Session # 205 5/18/17 from 2:00-3:15 Cash Conversion Cycle · cash conversion cycle process; 2. Identify key business drivers, incorporate them into an automated system early enough

Session # 205 5/18/17 from 2:00-3:15

CashConversion CycleBreathing Life into a Stale Dying Process

250 Commercial Street, STE 3012Manchester, NH 03101(603)573‐9206

BackgroundFASB describes liquidity as reflecting “an asset’s or liability’s nearness to cash” (Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises; PP 24, Footnote13). In accounting and auditing textbooks, the current and quick ratios continue to be the focus of liquidity analysis.

Noticeably absent from most accounting and auditing textbooks is an approach to liquidity analysis that incorporates the element of time—the cash conversion cycle (CCC), was introduced in 1980 by Verlyn Richards and Eugene Laughlin in their article “A Cash Conversion Cycle Approach to Liquidity Analysis,” Financial Management, Vol. 9, No.1 (Spring 1980).

Consideration of the CCC along with the traditional measures of liquidity should lead to a more thorough analysis of a company’s liquidity position.

Static measures of liquidity, such as the current ratio, do not account for the amount of time involved in converting current assets to cash or the amount of time involved in paying current liabilities and…can be easily manipulated.

MethodologyLet’s discuss the elephant in the room…

An illustration of Static MeasuresCompany A has $1,000,000 in current assets and $750,000 in current liabilities. The current ratio reveals that the Company A can cover its current liabilities with its current assets 1.33 times [$1,000,000 ÷ $750,000]. If Company A wished to maintain a higher current ratio or if a creditor’s loan covenant requires a higher current ratio, Company A could pay $500,000 of its current liabilities. As a result, Company A would then report $500,000 of current assets and $250,000 of current liabilities.

The current ratio calculates to a 2.0 [$500,000 ÷ $250,000], but this action could have actually harmed the company’s liquidity position, leaving it with $500,000 less cash to meet unexpected needs. Furthermore, if those current liabilities were not due for another month, then Company’ As desire to report a better current ratio could have cost the business a month of interest-free financing of liabilities and a month’s return on the cash that could have been invested elsewhere.

A high current ratio will also result from buildups of accounts receivable, a situation that is not necessarily desirable. The effects of lengthening the collection period of receivables, an act that harms company liquidity, would not be readily apparent in either the current ratio or the more conservative quick ratio.

A disadvantage of static measures of liquidity - despite how simple they are to compute; can be quite difficult to interpret. Higher is generally considered better, but too high may indicate inefficient use of assets. Lower is generally regarded as unfavorable but may actually be the result of an efficient use of working capital.

A current ratio of approximately 1.0, which would indicate that the company is barely able to cover current liabilities, does not necessarily indicate a weak liquidity position if the company manages its working capital with such precision that the inflows of cash can be matched with the required outflows of cash.

Static Measures of Liquidity

Cash Conversion Cycle (CCC)

CCCThe CCC calculates the time required to convert cash outflows into cash inflows. It indicates how efficiently a company is using its current assets and liabilities. Each stage of the CCC is illustrated below.

CCC Formula = (+DIO +DSO –DPO)

+ Days Inventory (DIO) = AVG Inventory * 365COGS

+ Days Sales (DSO) = AVG A/R * 365 REVENUE

- Days Payable (DPO) = AVG A/P * 365COGS

Business Timeline – Standard

Is this realistic?

CCC - Standard

-55

Process:DIO = 7,000/15,000*365=170.3

DSO = 5,000/32,000*365=57.3

DPO= 3,000/15,000*365= 73

CCC = +171+58-73= 154.6

Forecast:

AVG

AVGAVG

Business results

CCC Key Business Drivers

Build Architecture- Define ‘thy inner self’Many companies’ report business performance measurements (BPMs) through arcane processes and disconnected spreadsheets. Putting them together requires a great deal of effort, yet lack accountability and process ownership is unclear. The constant across companies is that treasury professionals generally try to avoid being saddled with this responsibility. Usually, treasury professionals see little upside for coordinating a company's cash flow forecasting and measuring efforts, yet may face the wrath of C-level executives if forecasts and measurements fail to align with strategic goals.

