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this is a note about asset conversion cycle which is an important aspects of working capital cycle.
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THE ASSET CONVERSION CYCLE
SPONTANEOUS FINANCING of the CYCLE
ASSETS LIABILITIESInventory Raw Materials $100 Accounts Payable $100
Net Worth 0
Total Assets $100 Total Liabilities & Net Worth $100
Inventory Raw Materials 0 Work in Process $125 Finished Goods 0
Accounts Payable $100Accrued Expenses 25
Net Worth 0Total Assets $125 Total Liabilities & Net Worth $125
Inventory Raw Materials 0 Work in Process 0 Finished Goods $150
Accounts Payable $100Accrued Expenses 50
Net Worth 0Total Assets $150 Total Liabilities & Net Worth $150
Accounts Receivable $180Inventory Raw Materials 0 Work in Process 0 Finished Goods 0
Accounts Payable $100Accrued Expenses 50
Profit (Retained earnings) 30
Total Assets $180 Total Liabilities & Net Worth $180
Cash $30Accounts Receivable 0Inventory Raw Materials 0 Work in Process 0 Finished Goods 0
Accounts Payable 0Accrued Expenses 0
Profit (Retained earnings) 30
Total Assets $ 30 Total Liabilities & Net Worth $ 30
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10 Days + 20 Days= 30 Days
|_______________________|____________________________| Cash RM WIP Finished Goods Accts. Receivable Cash = 30 Days
30 Days |____________________________________________________| = 30 Days
Accounts Payable and Accrued Expenses
A PERFECTLY TIMED ASSET CONVERSION CYCLE: SPONTANEOUS FINANCING !!
IMPERFECTLY TIMED ASSET CONVERSION CYCLES REQUIRE NON-SPONTANEOUS FINANCING TO COMPLETE THE CYCLE:
THE CONCEPT OF WORKING INVESTMENT
WI = (Acct’s Receivable + Inventory) – (Acct’s Payable + Accrued Expenses)
WI = the portion of trading assets that are not covered by spontaneous financing.
Concepts:
Permanent Level of Working Investment
Increasing Working Investment due to Sales Growth
Changing Working Investment due to Seasonality
Financing Non-Current Assets
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SOURCES OF FINANCING OF THE REQUIRED WORKING INVESTMENT
DEBT = External Claims Fixed Amount Maturities Senior
EQUITY = Internal (Owners) Claims Residual Undated Junior
GREY AREA = Between Debt and Equity
DEBT
Spontaneous: Accounts Payable Accrued Expenses (Non-interest Bearing)
Short Term: Notes Payable Overdraft Current Portion Long Term
Long Term: Bank Loans Bonds Subordinated Debt
Current Debt: Under one Year
Non-Current Debt: Over one Year
Contingent Liabilities
EQUITY GREY AREA
Common Stock Deferred Taxes Preferred Stock Minority Interest Treasury Stock Provisions Capital Surplus Pension Liabilities Retained Earnings
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SOURCES OF FUNDS
The Primary Source of Debt Repayment to a Bank is Cash Generation.
