CHAPTER 3 MANAGING OPERATING FUNDS We now turn to the key issues surrounding the flow of funds through a business, that is, how to properly manage, on an ongoing basis, cash inflows and funding re- quirements for day-to-day operations. Managers must understand the specific cash movements within the business system, which are caused by their daily de- cisions on investment, operations, financing, and the many external circumstances affecting the business. These decisions and events, in one form or another, affect the company’s ability to pay its bills, obtain credit from suppliers and lenders, ex- tend credit to its customers, and maintain a level of operations that matches the demand for the company’s products or services, supported by appropriate invest- ments. In the end, the combined effect of these decisions is the creation of share- holder value—but, as we’ve stated before, only if the net cash flows achieved by the business exceed the market’s expectations over time. It should be obvious by now that every decision has a monetary impact on the ongoing pattern of uses and sources of cash. Management’s job is to maintain at all times an appropriate balance between cash inflows and outflows, and to plan for the cash impact of any changes in operations—whether caused by man- agement’s decisions or by outside influences—that might affect these flows. Properly managing operating cash flows is, therefore, fundamental to successful business performance. The principle is quite simple: Obtain the most performance over time with the least commitment of resources. In practice, however, leads and lags in receipts and payments, unexpected deviations from planned conditions, delays in receiv- ing cash from funding sources, and myriad other factors can make cash flow man- agement a complex challenge. New businesses often find that balancing operating funds needs and sources is a continuous struggle for survival. Yet, even well- established companies need to devote considerable management time and effort to balance the ongoing funding of their operations as they strive for optimal economic results. 59 hel78340_ch03.qxd 9/27/01 11:00 AM Page 59 Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use. 60 Financial Analysis: Tools and Techniques In addition to managing working capital, balancing operating funds flows requires dealing with the changing cash flow patterns of periodic profits and losses, and with the ultimate cash impact of current decisions on both new invest- ment and new financing choices. As we’ll demonstrate, managing operating funds requires a thorough un- derstanding of the combined systems effect of investment, operating, and financ- ing decisions. This includes recognizing the impact on funds uses and sources caused by various basic operating conditions, such as seasonal peaks and valleys, cyclical variations, rapid growth, or gradual decline. In every circumstance the re- sulting cash flow patterns will behave in very different ways, and will put stresses on the financial system at different points and in different time frames. For Example Managing working capital soundly is a major operating cash flow challenge. The key components of working capital, accounts receivable, inventories, and accounts payable often represent significant funds commitments and sources for a business. In fact, the basic level of working capital (commonly defined as the difference between current assets and current liabilities) with which a business operates represents a long-term investment supported by long-term capital sources. Each component, however, must be carefully managed to match the changing requirements of operations—with the objective of minimizing the resources committed at any point in time while meeting all operational needs, such as ensuring smooth production and customer service goals. Management should plan for fluctuations in working capital as a result of changing conditions, rather than be surprised by soaring inventories or overextended supplier credit. As in all business decisions, economic trade-offs apply here: Is the cost of carrying extra inventory outweighed by better service to customers? Is the cost of granting higher discounts for early payment offset by the reduction in receivables likely to be outstanding? What is the real cost of not meeting the credit terms extended by the company’s vendors? In Chapter 4, we’ll examine a variety of performance measures drawn from financial statements, which we know to be periodic summaries of finan- cial condition and operating results. As we’ll see, these summaries often mask peaks and valleys of funds movements—for example, a seasonal buildup caus- ing critical near-term financing needs—because these points mights lie within the period spanned by the statements. Obviously, managing a business is an Current assets Working capital Fixed assets Other assets Current liabilities Long- term debt Share- holders' equity hel78340_ch03.qxd 8/6/01 3:31 PM Page 60 CHAPTER 3 Managing Operating Funds 61 ongoing day-to-day process, which must deal with peaks and valleys of cash flows as they occur. In this chapter, we’ll describe how operating funds cycle through a business, what the implications of these movements are, and how to identify the critical