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FINANCE FOR EXECUTIVES

Managing for Value Creation

FINANCE FOR EXECUTIVES

Managing for Value Creation

Gabriel HawawiniGabriel Hawawini

Claude VialletClaude Viallet

Gabriel HawawiniGabriel Hawawini

Claude VialletClaude Viallet

ASSESSING LIQUIDITY ANDASSESSING LIQUIDITY ANDOPERATIONAL EFFICIENCYOPERATIONAL EFFICIENCYASSESSING LIQUIDITY ANDASSESSING LIQUIDITY ANDOPERATIONAL EFFICIENCYOPERATIONAL EFFICIENCY

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EXHIBIT 3.1a: OS Distributors’ Balance Sheets.OS Distributors’ Balance Sheets.Figures in millions of dollars

DEC. 31, 1995 DEC. 31, 1996 DEC. 31, 1997

ASSETS CURRENT ASSETS $104.0 $119.0 $137.0

Cash1 $6.0 $12.0 $8.0

Accounts receivable 44.0 48.0 56.0

Inventories 52.0 57.0 72.0

Prepaid expenses2 2.0 2.0 1.0

NONCURRENT ASSETS 56.0 51.0 53.0

Financial assets & intangibles 0.0 0.0 0.0

Property, plant, & equip. (net) 56.0 51.0 53.0

Gross value3 $90.0 $90.0 $93.0

Accumulated depreciation (34.0) (39.0) (40.0)

TOTAL ASSETS $160.0 $170.0 $190.0

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EXHIBIT 3.1b: OS Distributors’ Balance Sheets.OS Distributors’ Balance Sheets.Figures in millions of dollars

LIABILITIES AND OWNERS’ EQUITY CURRENT LIABILITIES $54.0 $66.0 $75.0

Short-term debt $15.0 $22.0 $23.0

Owed to banks $7.0 $14.0 $15.0

Current portion of long-term debt

8.0 8.0 8.0

Accounts payable 37.0 40.0 48.0

Accrued expenses4 2.0 4.0 4.0

NONCURRENT LIABILITIES 42.0 34.0 38.0

Long-term debt5 42.0 34.0 38.0

Owners’ equity6 64.0 64.0 70.0 70.0 77.0 77.0

TOTAL LIABILITIES ANDOWNERS’ EQUITY $160.0 $170.0 $190.0

DEC. 31, 1995 DEC. 31, 1996 DEC. 31, 1997

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EXHIBIT 3.2a: The Managerial Balance Sheet Versus the Standard The Managerial Balance Sheet Versus the Standard Balance Sheet.Balance Sheet.

THE MANAGERIAL BALANCE SHEET

INVESTED CAPITAL OR NET ASSETS CAPITAL EMPLOYED

Cash

Working capital requirement(WCR)

Operating assets less Operating liabilities

Net fixed assets

Short-term debt

Long-term financingLong-term debt

plusOwners’ equity

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EXHIBIT 3.2b: The Managerial Balance Sheet Versus the Standard The Managerial Balance Sheet Versus the Standard Balance Sheet.Balance Sheet.

THE STANDARD BALANCE SHEET

TOTAL ASSETSLIABILITIES

AND OWNER’S EQUITY

Short-term debtCash

Operating assets

Accounts receivable plus Inventories plus

Prepaid expenses

Net fixed assets

Operating liabilities

Accounts payable plus Accrued expenses

Long-term financingLong-term debt

plus Owners’ equity

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EXHIBIT 3.3: The Firm’s Operating Cycle and Its Impact on The Firm’s Operating Cycle and Its Impact on the Firm’s Balance Sheet.the Firm’s Balance Sheet. = Change in the balance sheet account

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EXHIBIT 3.4: The Firm’s Operating Cycle, Showing The Firm’s Operating Cycle, Showing Cash-to-Cash Period.Cash-to-Cash Period.

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YEAR RECEIVABLES INVENTORIES PAYABLES WCR1 CASH2 SALES

1994 $68 $1,939 $5,296 –$3,289 $3,123 $27,2601995 84 2,172 5,484 –3,228 3,281 28,922

EXHIBIT 3.5: Extracts from Carrefour’s Balance Sheets Extracts from Carrefour’s Balance Sheets and Income Statements.and Income Statements.Figures in millions of dollars

Source: Company’s Annual Report.1WCR = Working capital requirement = Receivables + Inventories – Payables2Includes cash lent to other companies.

