Introductory Corporate Finance: Working Capital Management Cash Management Reasons for Holding Cas Cash Management Techniques

What This Is

Cash management is the process of managing a company's cash inflows and outflows to ensure sufficient liquidity and minimize the need for external financing. Effective cash management is crucial for a company's financial health and stability. For example, consider Tesla, Inc., which generated $1.4 billion in cash from operations in 2020, but also had $1.2 billion in cash outflows for capital expenditures. By managing its cash effectively, Tesla can maintain its financial flexibility and invest in growth opportunities.

Key Formulas & Models

• Cash Conversion Cycle (CCC) = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) - Days Payable Outstanding (DPO): measures the length of time a company holds its inventory, sells its products or services, and pays its suppliers.
• Days Inventory Outstanding (DIO) = (Average Inventory / Cost of Goods Sold) x 365: measures the average number of days a company holds its inventory.
• Days Sales Outstanding (DSO) = (Average Accounts Receivable / Sales) x 365: measures the average number of days a company takes to collect its accounts receivable.
• Days Payable Outstanding (DPO) = (Average Accounts Payable / Cost of Goods Sold) x 365: measures the average number of days a company takes to pay its accounts payable.
• Cash Flow from Operations (CFO) = Net Income + Depreciation + Amortization - Change in Working Capital: measures the cash generated from a company's core operations.
• Cash Flow from Investing (CFI) = Capital Expenditures - Proceeds from Sale of Assets: measures the cash used or generated from a company's investments in assets.
• Cash Flow from Financing (CFF) = Net Borrowing - Dividends Paid: measures the cash used or generated from a company's financing activities.
• Free Cash Flow (FCF) = CFO - Capital Expenditures: measures the cash generated from a company's core operations after investing in assets.
• Sustainable Growth Rate (SGR) = ROE x (1 - Retention Ratio): measures the maximum rate at which a company can grow without needing external financing.
• Degree of Operating Leverage (DOL) = (Q x (P - V)) / (Q x (P - V) - F): measures the sensitivity of a company's EBIT to changes in sales.

Step-by-Step Calculation

1. Calculate the cash conversion cycle (CCC) by adding the days inventory outstanding (DIO) and days sales outstanding (DSO), and subtracting the days payable outstanding (DPO).
2. Calculate the free cash flow (FCF) by subtracting the capital expenditures from the cash flow from operations (CFO).
3. Calculate the sustainable growth rate (SGR) by multiplying the return on equity (ROE) by (1 - retention ratio).
4. Calculate the degree of operating leverage (DOL) by dividing the product of the quantity (Q) and the difference between the price (P) and the variable cost (V) by the product of the quantity (Q) and the difference between the price (P) and the variable cost (V), minus the fixed cost (F).
5. Calculate the cash flow from operations (CFO) by adding the net income, depreciation, and amortization, and subtracting the change in working capital.
6. Calculate the cash flow from investing (CFI) by subtracting the proceeds from the sale of assets from the capital expenditures.

Common Mistakes

• Mistake: Using the book value of debt instead of the market value of debt in the weighted average cost of capital (WACC) calculation.
• Correction: Use the market value of debt to reflect the current market conditions and the company's creditworthiness.
• Mistake: Ignoring the flotation costs when calculating the weighted average cost of capital (WACC).
• Correction: Include the flotation costs in the WACC calculation to reflect the true cost of capital.
• Mistake: Confusing the sunk cost with the opportunity cost.
• Correction: Recognize that the sunk cost is a past investment that cannot be changed, while the opportunity cost is the potential benefit of an alternative investment.

Exam / CFA Tips

• Tip: Be careful when using the M&M Proposition I (no taxes) and M&M Proposition II (with taxes) in the WACC calculation.
• Tip: Understand the difference between the internal rate of return (IRR) and the net present value (NPV) in capital budgeting decisions.
• Tip: Recognize the distinction between the dividend irrelevance theorem and the bird-in-hand theorem.

Quick Practice Problem

A company has EBIT of $10 million, interest of $2 million, and tax of 25%. Calculate the degree of operating leverage (DOL).

Answer: DOL = (Q x (P - V)) / (Q x (P - V) - F) = (10,000,000 / (10,000,000 - 2,500,000)) = 4.

Explanation: The degree of operating leverage (DOL) measures the sensitivity of the company's EBIT to changes in sales.

Last-Minute Cram Sheet

• Cash Conversion Cycle (CCC) = DIO + DSO - DPO: measures the length of time a company holds its inventory, sells its products or services, and pays its suppliers.
• Days Inventory Outstanding (DIO) = (Average Inventory / Cost of Goods Sold) x 365: measures the average number of days a company holds its inventory.
• Days Sales Outstanding (DSO) = (Average Accounts Receivable / Sales) x 365: measures the average number of days a company takes to collect its accounts receivable.
• Days Payable Outstanding (DPO) = (Average Accounts Payable / Cost of Goods Sold) x 365: measures the average number of days a company takes to pay its accounts payable.
• Cash Flow from Operations (CFO) = Net Income + Depreciation + Amortization - Change in Working Capital: measures the cash generated from a company's core operations.
• Cash Flow from Investing (CFI) = Capital Expenditures - Proceeds from Sale of Assets: measures the cash used or generated from a company's investments in assets.
• Cash Flow from Financing (CFF) = Net Borrowing - Dividends Paid: measures the cash used or generated from a company's financing activities.
• Free Cash Flow (FCF) = CFO - Capital Expenditures: measures the cash generated from a company's core operations after investing in assets.
• Sustainable Growth Rate (SGR) = ROE x (1 - Retention Ratio): measures the maximum rate at which a company can grow without needing external financing.
• Degree of Operating Leverage (DOL) = (Q x (P - V)) / (Q x (P - V) - F): measures the sensitivity of a company's EBIT to changes in sales.
• ⚠️ In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield.
• ⚠️ The WACC calculation should include the flotation costs to reflect the true cost of capital.
• ⚠️ The sunk cost is a past investment that cannot be changed, while the opportunity cost is the potential benefit of an alternative investment.