fi- nancial variables that must be weighed in making daily operating decisions. We’ll demonstrate how significantly different types of operations impact a company’s cash flow pattern, and also highlight key accounting issues, such as inventory costing and methods of depreciation. Then we’ll return to the interpretation of cash flow statements, using our sample of TRW’s 1997 and 1996 financial data, and demonstrate how to use cash flow statements in a meaningful way. Finally, we’ll discuss the key levers available to managers with which to minimize funds needs, moderate the impact of fluctuations, and generally optimize the manage- ment of operating funds as part of shareholder value creation. Funds Flow Cycles Businesses vary widely in orientation, size, structure, and products or services, but they all experience operating funds cycles that eventually affect cash needs and availability. To illustrate the simplest of circumstances, let’s observe a solitary ice cream vendor who sells cones from his cart for cash. To carry on this business, he has to provide an inventory on wheels, which he slowly converts into cash as the day progresses. Let’s also assume that he has invested his own cash at the begin- ning of the day to purchase the ice cream from his supplier. He obviously hopes to recoup these funds as well as pocket a profit by the end of the day. Our vendor’s decision to commit his own cash to inventory can be visual- ized in Figure 3–1, which traces the funds movements in a simple diagram. Note that the layout reflects the three decision areas we discussed in Chapter 2. FIGURE 3–1 Ice Cream Vendor Initial Cash Investment to Start the Day Investment Operations Financing Management Decision Context Cash Ice cream inventory Owner's equity hel78340_ch03.qxd 9/27/01 11:00 AM Page 61 62 Financial Analysis: Tools and Techniques The initial cash investment is financed from the owners’equity, and in turn, the cash is used to invest in the first day’s inventory. If our vendor was short of cash, he could sign an IOU for the supplier, promising to pay for the inventory the next morning, using the day’s cash receipts as funding. This assumption modifies the diagram, as shown in Figure 3–2. Here, the creditor’s funds effectively sup- plant the owner’s funds, if only for a single day. In any event, our vendor’s funds cycle is very short. The initial investment in inventory, funded either with his own cash or with credit from his supplier, is followed by numerous individual cash sales during the day. These receipts build up his cash balance for the following day’s operations. Next, we’ve represented the first day of operations—assuming the vendor fi- nanced the inventory himself—in Figure 3–3, where cash on hand is built up by sales receipts, inventory is drawn down during the day, and the difference between sales revenue and the cost of the ice cream sold represents the profit earned. This profit increases ownership equity, reflecting the value created during the day. The following morning, our vendor uses the accumulated cash either to re- plenish his inventory, or to pay off the supplier so that he’ll be extended credit for another day’s cycle. Any profit he has earned above the cost of the goods sold will, of course, be his to keep, or to invest in more inventory for the next day. Figure 3–4 shows the alternative funds movements that would arise had our vendor used supplier credit for the first day. He would find that the amount of cash left after repayment of the initial supplier credit—the amount of his profit for the first day—would purchase only a portion of the next day’s inventory. To continue operating on the second day he would have to decide whether to • Ask for renewed credit from his supplier, or • Provide the additional funds from any resources of his own that aren’t yet committed to the business. FIGURE 3–2 Ice Cream Vendor Initial Use of Credit to Start the Day Investment Operations Financing Management Decision Context Cash Ice cream inventory I. O. U. to supplier Owner's equity hel78340_ch03.qxd 9/27/01 11:00 AM Page 62 CHAPTER 3 Managing Operating Funds 63 FIGURE 3–4 Ice Cream Vendor Repayment of Credit after Profitable First Day Investment Operations Financing Management Decision Context Cash on hand Ice cream inventory less Cash sales Cost of goods sold Profit for the day Supplier credit Owner's equity FIGURE 3–3 Ice Cream Vendor Profitable Operations during the First Day Investment Operations Financing Management Decision Context Cash on hand Cash sales Ice cream inventory Cost of goods sold less Profit for the day Supplier credit Owner's equity hel78340_ch03.qxd 9/27/01 11:00 AM Page 63 64 Financial Analysis: Tools and Techniques Funds cycles of larger and more structured businesses differ from this sim- ple situation only in complexity, not in concept. Even for the most complex inter- national conglomerate, the ultimate form of settlement of any transaction is cash. However, such a company’s operational funds cycle usually involves a variety of partially offsetting credit extensions, changes in inventories, transformations of assets, etc., that precede the cash collections or payments. In essence, any funds cycle arises because of a series of lags in the timing of business