THE ASSET CONVERSION CYCLE

SPONTANEOUS FINANCING of the CYCLE

ASSETS Inventory Raw Materials LIABILITIES $100 Accounts Payable Net Worth Total Assets $100 $100 0

Total Liabilities & Net Worth $100

Inventory Raw Materials Work in Process Finished Goods Total Assets

0 $125 0 $125

Accounts Payable Accrued Expenses

$100 25

Net Worth 0 Total Liabilities & Net Worth $125

Inventory Raw Materials Work in Process Finished Goods Total Assets

0 0 $150 $150

Accounts Payable Accrued Expenses

$100 50

Net Worth 0 Total Liabilities & Net Worth $150

Accounts Receivable Inventory Raw Materials Work in Process Finished Goods Total Assets

$180 0 0 0 $180

Accounts Payable Accrued Expenses

$100 50

Profit (Retained earnings)

30

Total Liabilities & Net Worth $180

Cash Accounts Receivable Inventory Raw Materials Work in Process Finished Goods Total Assets

$30 0 0 0 0 $ 30

Accounts Payable Accrued Expenses

0 0

Profit (Retained earnings)

30

Total Liabilities & Net Worth $ 30

10 Days + 20 Days = 30 Days |_______________________|____________________________| Cash RM WIP Finished Goods Accts. Receivable Cash

= 30 Days

30 Days |____________________________________________________| Accounts Payable and Accrued Expenses

= 30 Days

A PERFECTLY TIMED ASSET CONVERSION CYCLE: SPONTANEOUS FINANCING !!

IMPERFECTLY TIMED ASSET CONVERSION CYCLES REQUIRE NON-SPONTANEOUS FINANCING TO COMPLETE THE CYCLE:
THE CONCEPT OF WORKING INVESTMENT WI = (Accts Receivable + Inventory) (Accts Payable + Accrued Expenses) WI = the portion of trading assets that are not covered by spontaneous financing. Concepts: Permanent Level of Working Investment Increasing Working Investment due to Sales Growth Changing Working Investment due to Seasonality Financing Non-Current Assets

SOURCES OF FINANCING OF THE REQUIRED WORKING INVESTMENT

DEBT

External Claims

Fixed Amount Maturities

Senior

EQUITY

Internal (Owners) Claims

Residual

Undated

Junior

GREY AREA =

Between Debt and Equity

DEBT Spontaneous: Short Term: Long Term: Accounts Payable Notes Payable Bank Loans Accrued Expenses (Non-interest Bearing) Overdraft Bonds Current Portion Long Term Subordinated Debt

Current Debt: Non-Current Debt: Contingent Liabilities

Under one Year Over one Year

EQUITY Common Stock Preferred Stock Treasury Stock Capital Surplus Retained Earnings

GREY AREA Deferred Taxes Minority Interest Provisions Pension Liabilities

SOURCES OF FUNDS
The Primary Source of Debt Repayment to a Bank is Cash Generation.
1. Net Profit (after Tax) Assets 1999 Cash Accs/Recble Inventory Fixed Assets Total Assets 150 400 300 500 1,350 2000 200 400 300 500 1,400 Liabilities Accs Payable Notes Payable Retained Earnings Capital Stock Total L & E 1999 200 300 700 150 1,350 2000 200 300 750 150 1,400

2. Conversion of an Asset to Cash Assets 1999 2000 Cash Accs/Recble Inventory Fixed Assets Total Assets 150 400 300 500 1,350 350 300 200 500 1,350

Liabilities Accs Payable Notes Payable Retained Earnings Capital Stock Total L & E

1999 200 300 700 150 1,350

2000 200 300 700 150 1,350

3. Increase in Liabilities Assets 1999 Cash Accs/Recble Inventory Fixed Assets Total Assets 150 400 300 500 1,350

2000 300 400 300 500 1,500

Liabilities Accs Payable Notes Payable Retained Earnings Capital Stock Total L & E

1999 200 300 700 150 1,350

2000 250 400 700 150 1,500

4. Increase in Equity Assets 1999 Cash Accs/Recble Inventory Fixed Assets Total Assets 150 400 300 500 1,350

2000 350 400 300 500 1,550

Liabilities Accs Payable Notes Payable Retained Earnings Capital Stock Total L & E

1999 200 300 700 150 1,350

2000 250 300 700 350 1,550

USES OF FUNDS (CASH)

1. Net Loss (after Taxes) 2. Increase in Assets 3. Decrease in Liabilities 4. Reduction in Equity

Sources and Uses of Cash: Assets Cash Accs/Recble Inventory Fixed Assets Total Assets Sources: Net Profit Increase in Acc. Pble Increase in Notes Pble Decrease in Cash TOTAL $ 50 $ 40 $ 10 $150 $250 1999 150 400 300 500 1,350 2000 Liabilities 0 Accs Payable 475 Notes Payable 375 Retained Earnings 600 Capital Stock 1,450 Total L & E 1999 200 300 700 150 1,350 Uses Increase in Acc. Receivable Increase in Inventory Increase in Fixed Assets $ 75 $ 75 $100 2000 240 310 750 150 1,450

$250

WHAT HAPPENED HERE?

