A model for working capital requirements and corporate liquidity management
Kiernan, Joseph K
A significant (and positive) development in corporate financial management over recent years has been an increased emphasis on liquidity and the management of operating cash flows. Reasons for this increased emphasis include economic recession, corporate restructuring activities, and the need to increase and conserve operating cash flaws to meet higher debt service requirements or finance more modern facilities. In the academic, as well as the professional, world old tools are being reassessed and new tools developed to aid the treasury professional in the efficient management of corporate cash resources. The purpose of this paper is to integrate two tools of liquidity management; the cash conversion period and the net liquid balance.
The Cash Conversion Period
Initially presented by Richards and Laughlin ( 1980); the cash conversion period is now routinely discussed in most corporate finance textbooks. (See for example, Brigham and Gapenski (1997), Moyer, McGuigan, and Kretlow (1998), and Gitman (1998.) The cash conversion period measures the number of days between the actual expenditure of the firm’s cash for the purchase of productive resources and the ultimate collection of cash from product sales. Incorporated within the cash conversion period model are management issues involving the control of inventories, the collection of receivables, and the timing of payments for productive resources such as materials and labor. In the cash conversion model, increases in the number of days a product remains in inventory, increases in the number of days required to collect receivables following the point of sale, and decreases in the number of days a firm takes to meet its trade credit obligations will increase the firm’s cash conversion period. The increased cash conversion period reflects additional resources required in the form of working capital to maintain the firm’s operations.
A weakness of the cash conversion period model is its inability to clearly convert the number of days in the conversion period to a dollar amount of needed working capital. Additionally, the model does not reflect the distinction between cash sales and credit sales. For instance, two firms may have the same receivables conversion period but have different credit sales/total sales ratios.
In the standard cash conversion period model (all else the same) both firms would have the.same cash conversion period. However, the firm with the lower credit sales/total sales ratio would clearly be in a better position to meet obligations as they come due since a larger portion of its sales are collected sooner and with greater certainty.
Further, the cash conversion period model does not reflect the effect of profitability on liquidity. As the model focuses on the length of time between the expenditure of resources to produce operating revenue and the actual receipt of the revenue, it fails to recognize that the revenue received will exceed the expenditure by the amount of profit earned. Since the profit represents additional resources available to meet obligations, profitability is clearly a contributing factor to overall corporate liquidity. As shown later, the gross profit margin and the credit sales/total sales ratio can be incorporated into the cash conversion period model. The modified cash conversion period can then be easily converted to dollar amount of working capital needed to sustain the firm’s operating cycle. This amount of net working capital required for operations (NWCROP) would then serve as input in an assessment of overall corporate liquidity.
Net Liquid Balance
Shulman and Cox (1985) and Shulman and Dambolena (1986) developed a useful tool for liquidity analysis known as Net Liquid Balance (NLB). Essentially, the NLB model recognizes that the firm’s ability to meet its obligations as they come due is not reflected by the firm’s total working capital, but by the amount of working capital remaining once the requirements of the firm’s operating cycle are met. Alternatively, the NLB is the difference between the firm’s immediately available cash resources and its non-operating, or negotiated, short-term debt. Empirical tests conducted by Shulman and Dambolena indicate the NLB to be a superior indicator of corporate liquidity when compared to more widely known indicators such as the quick ratio. A problem with the NLB model is that the NLB is a residual amount remaining after the working capital needed to sustain the firm’s operating cycle (NWCROP) is deducted from total working capital. Hence, a means of estimating the amount of working capital needed to sustain the operating cycle is needed to make liquidity analysis using NLB operational. As shown below, NWCROP can be estimated using the modified cash conversion period model and then used as an input to the NLB model thereby improving the effectiveness of the NLB model in assessing corporate liquidity.
A Modified Cash Conversion Period
The traditional cash conversion period (CCP) and its components can be presented as follows:
(1) CCP = ICP + RCP – PDP
Where: CCP = cash conversion period
ICP = inventory conversion period
RCP = receivables conversion period
PDP = payables deferral period
The modified cash conversion period (MCCP) is obtained by modifying the inventory conversion period to incorporate the gross profit margin and the receivables conversion period to incorporate the credit sales/total sales ratio.