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EXHIBIT 3.6: OS Distributor’s Managerial Balance Sheets.OS Distributor’s Managerial Balance Sheets.All data from the balance sheets in Exhibit 3.1; figures in millions of dollars

INVESTED CAPITAL OR NET ASSETS

• Cash• Working capital requirement (WCR)1

• Net fixed assets

$ 6.0 5%59.0 49%56.0 46%

$121.0 100%TOTAL INVESTED CAPITAL OR NET ASSETS

CAPITAL EMPLOYED

DEC. 31, 1995 DEC. 31, 1996 DEC. 31, 1997

$12.0 10%63.0 50%51.0 40%

$126.0 100%

$ 8.0 6%77.0 56%53.0 38%

$138.0 100%

• Short-term debt• Long-term financing

Long-term debtOwners’ equity

$ 15.0 12%106.0 88%

$42.0 64.0

$121.0 100%

$ 22.0 17%104.0 83%

$34.070.0

$126.0 100%

$ 23.0 17%115.0 83%

$38.077.0

$138.0 100%TOTAL CAPITAL EMPLOYED

1 WCR = (Accounts receivable + Inventories + Prepaid expenses) – (Accounts payable + Accrued expenses).These amounts are given in Exhibit 3.1.

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EXHIBIT 3.7: The Behavior of Working Capital Requirement overThe Behavior of Working Capital Requirement overTime for a Firm with Seasonal Sales.Time for a Firm with Seasonal Sales.WCR is assumed to be set at 25 percent of sales

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EXHIBIT 3.8a: OS Distributor’s Net Investment in Its OperatingOS Distributor’s Net Investment in Its OperatingCycle and Its Financing.Cycle and Its Financing.All data from the balance sheets in Exhibit 3.1; figures in millions of dollars

DECEMBER 31, 1995NET INVESTMENT IN THE OPERATING CYCLE ORWORKING CAPITAL REQUIREMENTS (WCR)

WCR = [Accounts receivable + Inventories + Prepaid expenses]– [Accounts payable + Accrued expenses]

[$44 + $52 + $2] – [$37 + $2] =$59

THE FINANCING OF THE OPERATING CYCLE

Net long-term financing (NLF) = Long-term debt + Owners’ equity – Net fixed assets

Net short-term financing (NSF) = Short-term debt – CashNLF/WCR = percentage of working capital

requirement financed long termNSF/WCR = percentage of working capital

requirement financed short term

$42 + $64 – $56 = $50$15 – $6 = $9

$50/$59 = 84.7%$9/$59 = 15.3%

100.0%

WORKING CAPITAL REQUIREMENT AND ITS FINANCINGWCR NSF $9

$59 NLF $50

15.3%

84.7%

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EXHIBIT 3.8b: OS Distributor’s Net Investment in Its OperatingOS Distributor’s Net Investment in Its OperatingCycle and Its Financing.Cycle and Its Financing.All data from the balance sheets in Exhibit 3.1; figures in millions of dollars

DECEMBER 31, 1996NET INVESTMENT IN THE OPERATING CYCLE ORWORKING CAPITAL REQUIREMENTS (WCR)

WCR = [Accounts receivable + Inventories + Prepaid expenses]– [Accounts payable + Accrued expenses]

[$48 + $57 + $2] – [$40 + $4] =$63

THE FINANCING OF THE OPERATING CYCLE

Net long-term financing (NLF) = Long-term debt + Owners’ equity – Net fixed assets

Net short-term financing (NSF) = Short-term debt – CashNLF/WCR = percentage of working capital

requirement financed long termNSF/WCR = percentage of working capital

requirement financed short term

$34 + $70 – $51 = $53$22 – $12 = $10

$53/$63 = 84.1%$10/$63 = 15.9%

100.0%

WORKING CAPITAL REQUIREMENT AND ITS FINANCINGWCR NSF $10

$63 NLF $53

15.9%

84.1%

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EXHIBIT 3.8c: OS Distributor’s Net Investment in Its OperatingOS Distributor’s Net Investment in Its OperatingCycle and Its Financing.Cycle and Its Financing.All data from the balance sheets in Exhibit 3.1; figures in millions of dollars

DECEMBER 31, 1997NET INVESTMENT IN THE OPERATING CYCLE ORWORKING CAPITAL REQUIREMENTS (WCR)

WCR = [Accounts receivable + Inventories + Prepaid expenses]– [Accounts payable + Accrued expenses]

[$56 + $72 + $1] – [$48 + $4] =$77

THE FINANCING OF THE OPERATING CYCLE

Net long-term financing (NLF) = Long-term debt + Owners’ equity – Net fixed assets

Net short-term financing (NSF) = Short-term debt – CashNLF/WCR = percentage of working capital

requirement financed long termNSF/WCR = percentage of working capital

requirement financed short term

$38 + $77 – $53 = $62$23 – $8 = $5

$62/$77 = 80.5%$15/$77 = 19.5%

100.0%

WORKING CAPITAL REQUIREMENT AND ITS FINANCINGWCR NSF $15

$77 NLF $62

19.5%

80.5%

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EXHIBIT 3.9a: Some Benchmark Ratios of Working CapitalSome Benchmark Ratios of Working CapitalRequirement to Sales for a Sample of U.S. SectorsRequirement to Sales for a Sample of U.S. Sectors11..