For a treasury team, inaccuracies in cash flow forecasts and measurements are more costly today than ever before. Because of turbulence in the external economic environment, as well as investors’ and analysts’ increased interest in corporate cash flows, senior management is paying more attention than ever before to the cash conversion cycle process. The treasury department is also under increasing pressure to intervene and make significant process improvements.

Objectives - CASH IS KING

Reduce InventoriesExcess inventory is one of the most overlooked sources of cash. By streamlining processes within the company—as well as processes involving suppliers and customers—companies can minimize inventory throughout the value chain.

• Enhanced forecast accuracy and demand planning: Improved forecast accuracy and regular updatesof customer demand lead to a much more reliable planning process and help companies not only to reduce their inventory but also to improve the ability to deliver.

• Advanced delivery and logistics concepts: In order to keep inventories at lower levels, top-performing companies establish advanced and demand-driven logistics concepts with their suppliers, such as vendor-managed inventory, just in time (JIT) or just in sequence (JIS) and collaborate with their suppliers.

• Optimized production processes: An important lever to reduce work-in-progress inventory is the redesign of production processes. The main objectives here are to reduce non-value-adding time (“white-space reduction”) and excessive inventory between production steps. Promising measures are removing bottlenecks and migrating from push concepts to demand-driven pull systems.

• Service level adjustments: An increased service level for products which are critical to the customer(and thus allow higher prices) and a decreased service level for products which are uncritical to the customer should lead to optimized stocks. A sophisticated approach to calculating security stocks based on target availability and deviations in production & demand will also reduce out-of stock situations for critical parts.

• Variance management: Reducing product complexity and carefully tracking demand of product variants in order to identify low-turning products is one way to reorganize and tighten the assortment and concentrate on the most important products.

Reduce ReceivablesMany companies are early payers and late collectors—a formula for squandering working capital. Other companies—particularly project-based businesses and manufacturers of large, costly products with lengthy production cycles—have cash flow problems caused by a mismatch in timing between costs incurred and customer payments. Efficient management of receivables and prepayments received is key. Optimization can yield significant potential.

• Invoicing cycle: The main target is to get invoices to the customers as quickly as possible. Processes and systems should be aligned to allow invoicing promptly after dispatch or service provision. Companies can reduce invoicing lead times by multiplying their invoicing runs.

• Early reminders/dunning cycles: Best-in-class companies reduce grace periods to a minimum or remind their customers of upcoming payments even before the due date. Establishing direct debiting with main customers is the most effective means to avoid overdue payments.

• Payment terms: Renegotiated payment terms will lead to reduced DSO. The first step is often a harmonization and reduction of available conditions to decrease discretionary application. When preparing negotiations, companies should analyze their customers’ bargaining power and specific preferences in order to identify improvement potential in the terms and conditions for payments.

• Payment schedule: Companies operating in project business should introduce more advantageous payment schemes that cover costs incurred. Percentage of completion (POC) accounting helps to define relevant payments along milestones. Companies with small series productions, the introduction of prepayments and advances can significantly improve liquidity.

Rethink Payment Terms with SuppliersIf fast-paying companies are at one end of the spectrum, then companies that “lean on the trade” and use unpaid payables as a source of financing are at the other. Between these two extremes there is a more effective, integrated approach to payment renegotiation that takes into account all aspects of the customer–supplier relationship, from price and payment terms to delivery time frames, product acceptance conditions and international trade definitions.

• Payment cycle: Payment runs for payables can be reviewed and limited to a required frequency. Country-and industry-specific business conventions apply. Moderate adjustments of payment runs may require some changes in the accounting systems, but tend to be a “quick hit.”

