|Working Capital Management example
Let us conclude by seeing how the phenomenon of managing receivables
and payables can affect the balance sheet of a business.
We have a company that has a sales per day of $1000 and purchases
per day of $500.
At the moment the company is collecting its receivables on average in 45 days
and is paying its receivables on average in 30 days. This company has no cash as we see on the balance sheet, but it
has a line of credit that it is using to pay its bills.
As they collect receivables the line of credit goes down as
it pays its bills the line of credit goes up. Right now the company owes $19,500 on the line of credit. Lets assume
that this company gets sloppy and it collects its receivables in 90 days. Now its bank line of credit is sitting at
$64,500 because it has not collected the cash from its customers as quickly. The quicker you collect your receivables,
the more cash you have on hand and the less you owe on your line of credit. Just because it was a little less diligent
in collecting its receivables, it owes a lot more money to the bank. Conversely it is paying its bills rather quickly
at 30 days, lets suppose that you can negotiate with your supplier are extend the credit to 60 days. Now you only owe
$4,500 on your line of credit, simply because you haven’t paid your bills as fast. Account payable becomes greater,
but this sort of credit becomes cash to you.
This little example shows you the dynamics of managing your
receivables and payables. Trying to collect your receivables quickly and trying to pay your payables as slowly as practical
and acceptable to your supplier could collectively be a source of financing. Effective management of your working capital
is one important source of finance.
If we lower our receivables to 30 days and stretch our payables
to 60 days, now instead of owing on the bank line of credit we are in a credit position on the bank line of credit which means
we have surplus cash of $10,500. That is why effective management of working capital is so important. And that
is also why the turnover ratios are important to help us decide if the age of receivables is appropriate and if the age of
payables is appropriate. Can we tighten up the age of our receivables, can we lengthen the age of our payables?
Analysis of Financial Statements - Profit Terms
PAT Profit After
EBIT Earnings Before Interest
EBIAT Earnings Before Interest and
EBITDA Earnings Before Interest, Taxes and Depreciation Allowances
SUMMARY - ANALYSIS OF FINANCIAL STATEMENTS
Financial Ratios are used in the evaluation of the financial
condition and profitability of a company. The ratios are calculated from the financial information provided in the balance
sheet and income statements. Every firm has two basic financial objectives:
- to be financially sound
- to earn an adequate rate of return on invested capital
Liquidity and Solvency tell you how financially
sound the company is. Liquidity is the ability to meet short term financial obligations. Solvency is the ability to meet long
When analyzing financial statements you should keep in
mind the principles/practices that accountants use in preparing statements.
Types of Financial Ratios
- Liquidity Ratios:
- Current Ratio
- Acid Test Ratio
- Solvency Ratios:
- Debt/Equity Ratio
- Debt/Capitalization Ratio
- Profitability Ratios focus on earning an adequate rate of
- Gross Margin %
- Operating Ratio
- Return on Sales
- Return on Assets
- Return on Equity
- Return on Investment
- Turnover Ratios focus on how effective the company is in
the utilization of its assets and management of its working capital:
- Asset Turnover
- Inventory Turns
- Days Receivable
- Days Payable
Pay attention to how ratios are defined
when you are analyzing them. Different people use different ways to calculate the same ratio. For example, a bank might define
the Debt/Equity Ratio as Long Term Debt + Short Term Debt / Shareholder's Equity,
in this module it is defined as Long Term Debt / Shareholder's Equity.