Emplea usted la Didáctica al impartir sus clases, mediante: TABLA #

Having introduced some of the ratios associated with current asset and liability management, it is useful to return to cash management and consider the cash operating cycle. This indicates the net time interval

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between cash inflows from goods sold and cash outflows for the purchase of resources. It is a measure of the length of time a company has funds tied up in working capital, an increase (decrease) in the cycle indicating an increase (decrease) in working capital needs.

A company's cash operating cycle is equal to:

 The average number of days a given inventory is held, measuring the length of time required to purchase and sell its product: plus

 The average collection period on its account receivable, measuring the length of time required to collect sales revenue; minus

Table 3.5 The Cash Operating Cycle

__________________________________________________________

Annual NI00.000

Cost of Goods Sold N40.000

__________________________________________________________

Balance Ratios

Inventory 5000 Inventory

Cost of Goods N40.000 8

Inventory 5000

Accounts 10,000

Receivable Sales

100.000 10

Receivable 10.000

Account 5000

Turnover Receivables

100.000 10 Debtor Sales

Payable 10.000

Turnover Account Payable

 The average period of its accounts payable, measuring the length of time payments can be deferred on its purchase of resources.

This is, the cash operating cycle is equal to:

365 1 + 1

[Inventory Turnover Ratio Receivables turnover Ratio

- 1

Debtor Turnover Ratio]

Since each of these ratio measures, respectively, the number of times in a year that inventory, accounts receivable and accounts payable are 'turned over’, dividing each ratio into the number of days in a year measures the average number of days each of these components of working capital is held.

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To illustrate, consider a company which has average annual sales of EI00,000 at an average annual cost of goods sold of E40,000. given the average balances in its inventory, accounts receivable and accounts payable and the relevant ratios, as indicated in table 11.1 the cash operating cycle is:

3651 + 1-1

8 10 10 = 365 [0.125 + 0.1 -0.1] = 45.6 days

If for example, the company reduced its investment in accounts receivable there would be all other things being equal, an improvement in liquidity as measured by the cash operating cycle. Assuming accounts receivable are reduced to E6000, the receivable turnover ratio falls to EI00,000/E6000 = 16.7. Thus the cash operating cycles reduced from 45.6 days to 31 days: that is, in the latter case:

3651+ 1 -1

8 16.7 10 = 365 [0.125 + 0.06 -0.1] = 365[0.085] 31days Overall Working Capital Policy

To bring this unit to a close it is important to consider the overall policy which a company might adopt in respect of its working capital. There are two aspects of this, one involving the investment decision and the other involving the financing decision. The former is examined first.

Current Asset Policy

In an earlier part of this unit, when discussing cash and marketable securities, the importance of the risk-return relationship was identified. It was argued that the benefits of liquidity, in terms of producing low risk but low returns, should be weighed against relatively higher returns but higher risk produced by investing in long-term physical or fixed assets.

This risk-return principle applies to a company's investment decision in respect of its overall current assets. In this context there are three alternative strategies which can be adopted. They involve average, conservative and aggressive approaches to risk management. Under the conservative strategy, relative to the average, there is a relatively high proportion of investment in current assets. This produces below average risk and below average total return. Under the aggressive strategy, relative to the average, there is a relatively low proportion of investment in current assets, producing above average risk and above average total returns.

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The choice of strategy varies from industry to industry depending on the nature of the product and/or service being supplied and, among other factors on sales variation and the degree of operating leverage. Sales variation and operating leverage determine business risk and hence the variation in net cash flows. The overriding objective should be to determine the ratio of current assets to total assets which maximizes the total market value of a company.

Current and Long-Term Liability Policy

Once the investment decision has been made, strategies fro financing current assets must be addressed. This strategies involve choosing the term structure of liabilities appropriate to a given term structure of assets.

The analysis is aided by considering a company's cumulative capital requirement at a given point in time, that is, the total capital necessary to fund a company's total investment. The cumulative capital requirement is determined by fixed, or long-term, assets, permanent assets; and fluctuating current assets.

The division of current assets into permanent spontaneous components arises to the extent that a company can predicts its long-term trend in sales. To the extent that it can do this, the proportions of its current assets necessary to support this trend can be considered to be long term and, therefore, effectively permanently. The remaining proportions of current asset investments (in cash and marketable securities, inventories and accounts receivable) are spontaneous. They are spontaneous in that these current assets fluctuate to facilitate unanticipated changes in sales and as a result of the innate variation in the current asset components themselves.

The cumulative capital requirement is illustrated in figure 3.1.

There are three alternative financing strategies which involve average, aggressive and conservative hedging approaches to financial risk management.

The average hedging approach consists of marching the maturity structure of assets

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Figure 3.1: The Cumulative Capital Requirement and Average Hedging

And liabilities, on the assumption that permanent current assets can be treated as long-term investments. Here all fixed and permanent current assets are funded by long-term debt and equity, with spontaneous current assets being financed by short-term debt and accounts payable. This approach exposes a company to ‘average’ risk with ‘average’ risk with

‘average’ expected returns.