transactions. Our ice cream vendor has a lag of only a few hours between the purchase of his inventory and its conversion into cash through many small transactions. In contrast, a large manufacturer might have a lag of months between the time a product is made in the factory and the ultimate collection of the selling price from customers who purchased on trade credit. A service company might have a lag of weeks between the time salaried or contract professionals are paid for their work and the ultimate collection of service fees. Management must plan for and find the financing for company funds which are tied up because of these timing lags. This is important because these funds will remain committed for the foreseeable future, unless there are significant changes in the company’s operations. As with any type of investment, management should attempt to minimize this resource commitment while maintaining operational ef- fectiveness. Ways to reduce the funding required include methods such as “just- in-time” delivery of materials or parts in manufacturing, or purchasing merchandise on consignment in retailing. To illustrate the nature of the concept further, we’ll further explore the following three processes: • The funds cycle of a simplified manufacturing operation. • The funds cycle for selling the manufactured products. • The funds cycle for a service organization. We’ve separated these processes for purposes of illustration and discussion, even though the first two cycles are always intertwined in any ongoing business that both produces and sells products. The sales cycle alone, of course, applies to any retail, wholesale, or trading operation that purchases goods for resale, while the service cycle amounts to a modification of the sales cycle. The Funds Cycle for Manufacturing To keep the illustration simple, let’s assume that the Widget Manufacturing Com- pany has just begun operations and is going to produce widgets for eventual sale. Figure 3–5 shows the company’s funds flow cycle in the form of an overview, using minimal detail. We’ve again arranged the diagram to reflect the three man- agement decision areas. As is readily apparent, the company was initially financed through a com- bination of owners’ equity, long-term debt, and three kinds of short-term debt: hel78340_ch03.qxd 9/27/01 11:00 AM Page 64 CHAPTER 3 Managing Operating Funds 65 • Accounts payable due vendors of materials and supplies. • Some short-term loans from banks. • Other current liabilities, such as accrued wages and taxes. The initial investments involve fixed assets (such as plant facilities), other assets (such as patents and licenses), and three kinds of current assets: • Cash. • Raw materials inventory. • Finished goods inventory. Of course, the last of these won’t appear until the plant actually starts pro- ducing widgets. We can assume that long-term debt and owners’ equity are the logical sources of funds for investing in plant and equipment, because they match the long-term funding commitment involved. In contrast, the short-term loans most likely provided the ready cash needed to start operations. Materials and supplies were bought with short-term trade credit extended by the company’s vendors. FIGURE 3–5 Funds Flow Cycle for Manufacturing Investment Operations Financing Management Decision Context Materials Supplies Salable products Wages Expenses Write-off Depreciation Write-off Amortization Cash Raw materials inventory Finished goods inventory Fixed assets Other assets Expenses Accounts payable Short-term liabilities Other current liabilities Long-term liabilities Shareholders’ equity Production transformation hel78340_ch03.qxd 9/27/01 11:00 AM Page 65 66 Financial Analysis: Tools and Techniques As production begins, a basic transformation process takes place. Some of the available cash is used to pay weekly wages and various ongoing expenses. Materials and supplies are withdrawn from inventory and are used in manufactur- ing widgets. Inventories are replenished with additional credit. Some operating in- puts, like power and fuel oil, are obtained on credit, and are temporarily financed through accounts payable. Use of the plant and equipment is reflected in the form of a depreciation charge, which becomes part of the cost of the transformation process. Any patents and licenses are similarly amortized and charged to the production cost. As wid- gets are finished on the factory floor, they’re moved into the warehouse and their cost is added to the growing finished goods inventory account. In the absence of any widget sales, the production process continuously transforms cash, raw materials, expense accruals, and trade credit into a growing buildup of finished goods inventory. A fraction of the original cost of the building, machinery, and other depreciable assets used has now become part of the cost of finished goods via the depreciation charge—even though no cash is actually moved by this allocation process. This accounting write-off merely affects the company’s books by transferring a portion of the recorded cost of the assets into the cost of the inventory. Remember, the only time cash actually changed hands was when the assets were originally acquired. What are the funds implications of this