• Avoidance of early payments: Payments should be accomplished with the next payment run after the due date (ex post). Switching from ex ante to ex post payments is common practice and entails an easily implemented lever for increasing payables.

• Payment conditions: A DPO increase can be achieved by renegotiating payment conditions with certain suppliers. Best-practice approach reviews all payment terms in use and to define a clear set of payment terms for the future. Renegotiations with suppliers are based on these new standard terms. It is critical to take into account supplier specifics. For those suppliers with liquidity constraints the focus should lie on pricing, whereas for suppliers with high liquidity payment terms can often be extended.

• Product acceptance conditions: Connecting the settlement of payables to the fulfillment of allcontractual obligations may result in significant postponements of respective payments. Enforcing supplier compliance to stipulated quality, quantity, and delivery dates is also the basis for optimized, demand-oriented supply concepts. Prerequisite is full data transparency on phased relevant events.

• Back-to-back agreements: Balancing the due dates of receivables and payables helps to avoid excessive pre financing of suppliers and can even lead to a positive cash balance

New Efforts Demand New FocusMany companies have begun to fundamentally change how their BPMs are valued and applied. There are three key reasons for the shift.

1. Companies difficulties in securing liquidity in the market; 2. Economic slowdown has led to greater volatility in earnings and cash flows for many

companies; and3. Wall Street analysts are now using cash conversion cycle analysis as a barometer of a

company’s fiscal health.Companies should pursue a portfolio solution rather than a simpler, one-dimensional “accuracy fix.” To have a significant impact on cash conversion cycle reporting, companies should invest in three areas:

1. Improve the methodology- access to cash flow cycle data from the businesses affecting the cash conversion cycle process;

2. Identify key business drivers, incorporate them into an automated system early enough so that the company can recognize cash flow shortfalls and take corrective action before the end of the reporting period; and

3. Expand the role of cash flow cycle in the company’s internal performance management processes so that business unit leaders are effectively motivated to deliver performance.

Recalling FASB’s definition of liquidity, this formula, when compared to the current and quick ratios, better approximates assets’ and liabilities’ “nearness” to cash. The shorter the CCC, the more liquid the company’s working-capital position.How could the use of technology shorten the CCC?The first part of the CCC formula, days inventory outstanding (DIO), measures the number of days it takes a company turn raw materials into Cash. An undesirable buildup of slow-moving inventory would result in a less favorable CCC. In contrast, the current ratio does not distinguish between liquid current assets and illiquid current assets. As far as the current ratio is concerned, inventories and cash are the same thing and are immediately available to take care of current liabilities.

3 Stages of the CCC

CCC - DIODays Inventory (DIO) = AVG Inventory * 365

COGSQuarterly view: Static Calc BP CalcCOGS = 600,000Inventory = 300,000Days = 91 45.5 42.5Best Practice Automated processMonth 1 2 3____ COGS 165K 185K 250KInv 300K 300K 300KDays 28 28 35

3 Stages of the CCC

The second part of the CCC formula, days sales outstanding (DSO), measures the number of days a company takes to convert AR to Cash. If a company relaxes its credit policies, and receivables become less liquid, the static measures of liquidity will not indicate this. As with slow-moving inventories, an undesirable buildup of accounts receivable will result in a less favorable CCC.

Companies may want to consider deferred revenue and unbilled AR in the DSO calculation.

CCC - DSODays Sales (DSO) = AVG A/R * 365

REVENUEQuarterly view: Static Calc BP CalcRevenue = 750,000AR = 450,000Days = 91 54.6 51.2Best Practice Automated processMonth 1 2 3____ REV 205K 225K 320KAR 450K 450K 450KDays 28 28 35

The third part of the formula, days payables outstanding (DPO), measures how long it takes a company to pay its invoices from trade creditors, such as suppliers. With this portion of the formula, consideration is given to the length of time in which a company is able to obtain interest-free financing through credit relationships with vendors. The longer a company is able to delay payment (without harming vendor relations), the better the company’s working-capital position. Static measures of liquidity, however, punish the company for maintaining larger accounts payable balances.