The Modified Inventory Conversion Period
The Modified Cash Conversion Period and Working Capital Requirements
The MCCP/NWCROP Model: A Numerical Illustration
Exhibit 1 provides a numerical example using the MCCP/NWCROP model. Assuming hypothetical values for the components of the traditional cash conversion period, annual sales, gross profit margin, and the ratios of purchases and credit sales to total sales, the MCCP and NWCROP (using both the traditional CCP and the MCCP) is determined. Performing a sensitivity analysis of the firm’s sales, gross profit margin, and credit sales/sales ratio shows some interesting results.
Sales and Working Capital Requirements
Financial professionals and educators routinely warn of the liquidity dangers awaiting a firm that experiences rapid sales growth without proper financial planning and controls. The rising level of sales requires additional funding to support the inevitable increases in inventories and receivables that accompany growth. The positive relationship between sales and working capital requirements is shown in Figure 1. The slopes of the lines depicting the relationship are functions of the components of the firm’s cash conversion period and modified cash conversion period. Figure 1 also shows the difference in working capital requirements for a given level of sales when NWCROP is estimated using the MCCP as opposed to the traditional CCP. Using the traditional CCP to estimate NWCROP results in the firm overestimating its working capital requirements as sales grows. Using the data in Exhibit l, we see that the modified CCP estimates of working capital requirements are less than those indicated by the traditional CCP by almost 20%. Thus, incorporating the effects of the gross profit margin and the CS/S ratio result in a significant difference in the estimation of working capital requirements needed to support sales growth. For a given level of total working capital, a firm may have more resources available for non-operating purposes than is indicated by the traditional CCP approach. Hence, the use of the traditional CCP as a liquidity indicator may systematically underestimate the firm’s true ability to meet its obligations as they come due.
Working Capital Requirements and the CS/S Ratio
Figure 2 shows the relationship between NWCROP and the credit sales/total sales ratio (CS/S). As the CS/S ratio increases, additional working capital is required. This is intuitively obvious since a higher CS/S ratio results in more receivables for a given sales level. Working Capital Requirements and Profitability
Figure 3 shows the relationship between NWCROP and the firm’s gross profit margin. As the gross profit margin increases the need for working capital to support operations decreases. Incorporating profitability helps to make the cash conversion period a better indicator of liquidity. The traditional CCP failed to recognize that the cash inflow at the conclusion on the operating cycle is greater than the cash outflow at the beginning of the cash conversion period. The incremental amount of cash flow between the start and end of the cash conversion cycle is directly related to profitability. The modified CCP incorporates the effect of the additional cash resources made available by the generation of earnings from the firm’s operating cycle. Clearly, the more profitable the enterprise, the more cash resources generated from operations.
Corporate Liquidity, Working Capital Requirements and MCCP
The Net Liquid Balance approach to assessing corporate liquidity divides the firm’s total working capital into the portion required to sustain the firm’s operations and the firm’s surplus cash resources or Net Liquid Balance (NLB). A positive value for NLB indicates that the firm has sufficient cash resources to meet its short-term obligations without reducing the resources allocated to the operating cycle. A negative value for NLB indicates that the firm will have to acquire additional working capital or reduce the resources committed to the operating cycle to meet short-term obligations. If the components of the MCCP are considered to be at optimal levels, reducing resources committed to the operating cycle may result in lost sales, less operating efficiency, and/or a deterioration in relations with trade creditors. All of these are symptoms of a firm with liquidity problems.
Financial managers and analysts can use the NLB as a measure of the firm’s current or expected future liquidity. The level of working capital necessary to support operations (NWCROP) can be estimated for current or expected sales levels using optimal values for the components of MCCP. The desired level of NWCROP can then be compared to the firm’s actual net working capital. If desired NWCROP exceeds available working capital (NLB
The purpose of the paper is to integrate two tools of liquidity management; the cash conversion period and the net liquid balance. The traditional cash conversion model was modified to incorporate the effects of the firm’s profitability and credit sales/total sales ratio. The modified cash conversion period was then used to estimate the working capital needed to support the firm’s operating cycle (NWCROP). The optimal level of NWCROP, when compared with available working capital provides an indication of the surplus or deficit position of the firm with respect to available resources not committed to the operating cycle. A surplus or rising amount of available resources is an indicator of adequate or improving liquidity for the firm.
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Joseph J Kiernan, Ph.D., CCM, CFP is Assistant Professor of Economics and Finance at Fairleigh Dickinson University in Teaneck New Jersey. Dr. Kiernan may be contacted by calling 201-692-2000
Copyright Credit Research Foundation Third Quarter 1999
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