transformation? The operational funds flows, which occurred after the business was established, so far had affected only working capital components. The major sources of funding for the produc- tion process largely came from drawing down cash and raw materials, which were among the initial funds committed. An additional source was found in increased trade credit and in expenses accrued but not yet paid. The major use of these funds was in the buildup of finished goods inven- tory. Unless the company can eventually turn finished goods into cash through successful sales to its customers, the continued inventory buildup will eventually drain both the cash reserves and the stores of raw material. These will have to be replenished by new infusions of credit or owners’ equity, or both. Adding to the cash drain is the obligation to begin the repayment— on normal terms such as 30 or 45 days from the invoice date—of accounts payable for trade credit incurred. From a funds flow standpoint, several timing lags are significant in our example: • A supply of raw materials sufficient for several days of operation has to be kept on hand to ensure uninterrupted manufacturing, assuming that just-in-time delivery arrangements are not possible. • The physical lag in the number of days required to produce a widget causes a buildup of an inventory of work in process, that is, widgets in various stages of completion. • A sufficient number of widgets must be produced and kept at all times in finished goods inventory to support an ongoing sales and service effort. hel78340_ch03.qxd 9/27/01 11:00 AM Page 66 TEAMFLY Team-Fly ® CHAPTER 3 Managing Operating Funds 67 The combined funds commitment caused by these lags has to be financed on a continuous basis through resources provided by owners and creditors, as long as the pattern of lags remains unchanged. Offsetting this funding requirement, but only in part, is the length of time over which credit is extended by the company’s suppliers. This is a favorable lag because purchases of raw material and supplies, as well as certain other expenses, will be financed by vendors as accounts payable for 30 or 45 days, or for whatever length of time is common usage in the industry. New credit will continue to be ex- tended as repayments are made of the accounts coming due. Another significant favorable lag is the temporary funding provided by the employees of the company whose wages are paid periodically. In effect, employ- ees are extending credit to their employer for a week, two weeks, or even a month, depending on the company’s payroll pattern. Such funding is recognized among current liabilities as accrued wages. Other expense accruals, such as income taxes currently owed, will provide temporary funds as well. As we observed before, however, the buildup of finished goods in the ware- house cannot go on indefinitely, and at some point, revenues from the sale of the widgets become essential to replenishing cash in order to meet the company’s obligations as accounts become due. To complete the picture, we must examine the funds implications of the selling process. The Funds Cycle for Sales The funds flows caused by selling the widgets can be examined within our deci- sional framework, as shown in Figure 3–6. The operations segment in the center of the diagram now includes the main elements of an income statement: • Sales revenue. • Cost of goods sold. • Selling expenses. • General and administrative expenses. • Net income. The selling cycle is based on a major timing lag, which arises from the extension of credit to the company’s customers. If the widgets were sold for cash, collection would, of course, be instantaneous. If the company provides normal trade credit, however, the collection of accounts receivable will be delayed by the terms ex- tended to customers, such as 30 or 45 days, depending on prevailing practice in the business sector. This sales lag, like the lags incurred during the production cycle, has to be fi- nanced continuously, because for any given volume of sales, the equivalent of 30, 40, or 50 days’ worth of sales will always be outstanding. As accounts becoming due are collected, new credit will be extended to customers on current sales—as was the case with the vendors supplying materials and other items to the company itself. hel78340_ch03.qxd 9/27/01 11:00 AM Page 67 68 Financial Analysis: Tools and Techniques Cost of goods sold represents the value of the widgets withdrawn from fin- ished goods inventory, each of which contains a share of the labor, raw material, and overhead. Other costs expended in its manufacture include apportioned de- preciation for the use of the facilities and a share of the amortization of any patents or licenses involved. Selling expenses, which consist of the salaries of the sales force, the mar- keting support staff, and advertising and promotional costs, will be paid partly in cash and partly with funds obtained from creditors. General and administrative expenses will be paid in a similar fashion. Once all these costs and expenses have been subtracted from sales revenue, the resulting net income (or loss), after al- lowing for state and federal income taxes, causes an increase (or decrease) in owners’ equity. What are the funds flow implications of this picture? First of all, assuming that the company is maintaining a level volume of sales and manufacturing oper- ations, management must plan for a continuous long-term commitment of funds to support the necessary amount of working capital. This means that sufficient funds must be provided to carry inventories of raw materials and work in process FIGURE 3–6 Funds Flow Cycle for Sales Investment Operations Financing Management Decision Context Cash Accounts receivable Inventories Fixed assets Other assets Expenses Accounts payable Short-term liabilities Other current liabilities Long-term liabilities Shareholders’ equity Sales Cost of sales Operating expenses Net income Write-offs hel78340_ch03.qxd 9/27/01 11:00 AM Page 68 [...]