at cost) $ 500,000 $ 450,000
Accounts Receivable less allowance for bad
debts
$ 2,000,000 $ 1,600,000
Inventories $ 3,000,000 $ 2,000,000
Total current assets $ 6,000,000 $ 4,550,000
Dr. Pepper Manufacturing Corporation Balance Sheet
Cash Conversion Cycle
2013 2012
Consolidated Income Statement
Net Sales $ 11,500,000 $ 10,700,000
Cost of sales and operating expenses:
Cost of goods sold $ 8,200,000 $ 7,684,000
Depreciation $ 300,000 $ 275,000
Selling and administrative expenses $ 1,400,000 $ 1,325,000
Operating profit $ 1,600,000 $ 1,416,000
Dr. Pepper Manufacturing Corporation Income Statement
Cash Conversion Cycle
Compute for Days in Receivable
Days in Receivables = 365 days
Ave. Receivable Turnover
= 365 days
6.4
= 57 days
Cash Conversion Cycle
Compute for Average Payables
Ave. Payables = $ 1.0 million + $ 0.75 million
2
= $ 0.875 million
Accounts Payable Deferral Period = Cost of Goods Sold
Average Payables
= $ 8.2 million
$ 0.875 million
= 9.4
Cash Conversion Cycle
2013 2012
Consolidated Income Statement
Net Sales $ 11,500,000 $ 10,700,000
Cost of sales and operating expenses:
Cost of goods sold $ 8,200,000 $ 7,684,000
Depreciation $ 300,000 $ 275,000
Selling and administrative expenses $ 1,400,000 $ 1,325,000
Operating profit $ 1,600,000 $ 1,416,000
Dr. Pepper Manufacturing Corporation Income Statement
Cash Conversion Cycle
2013 2012
Liabilities
Current Liabilities
Accounts payable $ 1,000,000 $ 750,000
Notes payable $ 1,500,000 $ 500,000
Accrued expenses payable $ 250,000 $ 225,000
Taxes payable $ 250,000 $ 225,000
Total current liabilities $ 3,000,000 $ 1,700,000
Dr. Pepper Manufacturing Corporation Balance Sheet
Cash Conversion Cycle
Compute for Days in Payables
Days in Payables = 365 Days
Accounts Payable Deferral Period
= 365 Days
9.4
= 38.8 days
Cash Conversion Cycle
Compute for Operating Cycle and Cash Cycle
Operating Cycle = Days in Inventory + Days in Receivable
= 110.6 days + 57 days
= 167.6 days
Cash Cycle = Operating Cycle Days in Payables
= 167.6 days 38.8 days
= 128.8 days
Current Liquidity Index
Current Liquidity Index
= Cash Assets + Cash Flow From Operations
Notes Payable + Current Maturing Long Term Debt
Measuring Liquidity:
Alternative Liquidity Measures
Comprehensive liquidity index (CLI)
is an adjusted current ratio.
Liquidity weighted version of the current ratio.
Traditional current ratio treats all assets and
liabilities as being of equal degree of liquidity.
CLI avoids this by weighing each current asset or
current liability based on its turnover or nearness
to cash
The accounts receivable, inventory, accounts
payable and accrued expenses are adjusted by a
turnover factor.
Measuring Liquidity:
Alternative Liquidity Measures
Comprehensive liquidity index
Each current asset or liability is multiplied by one,
minus the inverse of the of the assets or liabilitys
turnover ratio.
Accounts receivable x [ 1 ( 1/arto)]
In cases of more than one turnover required to
generate cash from the asset, the inverse of each
of these ratios is subtracted.
Inventory x [1 (1/arto) (1/invto)]
Comprehensive Liquidity Index
Comprehensive Liquidity Index = Adjusted Current Asset
Adjusted Current Liability
Comprehensive liquidity index considers the degree
of liquidity of current assets and time to repay
current liabilities
Comprehensive Liquidity Index
Specific weight is assigned to
each current asset
considering their liquidity
degree and their adjusted
amount is calculated
A coefficient of one is
assigned to cash and short
term investments due to
their high liquidity quality
and their weight does not
need to be adjusted
Comprehensive Liquidity Index
Accounts receivable is adjusted
Adjusted Accounts Receivable = Average Accounts Receivable * [1 (1 /Accounts Receivable Turnover)]
Comprehensive Liquidity Index
Compute for Average Accounts Receivable and Average
Receivable Turnover
Ave. Accounts Receivable = $ 2.0 million + $ 1.6 million
2
= $ 1.8 million
Ave. Receivable Turnover = Credit Sales*
Ave. Accounts Receivable
= $ 11.5 million
$ 1.8 million
= 6.4
*Assumes company has no cash sales
Comprehensive Liquidity Index
2013 2012
Assets
Current Assets
Cash $ 500,000 $ 500,000
Marketable Securities (at cost) $ 500,000 $ 450,000
Accounts Receivable less allowance for bad
debts
$ 2,000,000 $ 1,600,000
Inventories $ 3,000,000 $ 2,000,000
Total current assets $ 6,000,000 $ 4,550,000
Dr. Pepper Manufacturing Corporation Balance Sheet
Comprehensive Liquidity Index
Inventory is adjusted
AINV = INV * [1 (1/ARTO) (1/INVT)]
Adjusted Inventory = Average Inventory * [1 (1 /Accounts Receivable Turnover) (1/Inventory Turnover Ratio)]
AINV = Adjusted Inventory
INV = Average Inventory
ARTO = Accounts Receivable Turnover Ratio
INVT = Inventory Turnover Ratio
Comprehensive Liquidity Index
Compute for Average Accounts Receivable and Average
Receivable Turnover
Ave. Accounts Receivable = $ 2.0 million + $ 1.6 million
2
= $ 1.8 million
Ave. Receivable Turnover = Credit Sales*
Ave. Accounts Receivable
= $ 11.5 million
$ 1.8 million
= 6.4
*Assumes company has no cash sales
Comprehensive Liquidity Index
2013 2012
Assets
Current Assets
Cash $ 500,000 $ 500,000
Marketable Securities (at cost) $ 500,000 $ 450,000
Accounts Receivable less allowance for bad debts $ 2,000,000 $ 1,600,000
Inventories $ 3,000,000 $ 2,000,000
Total current assets $ 6,000,000 $ 4,550,000
Dr. Pepper Manufacturing Corporation Balance Sheet
Comprehensive Liquidity Index
Compute average inventory first
Ave. Inventory = $ 3 million + $ 2 million
2
= $ 2.5 million
Comprehensive Liquidity Index
2013 2012
Assets
Current Assets
Cash $ 500,000 $ 500,000
Marketable Securities (at cost) $ 500,000 $ 450,000
Accounts Receivable less allowance for bad
debts
$ 2,000,000 $ 1,600,000
Inventories $ 3,000,000 $ 2,000,000
Total current assets $ 6,000,000 $ 4,550,000
Dr. Pepper Manufacturing Corporation Balance Sheet
Comprehensive Liquidity Index
Compute Inventory Turnover Ratio
Inventory Turnover Ratio = Cost of Goods
Ave. Inventory
= $ 8.2 million
$ 2.5 million
= 3.3
This means an inventory cycle of 3.3 times per year
Comprehensive Liquidity Index
2012 Amount Adjusted
Weight
Adjusted
Amount
Assets
Current Assets
Cash $ 500,000 100 % $ 500,000
Marketable Securities (at cost) $ 500,000 100 % $ 500,000
Average Accounts Receivable (AR) less allowance
for
bad debts
($ 2,000,000 +
$ 1,600,000)/2
= $ 1,800,000
Adj. AR = Ave.
AR x [( 1
1/ARTO)]
$ 1,800,000 x
[( 1
1/ARTO)]
Average Inventories (INV) ($ 3,000,000 +
$ 2,000,000)/2
= $ 2,500,000
Adj. INV =
Ave. INV x [( 1
1/ARTO)
(1/INVT)]
$ 2,50,000 x
[( 1
1/ARTO)
(1/INVT)]
Total current assets $ xxxxxxxx.00
Note:
Adj. AR = Adjusted Accounts Receivable
Ave. AR = Average Accounts Receivable
ARTO = Accounts Receivable Turnover Ratio
Adj. INV = Adjusted Inventory
Ave. INV = Average Inventory
INVT = Inventory Turnover Ratio
Dr. Pepper Manufacturing Corporation Balance Sheet
Comprehensive Liquidity Index
Specific weight is assigned to
each current liabilities
considering their timing of
repayment and their
adjusted amount is
calculated
Comprehensive Liquidity Index
Accounts Payable is adjusted
AAP = AP * [1 (1/APT)]
APT = PUR/AP
Adjusted Inventory = Average Inventory * [1 (1 /Accounts Receivable Turnover) (1/Inventory Turnover Ratio)]
AAP = Adjusted Accounts Payable
AP = Average Accounts Payable
APT = Accounts Payable Turnover Ratio
PUR = Total purchases
Comprehensive Liquidity Index
Compute for Average Payables
Ave. Payables = $ 1.0 million + $ 0.75 million
2
= $ 0.875 million
Accounts Payable Deferral Period = Cost of Goods Sold
also called Accounts Payable Turnover Average Payables
= Total Purchases
Average Accounts Payables
= $ 8.2 million
$ 0.875 million
= 9.4
Comprehensive Liquidity Index
2013 2012
Consolidated Income Statement
Net Sales $ 11,500,000 $ 10,700,000
Cost of sales and operating expenses:
Cost of goods sold $ 8,200,000 $ 7,684,000
Depreciation $ 300,000 $ 275,000
Selling and administrative expenses $ 1,400,000 $ 1,325,000
Operating profit $ 1,600,000 $ 1,416,000
Dr. Pepper Manufacturing Corporation Income Statement
Comprehensive Liquidity Index
2013 2012
Liabilities
Current Liabilities
Accounts payable $ 1,000,000 $ 750,000
Notes payable $ 1,500,000 $ 500,000
Accrued expenses payable $ 250,000 $ 225,000
Taxes payable $ 250,000 $ 225,000
Total current liabilities $ 3,000,000 $ 1,700,000
Dr. Pepper Manufacturing Corporation Balance Sheet
Comprehensive Liquidity Index
Other components of liabilities can be adjusted by the
same method
Comprehensive Liquidity Index
2013 Amount Adjusted Weight Adjusted Amount
Liabilities
Current Liabilities
Average Accounts Payable ($ 1,000,000 +
$ 750,000)/2
= $ 875,000
Adj. AP = Ave. AP x [1
(1/APT)]
$ 875,000 x [( 1 1/APT)]
Average Notes Payable ($ 1,500,000 +
+ $ 500,000)/2
= $ 1,000,000
Adj. NP =
Ave. NP x [ 1 (1/NPT)]
$ 1,000,000 x
[ 1 (1/APT) (1/NPT)]
Average Accrued Expenses
payable
($ 250,000 +
$ 225,000)/2
= $ 237.50
Adj. AEP =
Ave. AEP x [ 1 (1/AEPT)]
$ 237,500
x [ 1 (1/APT) (1/AEPT)]
Taxes Payable ($ 250,000 +
$ 225,000)/2
= $ 237.50
Adj. TP = Ave. TP x [ 1
(1/TPT)]
$ 237,500 x
[ 1 (1/APT) (1/TPT)]
Total current liabilities $ xxxxxxx.00
Dr. Pepper Manufacturing Corporation Balance Sheet
Note:
Adj. AP = Adjusted Accounts Payable = Ave. AP x [1 (1/APT)]
Ave. AP = Average Accounts Payable
APT = Accounts Payable Turnover Ratio = Total Purchases/ Ave. Accounts Payable
ANP = Adjusted Notes Payable = Ave. Notes Payable x [1 (1/NPT)]
NPT = Notes Payable Turnover
AAEP = Adjusted Accrued Expenses Payable = Ave. Accrued Expenses Payable x [ 1 (1/AEPT)]
AEPT = Accrued Expenses Payable Turnover
ATP = Adjusted Taxes Payable = Ave. Taxes Payable x [1 (1/TPT)]
TPT = Taxes Payable Turnover
Comprehensive Liquidity Index
Mc. Ilhenny Co. has the following short term balance sheet
below:
Its account receivable turnover ratio is 20, while its inventory
turnover ratio is 12.
Assets
Current Assets
Cash $ 15,000,000
Average Accounts Receivables $ 50,000,000
Average Inventories $ 75,000,000
Total current assets $ 140,000,000
Comprehensive Liquidity Index
Mc. Ilhenny Co. has the following short term balance sheet
below:
Its accounts payable turnover ratio is 3.64, while its wages
payable turnover ratio is 8.33.
What is its comprehensive liquidity index and its
current ratio?
Liabilities
Current Liabilities
Average Accounts Payable $ 110,000,000
Average Wages Payable $ 60,000,000
Total current liabilities $ 170,000,000
Comprehensive Liquidity Index
Amount Adjusted Weight Adjusted Amount
Assets
Current Assets
Cash $ 15,000,000 100 % $ 15,000,000
Average Accounts Receivables (AR) $ 50,000,000 Adj. AR = Ave. AR x [(
1 1/ARTO)]
$ 50,000,000 x [( 1
1/20)]
= $ 47,500,000
Average Inventories (INV) $ 75,000,000 Adj. INV = Ave. INV x
[( 1 1/ARTO)
(1/INVT)]
$ 75,00,000 x ( 1
1/20) (1/12)]
= $ 65,000,000
Total adjusted current assets $ 127,500,000
Note:
Adj. AR = Adjusted Accounts Receivable
Ave. AR = Average Accounts Receivable
ARTO = Accounts Receivable Turnover Ratio
Adj. INV = Adjusted Inventory
Ave. INV = Average Inventory
INVT = Inventory Turnover Ratio
Comprehensive Liquidity Index
2013 Amount Adjusted Weight Adjusted Amount
Liabilities
Current Liabilities
Average Accounts Payable $ 110,000,000 Adj. AP = Ave. AP x [1
(1/APT)]
$ 110,000,000 x [( 1 1/3.64)]
= $ 79,750,000
Average Wages Payable $ 60,000,000 Adj. NP =
Ave. NP x [ 1 (1/NPT)]
$ 60,000,000 x
[ 1 (1/3.64) (1/8.33)]
= $ 52,800,000
Total current liabilities $ 132,550,000
Comprehensive Liquidity Index
Comprehensive Liquidity Index = Adjusted Current Asset
Adjusted Current Liability
= $ 127,500,000
$ 132,550,000
= 0.96
Current Ratio = ( $ 15,000,000 + $ 50,000,000 + $ 75,000,000)
($ 110,000,000 + $ 60,000)
= 0.82
Measuring Liquidity:
Alternative Liquidity Measures
Lambda = Liquid resources + Expected cash flow
Uncertainty of cash flow during analysis horizon
= Cash Flow at beginning of month + Cash Flow during the month
+ Unused Short Term Borrowing Facility
Standard deviation or Cumulative degree of fluctuation from beginning of
the year up to that point
Lambda
Lambda
= Initial Liquid Reserve + Total Anticipated Net Cash Flow During Analysis
Horizon
Uncertainty of net cash flow during analysis horizon
Initial Liquid Reserve = Cash Balances + Marketable Securities/Short
Term Investments + Available Unused Credit Lines but
not inventory and receivables
Expected Cash Flow = Net Cash Flow Expected to be received or paid during
the analysis period (the difference between cash receipts and
disbursements)
Uncertainty of net cash flow during analysis horizon = standard deviation of
the net cash flow expectation
Measuring Liquidity:
Alternative Liquidity Measures
Lambda Index
Liquid resources include cash, marketable securities, and
unused credit lines.
Expected cash flow includes any expected planned
financing and investment as well as net cash from
operation from operations for the time period of the
analysis.
This term can be either positive or negative.
Lambda Index
Helps a company
forecasts where it
will have adequate
cash and credit to
survive or not
enough, and will
become insolvent
and go bankrupt
Lambda Index
Measures the
uncertainty about
the companys
future cash flows
using standard
deviation of those
cash flows
Lambda Index
The numerator of the
Lambda Index
measures total cash
available over time,
while the
denominator
measures expected
volatility of cash
Lambda Index
The higher the
Lambda value
obtained, the
smaller the chance
that the company's
cash requirements
will exceed its cash
on hand
Lambda Index
Lambda Index
model has proven
itself statistically
superior to both
bond rating models
and Altman's Z-
score bankruptcy
model in various
studies of its
predictive accuracy
Lambda Index
The Lambda Index can
be used to estimate the
probability of default
since it measures the
viability of the current
liquidity reserve of a
company
Lambda Index
A Lambda index of 15 is
considered safe, while
index below 2 means the
company is in serious
trouble
A Lambda index of 1.64
means there is a chance
of one in 20 that cash
requirements will exceed
cash on hand
Lambda Index
A Lambda index of 3.00
means there is a chance
of one in 1,000 that cash
requirements will exceed
cash on hand
A Lambda index of 3.29
means there is a chance
of one in 2,000 that cash
requirements will exceed
cash on hand
Lambda Index
A Lambda index of 3.90
means there is a chance
of one in 20,000 that cash
requirements will exceed
cash on hand