1. Net Profit (after Tax)Assets 1999 2000 Liabilities 1999 2000
Cash 150 200 Accs Payable 200 200
Accs/Rec’ble 400 400 Notes Payable 300 300
Inventory 300 300 Retained Earnings 700 750
Fixed Assets 500 500 Capital Stock 150 150
Total Assets 1,350 1,400 Total L & E 1,350 1,400
2. Conversion of an Asset to CashAssets 1999 2000 Liabilities 1999 2000
Cash 150 350 Accs Payable 200 200
Accs/Rec’ble 400 300 Notes Payable 300 300
Inventory 300 200 Retained Earnings 700 700
Fixed Assets 500 500 Capital Stock 150 150
Total Assets 1,350 1,350 Total L & E 1,350 1,350
3. Increase in LiabilitiesAssets 1999 2000 Liabilities 1999 2000
Cash 150 300 Accs Payable 200 250
Accs/Rec’ble 400 400 Notes Payable 300 400
Inventory 300 300 Retained Earnings 700 700
Fixed Assets 500 500 Capital Stock 150 150
Total Assets 1,350 1,500 Total L & E 1,350 1,500
4. Increase in EquityAssets 1999 2000 Liabilities 1999 2000
Cash 150 350 Accs Payable 200 250
Accs/Rec’ble 400 400 Notes Payable 300 300
Inventory 300 300 Retained Earnings 700 700
Fixed Assets 500 500 Capital Stock 150 350
Total Assets 1,350 1,550 Total L & E 1,350 1,550
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USES OF FUNDS (CASH)
1. Net Loss (after Taxes)
2. Increase in Assets
3. Decrease in Liabilities
4. Reduction in Equity
Sources and Uses of Cash:
Assets 1999 2000 Liabilities 1999 2000
Cash 150 0 Accs Payable 200 240
Accs/Rec’ble 400 475 Notes Payable 300 310
Inventory 300 375 Retained Earnings 700 750
Fixed Assets 500 600 Capital Stock 150 150
Total Assets 1,350 1,450 Total L & E 1,350 1,450
Sources: Uses
Net Profit $ 50 Increase in Acc. Receivable $ 75Increase in Acc. P’ble $ 40 Increase in Inventory $ 75
Increase in Notes P’ble $ 10 Increase in Fixed Assets $100Decrease in Cash $150
TOTAL $250 $250
WHAT HAPPENED HERE?
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ANALYSIS OF THE ASSET CONVERSION CYCLE
Identify the RISKS of the Asset Side of the Balance Sheet
Assess the LIQUIDITY of the Assets
Determine the EFFICIENCY of Asset Usage to Create Sales and Profitability
RISKS THAT MAY AFFECT THE ASSET CONVERSION CYCLE
Supply Risks
Production Risks
Demand Risks
Collection Risks
Business Risk: Type of Asset Structure, Length of the Cycle and Value Added
LIQUIDITY
Quality of Assets
Position in the Industry
EFFICIENCY IN THE USE OF ASSETS
How does a Company Generate Maximum Return from the Use of Assets?
INVENTORY - ACCOUNTS RECEIVABLE - FIXED ASSETS
INVENTORY ANALYSIS
Inventory Valuation: LIFO & FIFO Accounting Component Breakdown: Raw Materials, Work in Process, Finished Goods Inventory Turnover:
Inventory x 365 = Inventory Days on HandCost of Goods Sold
(Also calculate: Raw Materials – WIP – Finished Goods Days on Hand)
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Quality: Returns on Sales:
% Returns & Allowances to Sales Ratio: Returns & Allowances x 100Gross Sales
Contingent Purchase Commitments
ACCOUNTS RECEIVABLE ANALYSIS
Credit Terms Quality and Concentration of Customers Costs of Carrying the Receivables Historical Experience Aging Schedule Allowance for Bad Debts
Accounts Receivable Turnover:
Accounts Receivable x 365 = Receivable Days on HandNet Sales
Charge-Offs:
Beginning Allowance for Bad Debts (Balance Sheet)+ Provision for Bad Debts (Income Statement)- Ending Allowance for Bad Debts= Charge-offs
FIXED ASSETS ANALYSIS
The Adequacy of Plant Investment is measured by Plant Turnover:
Net Plant Turnover = Sales (Net Plant° + Net Plant¹)/2
Low Plant T/O: Heavy Industry High Plant T/O Supermarkets Hotels Commodity Traders Public Utilities Wholesalers
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ASSET INVESTMENT: SUMMARY
1. The Asset Turnover Ratio (ATO): Sales Total Assets
o Production Cycleo Capital Intensityo Asset Components: E. g. Inventory – Receivables – Cash – Securities
2. Return on Assets Ratio (ROA): Net Profit after Tax Total Assets
