Working Capital Gap

Shaker Cherukuri

Managing Principal

Process IS Inc.

(317)258-3552

[email protected]

http://process-improvement-solutions.com/

1/26/2010 1Copyright 2010, Process IS Inc.

� Assets (Current + LT) = Liabilities (Current + LT) + Stock Holders Equity (SE)

� Current Assets (CA)◦ Cash + Marketable Securities (notes etc)◦ Inventory (Inv.)◦ Accounts Receivables (A/R)◦ Pre-Paid Accounts (PPA)

Current Liabilities (CL)� Current Liabilities (CL)◦ Short Term Debt (STD)◦ Accounts Payables (A/P)◦ Unearned Revenue (UR)

� Stock Holders Equity (SE)◦ Paid in Capital (PIC)◦ Retained Earnings (RE)� Revenues-Expenses

1/26/2010 2Copyright 2010, Process IS Inc.

� Working Capital =� Current Assets (CA) – Current Liabilities (CA)

� If CA > CL, then positive Working Capital

� If CA < CL, then negative working capital

� So what do we want?

� Conventional Wisdom◦ Positive Working Capital is the norm.

◦ Increase in WC yields negative cash flows

� How do you fund it?◦ Cash flow from operations that is greater than the ◦ Cash flow from operations that is greater than the negative cash flow for working capital

◦ Cash flow from financing or investing

◦ Other?

1/26/2010 4Copyright 2010, Process IS Inc.

� Ratio Analysis to Measure Efficiency◦ Day’s Receivables (DR) = (Lower the better)

� Average Accounts Receivable/Average Daily Sales� Average number of days that elapse between sale and cash collection

◦ Days’ Inventory (DI) = (Lower the better)� Average Inventory/Average Daily COGS� Average number of days of sales that can be made using only the supply of inventory on hand

◦ Days’ Payables (DP) = (Higher the better)� Avg. Acc Payable/Average Daily Purchases� Avg. Acc Payable/Average Daily Purchases◦ Inventory Turnover = (Higher the Better)

� Cost of Goods Sold (COGS)/Average Inventory

� Cash Conversion Cycle (CCC) = DR + DI - DP◦ Working Capital Gap (lower the better)◦ Time between cash outflow and cash inflow

� Higher working capital indicates liquidity� However, excessive liquidity ties up capital and lowers overall return on assets.

1/26/2010 5Copyright 2010, Process IS Inc.

� Use unconventional wisdom and business model

� To fund internal operations using negative working capital

� Cash Conversion cycle could be negative!� Cash Conversion cycle could be negative!

� And get rewarded for it…..

� How do they do that?

1/26/2010 6Copyright 2010, Process IS Inc.

� Current Assets (CA)◦ Cash + Marketable Securities (notes etc)◦ Inventory (Inv.)◦ Accounts Receivables (A/R)◦ Pre-Paid Accounts (PPA)

� Current Liabilities (CL)◦ Short Term Debt (STD)◦ Accounts Payables (A/P)◦ Unearned Revenue (UR)◦ Unearned Revenue (UR)

� Stock Holders Equity (SE)◦ Paid in Capital (PIC)◦ Retained Earnings (RE)� Revenues-Expenses

� Cash Conversion Cycle (CCC) = DR + DI – DP

� WC = CA - CL

1/26/2010 7Copyright 2010, Process IS Inc.

� Requires the right business model.

� Automakers do not get paid before they ship. In fact they have their capital tied in inventory for a long time which is why they have a huge working capital.

� Amazon and Dell to an extent (since Dell is not just online/direct anymore as they used to be) get paid before they ship.

� So extending payables allows them to create a small � So extending payables allows them to create a small cash conversion cycle (could be negative).

� The Unearned revenue, which is a liability, turns the working capital negative (credit UR and debit cash)

� They pay the suppliers with cash they get from customers and have some left over all the time in essence getting an interest free loan from the customers!

1/26/2010 8Copyright 2010, Process IS Inc.

� Yes, you could. However, that usually is a red flag for the credit rating agencies (i.e. funding operations with cash from investing or financing activities)

� Amazon does not have to worry about credit rating downgrade due to A/P increase.

� They are doing it to increase their working capital � They are doing it to increase their working capital efficiency and not because of cash flow constraint.

� They did issue large amount of debt few years ago and was the reason for Amazon.bom Barron's article.

� Servicing that debt is not an issue anymore and they successfully used the capital raised to scale themselves and the rest as they say is history

1/26/2010 9Copyright 2010, Process IS Inc.

� Dell is going through a transformation◦ http://process-improvement-solutions.com/blog/2009/11/03/dells-transformation/◦ Is loosing PC market share◦ Due to focus on margin

� Strategic Decision to reposition during a trough in the economic cycle◦ http://process-improvement-solutions.com/blog/2009/04/20/repositioning-during-troughs/troughs/

� Objective being to move from products to services◦ http://process-improvement-solutions.com/blog/2009/03/03/from-products-to-services-how-do-they-do-that/

� Why? For profitable growth – A topic for another discussion

� Next: Case Scenarios with Numerical Examples

1/26/2010 10Copyright 2010, Process IS Inc.