3 Stages of the CCC

CCC - DPODays Payable (DPO) = AVG A/P * 365

COGSQuarterly view: Static Calc BP CalcCOGS = 600,000 AP = 305,000Days = 91 46.3 43.3Best Practice Automated processMonth 1 2 3____ COGS 165K 185K 250KAP 305K 305K 305KDays 28 28 35

CCC ComparisonCCC Static View CCC BP View

DIO 45.5 42.5DSO 54.6 51.2DPO 46.3 43.3

CCC 53.8 50.4Which would you prefer?

A shorter CCC is favorable, and it is entirely possible to have a negative CCC. This would indicate that the company manages its working capital so well that it is able to purchase inventory, sell inventory, and collect the resulting receivable before the corresponding payable from the inventory purchase becomes due.

-55

50.4

CCC Continued

Days Inventory OS

Days Sales Outstanding

akaNET Operating

Cycle

Purc

hase

Sell

Holding period Collection period

Col

lect

Days Payables

OutstandingCash

Conversion Cycle

LESS:Days Payables

OS

Paym

ent

Operating cycle

Cash Conversion Cycle (aka Net operating cycle)

Operating cycle

CCC Benefits of Automated Improvements

Benefits of a short or negative Cash Conversion Cycle • Reduce financing costs• Expand operations• Reduce inventory carrying costs• Reduce customer non-payments

DIO DSO DPO CCC

34.91 17.4 79.75 -27.44

Amazon.com for the year ended 12/31/16Cash today, cost tomorrow.

Amazon's cash conversion cycle is negative primarily by generating revenue from customers before having to pay its suppliers for the inventory.

Best-in-class companies understand the company industry-specific drivers behind each component of operative working capital, and focus on optimizing the most promising ones. During this process, they consider the entire value chain to reveal the root causes of tied-up cash and take into account all interdependencies between the respective components. By applying the appropriate levers for each component, obstacles that slow cash flow can be removed and overall company processes can be improved.http://s2.q4cdn.com/391606028/files/doc_presentations/2017/Q1-2017-Veeco-Investor-Presentation-D1.pdf

Conclusion CCC

Debt – The Tax View

Charles HillsL&V Partners

www.l-vpartners.com+1-978-749-9900

The Debt Experience

• Creditor’s Experience– Collection efforts – negotiations, etc.– Bad Debt Write-off for uncollectible amount– Prove uncollectible and worthless– Tax deduction for face amount

• Debtor’s Experience*– Ignore it– Dispute it– Compromise – New Debt– Equity– Insolvency– Bankruptcy

* The tax impact for Debtor is a little more complicated. Each can generate “COD”.

Debt Modification

•Specific tests per Treas. Reg. §1.1001‐3(e)

–Change in yield (greater than 25 basis pts or 5% of original yield)–Deferral of payments–Change in obligor–Change in recourse nature of the instrument–Change in accounting/financial covenants

Economically significant effects indicate an exchange and COD.

Cancellation of Debt Income –”COD”

• Basic Principles: » Debt Relief ≠ Cash Receipt» Debt Relief = Bad Debt W/O for creditor» Debt Relief = Taxable Income

A creditor discharges the debt, the debtor recognizes taxable income.

• Codified per IRC Sec. 61(a)(12)• Exclusions and rules of application per IRC Sec. 108• Applies to all types of indebtedness • Reduction of the principal amount due

Debt Modification - Discounted Debt

Original Debt 100,000,000 New Debt 95,000,000

Interest Rate 4% Interest Rate 3%

Term 5 Years Term 7 Years

Original Issue Value 90,000,000 Original Debt Issue Value 90,000,000

Trading FMV 80,000,000 New Debt Issue Value* 80,000,000

COD Income Realized 10,000,000

* New note considered exchanged at FMV of original.