WORKING CAPITAL REQUIREMENT SECTOR AS PERCENTAGE OF SALES

1996 Highest 1992–96 Lowest 1992–96Electronic components 24% 25% 22%Aircraft 22% 22% 19%Measurement instruments 21% 22% 21%Steel works 20% 20% 18%Motor vehicles 20% 20% 19%Machinery & equipment 19% 21% 18%Textiles 17% 20% 17%Chemicals 17% 17% 14%Wood products & buildings 16% 16% 14%Apparel products 15% 17% 15%Department stores 15% 19% 13%Plastic products 14% 15% 14%Computing equipment 14% 17% 14%Retail: Nongrocery stores 12% 15% 12%Paper 11% 12% 10%

AVERAGE: ALL SCORES 10% 11% 10%1 Source: Calculated by the authors using Compustat data.

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EXHIBIT 3.9b: Some Benchmark Ratios of Working CapitalSome Benchmark Ratios of Working CapitalRequirement to Sales for a Sample of U.S. SectorsRequirement to Sales for a Sample of U.S. Sectors11..

WORKING CAPITAL REQUIREMENT SECTOR AS PERCENTAGE OF SALES

Drugs 10% 13% 10%Wholesale: Durables 10% 10% 7%Soaps & perfumes 8% 8% 7%Food 7% 7% 5%Wholesale: Nondurables 5% 6% 5%Telephone 3% 3% –2%Oil & natural gas 2% 3% 2%Publishing 2% 2% 1%Beverages 1% 1% 0%Electric services 0% 2% 0%Grocery stores 0% 1% 0%Natural gas: Distribution –1% 2% –1%Services2 –1% –1% –5%Air transportation3 –13% –11% –13%

2The services sector covers a variety of industries, including advertising, cleaning, data processing, research and development, and management consultancy.3The air transportation sector covers scheduled and nonscheduled air transportation as well as air courier services and airports and terminal services.

1996 Highest 1992–96 Lowest 1992–96

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EXHIBIT 3.10: OS Distributor’s Management of Its Operating Cycle.OS Distributor’s Management of Its Operating Cycle.All data from the balance sheets in Exhibit 3.1 and the income statements in Exhibit 2.2; figures in millions of dollars

Working capital requirement (WCR)1

Sales

Cost of goods sold (COGS)Inventories

Accounts receivableAverage daily sales2

Accounts payableAverage daily purchases2,3

To evaluate the overall efficiency with which the

firm’s operating cycle is managed

OBJECTIVE DEC. 31, 1995 DEC. 31, 1997

1 WCR is found in Exhibit 3.6.2 We assume the year has 365 days.3 Purchases are equal to COGS plus the change in inventories (see equation 3.11). In 1994, inventories were $48, thus purchases (1995) = $328 + ($52 – $48) = $332. Purchases (1996) = $353 + ($57 – $52) = $358; and purchases (1997) = $400 + ($72 – $57) = $415.

$59$390

= 15%$77

$420= 16%

To evaluate the efficiency with which inventories are managed

$328$52

= 6.3 times$400$72

= 5.6 times

To evaluate the efficiency with which accounts receivable are managed

$44$390/365

= 41 days$56

$480/365= 43 days

To evaluate the efficiency with which accounts payable are managed

$37$332/365

= 41 days$48

$415/365= 42 days

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EXHIBIT 3.12: OS Distributor’s Net Working Capital (NWC) OS Distributor’s Net Working Capital (NWC) and Current and Quick Ratios.and Current and Quick Ratios.All data from the balance sheets in Exhibit 3.1; figures in millions of dollars

• NWC = [Current assets –Current liabilities]1

• NWC = [Long-term financing2 –Net fixed assets]3

• Current ratio = Current assets Current liabilities

• Quick ratio = Cash + Accts receivableCurrent liabilities

$104 – $54 = $50

DEC. 31, 1995 DEC. 31, 1996 DEC. 31, 1997

1 This is the traditional definition of net working capital.2 Long-term financing = Long-term debt + Owners’ equity.3 According to this definition, net working capital is the same as net long-term financing (see equation 3.4).

$119 – $66 = $53 $137 – $75 = $62

($42 – $64) – $56 = $50

($34 + $70) – $51 = $53

($38 + $77) – $53 = $62

$104$54

= 1.93$119$66

= 1.80$137$75

= 1.83

$6 + $44$54

= 0.93$12 + $48

$66= 0.91

$8 + $56$75

= 0.85

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EXHIBIT A3.1: Financing Investments Using a Matched Strategy.Financing Investments Using a Matched Strategy.

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EXHIBIT A3.2: Financing Investments Using a Conservative Strategy.Financing Investments Using a Conservative Strategy.

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EXHIBIT A3.3: Financing Investments Using an Aggressive Strategy.Financing Investments Using an Aggressive Strategy.