... (49) — $ (49) $ 434 182 298 _ $ 480 1 _ $ 479 _ 1 23. 7 1 23. 7 132 .8 128.7 $ 4. 03 $ (0.40) — $ (0.40) $ 3. 27 $ 1 .37 $ 2.25 _ $ 3. 62 _ $ 4. 03 $ (0.40) — $ (0.40) $ 13. 19 $ 6.58 $ 3. 29 $ 1.41 $ 2 .31 _ $ 3. 72 _ $ 17.29 $ 15.62 $ $ 480 10 549 154 442 10 500 148 hel7 834 0_ch 03. qxd 84 9/27/01 11:00 AM Page 84 Financial Analysis: Tools and Techniques • • • acquisitions,... Total liabilities and shareholders’ investment Source: Adapted from 1997 TRW Inc annual report 1996 Change $ 70 1,617 5 73 79 96 2, 435 6,074 $ 38 6 1 ,37 8 524 69 424 2,781 5,880 $ Ϫ 31 6 ϩ 239 ϩ 49 ϩ 10 Ϫ 32 8 _ Ϫ 34 6 _ ϩ 194 3, 4 53 3, 400 ϩ 53 _ 2,621 2,480 ϩ 141 6 73 232 905 94 811 139 404 $6,410 258 31 289 78 211 51 37 6 $5,899 ϩ... $ 411 33 8 859 846 38 99 128 2,719 788 1,117 57 105 $ 52 38 6 781 775 39 52 72 2,157 767 458 272 56 $ ϩ 35 9 Ϫ 48 ϩ 78 ϩ 71 Ϫ 1 ϩ 47 ϩ 56 _ ϩ 562 _ ϩ 21 ϩ 659 Ϫ 215 ϩ 49 1 78 462 1,776 ( 130 ) (5 63) 1,624 $6,410 1 80 437 1,978 47 (35 4) 2,189 $5,899 0 Ϫ 2 ϩ 25 Ϫ 202 Ϫ 177 Ϫ 209 _ Ϫ 565 _ ϩ 511 _ hel7 834 0_ch 03. qxd 9/27/01 11:00 AM Page 81 CHAPTER 3 Managing... and by other investments ($201 million) An increase of $ 239 million in accounts receivable, reflecting volume growth and the impact of the acquisitions A net increase of $194 million in property, plant, and equipment, reflecting new capital spending as well as disposals, and the impact of the hel7 834 0_ch 03. qxd 9/27/01 11:00 AM Page 83 CHAPTER 3 Managing Operating Funds 83 F I G U R E 3 14 TRW INC AND. .. of purchased research and development related to the acquisition of BDM International, depreciation of $480 million, amortization of hel7 834 0_ch 03. qxd 9/27/01 11:00 AM Page 86 86 Financial Analysis: Tools and Techniques F I G U R E 3 15 TRW INC AND SUBSIDIARIES Derived Funds Sources and Uses Statement For the Year Ended December 31 , 1997 ($ millions) Sources $ 49 $ 548 480 10 1 13 AM FL Y Funds from... this larger context hel7 834 0_ch 03. qxd 9/27/01 92 11:00 AM Page 92 Financial Analysis: Tools and Techniques 2 Operational funding is affected by both internal and external conditions and causes, which must be understood in terms of the business environment, economic conditions, and specific company processes and policies Identifying the key drivers of operational funds patterns and tracing their impact... category—the funds used for investment and by far less in the other two, $3 million and $52 million respectively hel7 834 0_ch 03. qxd 9/27/01 11:00 AM Page 88 88 Financial Analysis: Tools and Techniques F I G U R E 3 16 TRW INC AND SUBSIDIARIES Statements of Cash Flows For the Years Ended December 31 , 1997 and 1996 ($ millions) 1997 1996 $ (49) $ 480 Operating Activities: Net earnings (loss) ... retained earnings Cash dividends are also immersed in the net change in retained earnings hel7 834 0_ch 03. qxd 9/27/01 11:00 AM Page 80 80 Financial Analysis: Tools and Techniques F I G U R E 3 12 TRW INC AND SUBSIDIARIES Consolidated Balance Sheets at December 31 ($ millions) 1997 Assets Current assets: Cash and cash equivalents Accounts receivable Inventories ... of business, large or small We have added flow lines, which show the potential funds movements and linkages between the main accounts of the balance sheet and the income statement A summary, in terms of our hel7 834 0_ch 03. qxd 9/27/01 11:00 AM Page 78 78 Financial Analysis: Tools and Techniques F I G U R E 3 11 Generalized Funds Flow Model Management Decision Context Investment Operations Financing Sales... in later chapters, where cash flow patterns and expectations are a significant aspect of financial analysis techniques and practices Analytical Support Financial Genome, the commercially available financial analysis and planning software described in Appendix I, has the capability to develop cash flow statements from databases, spreadsheets, and direct inputs (see “Downloads Available” on p 431 ) Selected . need Funding after dividends 1999 2000 2001 2002 20 03 2004 2005 2006 hel7 834 0_ch 03. qxd 9/27/01 11:00 AM Page 73 74 Financial Analysis: Tools and Techniques Basically, the ability of the business. 2000 2001 2002 20 03 2004 2005 2006 hel7 834 0_ch 03. qxd 9/27/01 11:00 AM Page 77 78 Financial Analysis: Tools and Techniques familiar management decision context, of the sources and uses of the ultimate cash. on hand Cash sales Ice cream inventory Cost of goods sold less Profit for the day Supplier credit Owner's equity hel7 834 0_ch 03. qxd 9/27/01 11:00 AM Page 63 64 Financial Analysis: Tools and