General Rules of COD

• 1. Debt discharged or otherwise unenforceable creates COD.

• 2. The underlying debt is undisputed. Settlement recognizes the debt for tax purposes.

• 3. Buying debt back from a third-party creditor for less than face value triggers COD.

• 4. Acquisition of debt by a debtor’s related party triggers COD income whether or not the debt is formally cancelled.

• Relatedness – Direct or indirect common ownership greater than 50 percent. IRC Sec. 108(e)(4)(C).

• Family members are treated as related. IRC 108(e)(4)(B).

Exceptions to the Basic Principles

Specific Exclusions:• Title 11 - Discharges in bankruptcy• Insolvency• Qualified farm debt• Principal residence debt• Qualified real property business debt

Other Exclusions (outside bankruptcy & insolvency) –Sec. 108(e)(5)• Debts for lost deductions• Purchase Money Debt Reduction – purchase price adjustment

But Exceptions Have a Cost….

The excluded COD reduces tax credits and carryovers (Tax Attributes) that could reduce current and future tax liability:• Net Operating Loss• General Business Credits (R&D credit…)• Foreign Tax Credits• Capital Loss Carryovers• Minimum Tax Credit (from previously paid corporate

minimum tax)• Depreciable Value (Tax Basis) of related property

• Reduction can be dollar for dollar as for NOL or 33% or COD for credits.

COD Exclusion - InsolvencyOriginal Debt Balance 100,000,000  New Debt Balance 80,000,000 

NOL Balance 20,000,000 

Book ValueInsolvency 

Test

Total Assets 250,000,000  FMV of Assets 230,000,000 

Operating Liabilities 150,000,000  Operating Liabilities 150,000,000 

Interest Bearing Debt 100,000,000  Interest Bearing Debt 100,000,000 

Insolvency Amount (20,000,000)

Implied COD Income 20,000,000 

Insolvency Amount (20,000,000)

COD Income Realized 0

COD Exclusion – Tax Attribute Reduced

Original Debt Balance 100,000,000 New Debt Balance 80,000,000

NOL Balance 20,000,000

An Exception Is Not Applicable An Exception Is Applicable

Implied COD Income 20,000,000 Implied COD Income 0

Use of NOL Balance (20,000,000) Use of NOL Balance N/A

COD Income Realized 0 COD Income Realized 0

Tax Attribute Used 20,000,000 Tax Attribute Reduction (20,000,000)

NOL allowed to reduce taxable income. NOL offset against COD income.

(Due to NOL usage) (Due to Sec. 108)

COD in Debt RecapitalizationOriginal Debt Balance 100,000,000  New Debt Balance 80,000,000 

Preferred Stock N/A Preferred Stock 1,000 Shares

Stock Warrants N/A Stock Warrants 100,000 units

New Debt Balance 80,000,000  Original Debt Balance 100,000,000 

Preferred Stock Value 15,000,000  New Lender Value 97,500,000 

Stock Warrants Value 2,500,000 

New Lender Value 97,500,000  COD Income Realized 2,500,000 

Creditor has bad debt deduction. Possible recapture of deduction on sale of stock and warrants.

Purchase Money Debt Reduction - Sec. 108(e)(5)

• NewCo purchases all the assets and liabilities of OldCo for a $10 million note

• NewCo loses a major customer due to poor product performance. NewCo determines that OldCo was aware of product issues prior to the sale and didn’t disclose it in due-diligence.

• OldCo accepts $4 million plus interest in full satisfaction of the debt to avoid litigation.

• Purchase price adjustment exclusion applies to the $6M reduction.

• NewCo takes lower basis, $4M, in assets instead of $10M.

Debt must be from Seller, not 3rd party.

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