ANALYSIS OF THE ASSET CONVERSION CYCLE

Identify the RISKS of the Asset Side of the Balance Sheet Assess the LIQUIDITY of the Assets Determine the EFFICIENCY of Asset Usage to Create Sales and Profitability

RISKS THAT MAY AFFECT THE ASSET CONVERSION CYCLE Supply Risks Production Risks Demand Risks Collection Risks Business Risk: Type of Asset Structure, Length of the Cycle and Value Added

LIQUIDITY Quality of Assets Position in the Industry

EFFICIENCY IN THE USE OF ASSETS How does a Company Generate Maximum Return from the Use of Assets? INVENTORY ACCOUNTS RECEIVABLE FIXED ASSETS

INVENTORY ANALYSIS Inventory Valuation: LIFO & FIFO Accounting Component Breakdown: Raw Materials, Work in Process, Finished Goods Inventory Turnover: Inventory x 365 Cost of Goods Sold = Inventory Days on Hand

(Also calculate: Raw Materials WIP Finished Goods Days on Hand)

Quality: Returns on Sales: % Returns & Allowances to Sales Ratio: Returns & Allowances x 100 Gross Sales

Contingent Purchase Commitments

ACCOUNTS RECEIVABLE ANALYSIS Credit Terms Quality and Concentration of Customers Costs of Carrying the Receivables Historical Experience Aging Schedule Allowance for Bad Debts Accounts Receivable Turnover: Accounts Receivable x 365 Net Sales Charge-Offs: Beginning Allowance for Bad Debts (Balance Sheet) + Provision for Bad Debts (Income Statement) - Ending Allowance for Bad Debts = Charge-offs = Receivable Days on Hand

FIXED ASSETS ANALYSIS The Adequacy of Plant Investment is measured by Plant Turnover:

Net Plant Turnover

Sales (Net Plant + Net Plant)/2

Low Plant T/O: Heavy Industry Hotels Public Utilities

High Plant T/O

Supermarkets Commodity Traders Wholesalers

ASSET INVESTMENT:
1.

SUMMARY
Sales Total Assets

The Asset Turnover Ratio (ATO): o o o

Production Cycle Capital Intensity Asset Components: E. g. Inventory Receivables Cash Securities

2.

Return on Assets Ratio (ROA):

Net Profit after Tax Total Assets

3.

Working Investment to Sales Ratio:

Working Investment Sales

ANALYSIS OF PROFIT PERFORMANCE Format of the Income Statement Determinants of Profitability Quantitative Tools to Measure Operating Performance: o o o o o o o o o o Return on Sales (ROS) Sales Revenue Operating Leverage Cost of Goods Sold Gross Profit Margin Selling, General & Administrative Expenses (SG & A) EBIT Margin Interest Expense Investment Income Taxes

Return on Sales (ROS):

Net Profit after Tax (NPAT) Sales

ROS is determined by the components of the Income Statement: Sales Revenue = Volume x Price

Operating Leverage =

Fixed Costs Total Costs

{Different Industries have {different Breakeven Points

CGS/Sales

Cost of Goods Sold Sales

(%?)

Gross Profit Margin

Gross Profit Sales = Selling, General & Administrative Expenses (%) Sales

SG&A/Sales

EBIT Margin

Net Operating Profit (EBIT) Sales

(%)

Average Funded Debt

LTD+CPLTD+STD+LTD+CPLTD+STD 2

Interest Expense

Annual Interest Average Funded Debt

(%)

Investment Expense Dividends Provision for Income Taxes

SUMMARY:

ANALYSIS OF PROFIT PERFORMANCE

Return on Sales should be measured against: Extent of Value Added Risk/Return

Cash Flow and Profitability are not the same !!!

FINANCIAL RISK Analysis of the Right Hand Side of the Balance Sheet

Evaluation of Short Term Liquidity: Working Capital Adequacy Reliance on Inventory Evaluation of Long Term Solvency: Leverage Ratios --Profitability --Current Ratio --Quick Ratio

Evaluation of the Adequate Capital Structure: The Mix of Short and Long Term Debt & Equity is dependent on Asset Investments, the Operating Performance and the Asset Conversion Cycle

LIQUIDITY Working Capital = Current Assets Current Liabilities

Current Ratio

Current Assets Current Liabilities

Adequacy Depends on

1) Liquidity, 2) Increase/Decrease of Assets 3) Profitability Years 4) Window Dressing

Quick Ratio

Cash + Securities + Receivables Current Liabilities

Reliance on Inventory = (Shrinkage)

Bank Debt

- (NRV%) Acc. Receivable Inventory

LONG TERM SOLVENCY

Return on Sales (ROS): Leverage =

Profitability and Cash Flow Total Liabilities Tangible Net Worth

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Debt to Equity =

Total Liabilities Net Worth

Adjusted Leverage

Total Liabilities - Subordinated Debt Tangible Net Worth - Subordinated Debt

APPROPRIATE CAPITAL STRUCTURE When we have determined what the Left-Hand side of the balance sheet looks like, we can decide what the Right-Hand side SHOULD look like! Basically: TENORS SHOULD BE MATCHED BUSINESS RISK SHOULD BE COVERED BY EQUITY: Higher Business Risk should equal lower Financial Risk

Financing of Short Term Needs: o Adequacy of Working Capital: Liquidity of Receivables and Inventory after shrinkage should pay Short Term creditors. o Permanent Working Investment should be covered by permanent funds: either Long-Term Debt or Equity. o Whether long-term financing is debt or equity depends on the business risk. