Working Capital Basics Liquidity and the Cash Cycle

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Jul/Aug 2001

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Nothing is as crucial to a financially distressed company as cash in the bank, and
nothing affects cash as significantly as inefficient management of working capital. For
financially distressed companies, or those considering a chapter 11 bankruptcy filing,
cash and continued liquidity take on corporate life or death importance. Money tied
up in working capital is money that is not available to pay creditors or to fund
operations.

Working capital analysis has long been a tool used by financial analysts to understand
a company's available resources and prospects for growth. Used as a basis for
comparison to its industry peers or for gauging a company's period-on-period
performance, working capital ratios can reveal how efficiently a company is operating
its business. This article will explore the traditional components, definitions and
analyses of working capital and seek to understand their importance to financially
distressed companies.

<h3>Some Working-capital Ratios</h3>

Working capital and its components comprise the liquid assets and current obligations
of a company. These liquid assets and current obligations represent a company's ability
to meet its obligations on a timely basis. For the vast majority of companies, the
primary components of working capital are accounts receivable, inventory and accounts
payable.

The interplay of how and when a company pays for its inventory and monetizes its
sales is called its cash cycle. Maximizing the frequency of the cycle is crucial to
the efficient use of a company's working capital. Several working-capital ratios exist
that help provide an understanding of how efficiently a company is managing this cash
cycle. Three of these ratios are inventory turnover ratio, accounts receivable days and
accounts payable days. All of these ratios are easily calculated from any financial
statement.

<blockquote>
Inventory Turnover Ratio: Annualized Cost of Goods Sold (COGS)/Average Inventory
</blockquote>

Inventory turnover ratio calculates the number of times inventory is theoretically
turned or sold in a given period. The average inventory balance is calculated by
adding together the beginning and ending inventory balances found on a comparative balance
sheet and dividing by 2. The cost-of-goods-sold (COGS) figure comes from the
income statement and should be multiplied by the appropriate factor (e.g., 4 if
using quarterly figures) to annualize it. By dividing the inventory turns into 365
days in a year, the average days of inventory on hand can be calculated. By
increasing inventory turnover (reducing its days of inventory on hand), a company
minimizes its capital tied up in inventory and increases its cash availability.

<blockquote>
Accounts Receivable Days: Average Accounts Receivable/(Annualized Sales/365)
</blockquote>

Accounts receivable days, also commonly referred to as days sales outstanding
(DSO), represents the average number of days sales for which the company has not
yet been paid. As with the inventory calculation, the average receivables balance can
be derived from the balance sheets and should be based on gross receivables (i.e.,

before giving effect to any allowances for bad debts). The sales figure will come
from the income statement and should be annualized. Ideally, this calculation should
be based on credit sales, since these are the only sales that become receivables.
However, as this information is not always available, basing the calculation on total
sales at least provides a means for determining whether there has been improvement or
deterioration over time. As with inventory days on hand above, the fewer the days
of sales tied up in receivables, the quicker the cash cycle and the greater the
liquidity.

<blockquote>
Accounts Payable Days: Average Accounts Payable/(Annualized COGS/365)
</blockquote>

Accounts payable days, also commonly referred to as days payables outstanding
(DPO), represents the average number of days of inventory for which the company has
not yet paid its vendors. The payable and COGS figures come from the balance sheet
and income statement respectively and should be averaged/annualized. Ideally, this ratio
is calculated based on purchases, but this figure is rarely determinable from its
financial statements. Although COGS, particularly for manufacturing companies, often
includes labor and other direct or indirect costs, using COGS at least provides a
means for assessing a company's performance over time. Contrary to inventory days and
receivables days, which companies should strive to minimize, the higher the days in
accounts payables the greater the proportion of your inventory is being financed by
suppliers and hence the greater a company's cash availability.

The sum of the inventory days and receivable days minus payables days is often
referred to as days of working capital or the cash cycle. Other commonly used ratios
to gauge a company's working capital management include the current ratio (current
assets/current liabilities), which indicates how many dollars of readily convertible
capital is available for each dollar of current obligations, and sales to working
capital (annualized sales/average working capital), which gauges how many dollars of
sales a company can generate from each dollar of working capital (i.e., how
efficiently it utilizes its resources).

<h3>Working Capital—The Cash Cycle</h3>

The cash cycle refers to the timing between when a company makes an investment in
inventory and the time it actually collects cash with respect to sales of that
inventory. For any company, whether profitable, distressed or in bankruptcy, the
quicker it can get cash in the door the better.

A simple example will suffice to demonstrate the cash cycle; assume the following:

<blockquote>
Day 1: A company purchases $1M of raw materials under net-30-day terms

Day 15: The company sells the manufactured goods for $1.25M
 Day 30: The company must pay for the raw materials it purchased.
 Day 45: The company collects the accounts receivable for the sale of the goods.
</blockquote>

Now lets examine the how the cash cycle can impact working capital:

On Day 1, the company incurs a current liability by purchasing the raw materials.
At this time, the company also records inventory as a current asset on its books
in the same amount. Thus, net working capital is zero (this example ignores beginning
balances).

After converting the raw materials into finished goods and shipping them to stores,
the company is able to sell these goods on 30-day credit terms on Day 15. At
this time, the company eliminates the inventory recorded and books an account receivable
for the $1.25M sales price. The net working capital position is now a positive
$250K, representing the company's gross margin on the sale of the inventory.

On Day 30, the current liability comes due, and the company must pay its
supplier. In order to do this, the company needs cash. This cash may come from any
number of sources, including free cash flow from previous sales or borrowed capital.
In this example, we will assume the company incurred short-term borrowing to pay its
vendor. Thus net working capital remains at $250K.

Finally, on Day 45 the company collects its account receivable. At this time,
the company utilizes the cash collected to pay its short-term lender (including some
level of interest) and keeps the remaining generated working capital in the form of
cash to finance new purchases to generate new sales.

The length of this company's cash cycle, or its days of working capital, is 15
days: Fifteen days in inventory plus 30 days in receivables less 30 days terms
to the trade vendors.

Even when a company is able to finance purchases from its free cash flow, the
opportunity cost on the expended cash in the form of the time value of invested funds
can have a significant impact on a company's profitability. By shortening the cash
cycle, the company improves liquidity and ultimately profitability. Several ways exist
to achieve this end:

Shortening production/shipping cycles: Bringing inventory to market more quickly
generates sales sooner, increasing the likelihood that accounts receivable may be
collected closer to the date when the liability associated with the sold inventory comes
due. Although this is not often an option at financially strapped companies, obvious
inefficiencies may be eliminated and may produce a beneficial effect. Extended cash
cycles also point to slow moving and obsolete inventory. Although it may not have
been reflected in the company's income statement, the loss of value on such inventory
has occurred. Monetizing what value remains becomes the only alternative.

Negotiating increased terms with vendors: The ability to negotiate will largely
depend on the company demonstrating an ability to pay its debts as they come due.
Getting terms for companies in financial distress or in bankruptcy may almost seem an
impossibility—indeed, it is often during this time that vendors and even customers begin
to take advantage of a company's deteriorating financial condition—vendors by either
reducing terms to COD or even cash in advance, and customers by paying as late as
possible. In situations where vendors are reluctant to give credit terms to financially
distressed or bankrupt companies and customers take advantage of overworked collections
departments at these companies, the effects of a lengthening cash cycle become
exacerbated and can be disastrous.

Maximizing collections of accounts receivable: Perhaps this is easier said than
done; however, many customers appreciate discounts for faster payment because on their
own end they are trying to maximize profitability and cash flows as well. Many
companies overlook the option of offering sales discounts to customers in return for
quicker payment. Given that cash is the lifeblood of distressed and bankrupt entities,
these companies should be focused on maximizing the timing and receipts of cash first,
before focusing on income statement profitability. Like inventory, a long outstanding
receivable rarely increases in value over time. Another means to improving receivables
collections is to quickly address customer disputes (which are not uncommon in
distressed situations), since customers will often withhold all payments until a
dispute, no matter how insignificant, is resolved. Lastly, companies in distress can
explore the option of factoring receivables that, although often costly, may provide
a cost-effective alternative to short-term financing for the distressed company.

To readily see how vendor and customer terms impact the length of the cash cycle,
in the example above, consider the effects of negotiating additional five-day terms
from vendors and by offering an increased 2 percent discount for credit sales paid
in 10 days (assume that on average 25 percent of the company's customers take
advantage of the discount).

For our company, this equates to narrowing the cash cycle from 15 days to five
because the sales would, on average, be collected on Day 40, while the vendor
would be paid on Day 35. In the context of a bankruptcy and a weekly
debtor-in-possession (DIP) budget or budget for continued use of cash collateral,
the timing effects of such a measure can be significant and more beneficial than the
2 percent of cash foregone.

<h3>Some Other Useful Applications of Working Capital Ratios</h3>

Budgeting. Using the basic ratios defined above and a company's financial statements,
the components of a company's cash cycle may be utilized in preparing budgets. Assume
the following information was available in a company's financial statements:

<ul>
<li>Annual Sales: $50M
</li><li>Accounts Receivable Balance (beginning and ending): $4.5M
</li><li>Beginning Inventory: $6M
</li><li>Ending Inventory: $4M
</li><li>Costs of Goods Sold: $38.5M

</li><li>Accounts Payable (beginning and ending): $3.5M
</li></ul>

Given these balances, we can calculate the various ratios and estimate the timing of
cash receipts and disbursements with respect to sales and inventory.

<ul>
<li>Inventory Days: 365/($38.5M/(($6M+ $4M)/2))=48 Days
</li><li>Accounts Payable Days: $3.5M/ ($36.5M/365)=35 Days
</li><li>Accounts Receivable Days: $4.5M/ ($50M/365)=33 Days
</li></ul>

When budgeting sales, we may reflect cash on average as being collected 33 days from
date of sale. Inventory requirements can be forecasted based on projected sales and
the inventory turnover of 48 days, and payment of financed inventory as occurring
35 days from date of purchase. These three simple ratios can thus form the basic
outline for a projected cash budget.

<h3>Working Capital and Fraudulent Conveyances under Bankruptcy</h3>

Statute. The Bankruptcy Code provides that in order to demonstrate evidence of a
fraudulent conveyance, one must demonstrate, among other things, that the
transaction either took place while the debtor was insolvent, or that it left the
debtor with insufficient capital for paying its bills as they came due, and thus
directly precipitated the debtor's insolvency. For this reason, working capital has
been focused on as one aspect representing the ability of a company to meet its
obligations as they come due. Again, we look to the balance sheet to understand the
company's working-capital requirements.

Typical analyses in this respect include a review of historical levels of working
capital both prior and subsequent to the transaction in question. Further, assets of
questionable recovery may be scrutinized for exclusion from measures of liquidity. While
the highest level analysis would involve simply adding or subtracting the average working
capital requirement of the acquired or disposed-of segment of business, sometimes the
nature of the transaction itself may not permit such a comparison of working capital.
This is the case when a transaction significantly alters the size or nature of the
surviving company.

Such an example might be if a transaction were to double or triple the size of
a company in terms of sales, change its gross margin, or allow the post-transaction
company to obtain better terms with creditors by nature of increased volume or a new
brand equity.

In these cases, the use of the ratios described before becomes applicable in
analyzing the working-capital requirements. The first steps would involve understanding
industry standards with regard to accounts receivable and payable payment terms, as
well as inventory turns. Given average industry turnover ratios with respect to
accounts receivable, accounts payable and inventory, we can estimate working-capital
requirements from projected sales and gross margin figures of the post-transaction
company. Assume the following:

<ul>
<li>Projected sales of the new company of $100M
</li><li>Industry Averages:
</li><li>Gross Margin 12.5%
</li><li>Inventory Turns=2.5 annually
</li><li>Average Days Sales O/S=30
</li><li>Average Days Payable=20
</li></ul>

The calculated working capital requirements would be as follows:

<ul>
<li>$100M in sales assumes cost of goods sold of $89M annually (gross margin)
</li><li>$89M of COGS equates to an average inventory balance of 35.6M (inventory
turns ratio)
</li><li>$100M in sales equates to $8.2M in accounts receivable (DSO)

</li><li>$89M of purchases equates to $4.9M in accounts payable (average payables
in days)
</li></ul>

Thus, the net working capital requirements of the post-transaction entity based
on industry averages would be current assets of $43.8M and current liabilities
of $4.9M, or a net working capital position of $39M, all other things
constant. While this example is a very simplified one, it demonstrates once again
the usefulness of the three basic working-capital ratios.

<h3>Conclusion</h3>

The importance of working capital cannot be overstated. The effectiveness of managing
it can fund growth opportunities or weigh down performance. For the distressed
company, how well it is managed can mean the difference between having a future or
not. Working capital analysis, even in a changing economy, continues to provide a
basis for both simple and sophisticated financial analysis, and these ratios are useful
tools for any restructuring consultant.

Journal Authors

Steven R. Korf

Thomas A. Korf

Journal Date

Sunday, July 1, 2001 - 12:00

Bankruptcy Rule

2001