3. Working Investment to Sales Ratio: Working InvestmentSales
ANALYSIS OF PROFIT PERFORMANCE
Format of the Income Statement Determinants of Profitability Quantitative Tools to Measure Operating Performance:
o Return on Sales (ROS)o Sales Revenueo Operating Leverageo Cost of Goods Soldo Gross Profit Margino Selling, General & Administrative Expenses (SG & A)o EBIT Margino Interest Expenseo Investment Incomeo Taxes
Return on Sales (ROS): = Net Profit after Tax (NPAT)Sales
ROS is determined by the components of the Income Statement:
Sales Revenue = Volume x Price
Operating Leverage = Fixed Costs {Different Industries haveTotal Costs {different Breakeven Points
CGS/Sales = Cost of Goods Sold (%?) Sales
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Gross Profit Margin = Gross Profit Sales
SG&A/Sales = Selling, General & Administrative Expenses (%)Sales
EBIT Margin = Net Operating Profit (EBIT) (%)Sales
Average Funded Debt = LTD°+CPLTD°+STD°+LTD¹+CPLTD¹+STD¹2
Interest Expense = Annual Interest (%) Average Funded Debt
Investment Expense
Dividends
Provision for Income Taxes
SUMMARY: ANALYSIS OF PROFIT PERFORMANCE
Return on Sales should be measured against:
Extent of Value Added
Risk/Return
Cash Flow and Profitability are not the same !!!
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FINANCIAL RISK
Analysis of the Right Hand Side of the Balance Sheet
Evaluation of Short Term Liquidity:
Working Capital Adequacy --- Current Ratio --- Quick RatioReliance on Inventory
Evaluation of Long Term Solvency:
Leverage Ratios --- Profitability
Evaluation of the Adequate Capital Structure:
The Mix of Short and Long Term Debt & Equity is dependent on Asset Investments, the Operating Performance and the Asset Conversion Cycle
LIQUIDITY
Working Capital = Current Assets - Current Liabilities
Current Ratio = Current Assets Current Liabilities
Adequacy Depends on 1) Liquidity, 2) Increase/Decrease of Assets3) Profitability Years4) Window Dressing
Quick Ratio = Cash + Securities + ReceivablesCurrent Liabilities
Reliance on Inventory = Bank Debt - (NRV%) Acc. Receivable (Shrinkage) Inventory
LONG – TERM SOLVENCY
Return on Sales (ROS): Profitability and Cash Flow
Leverage = Total Liabilities Tangible Net Worth
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Debt to Equity = Total Liabilities Net Worth
Adjusted Leverage = Total Liabilities - Subordinated DebtTangible Net Worth - Subordinated Debt
APPROPRIATE CAPITAL STRUCTURE
When we have determined what the Left-Hand side of the balance sheet looks like, we can decide what the Right-Hand side SHOULD look like!
Basically:TENORS SHOULD BE MATCHEDBUSINESS RISK SHOULD BE COVERED BY EQUITY:
Higher Business Risk should equal lower Financial Risk
Financing of Short Term Needs:o Adequacy of Working Capital: Liquidity of Receivables and Inventory after
shrinkage should pay Short Term creditors.o Permanent Working Investment should be covered by permanent funds:
either Long-Term Debt or Equity.o Whether long-term financing is debt or equity depends on the business risk.
Longer Asset Conversion Cycles tend to have more permanent working investment and more business risk.
Financing of Long-term Needs:o The tools are Cash Flow Projections.
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THE ROE EQUATION
ROE = Net Profit After TaxNet Worth
Net Profit After Tax = NPAT x Sales x Total AssetsNet Worth Sales Total Assets Net Worth(ROE) = (ROS) x (ATO) x (ALEV)
=
NPAT x Total AssetsTotal Assets Net Worth
(ROE) = (ROA) x (ALEV)
The Fact Sheet used for Analysis breaks down ROE, ROS, ATO and ALEV into their different components to highlight the elements of Profitability, Efficiency and Equity mix, both horizontally (over certain periods) and vertically (for the period in question).
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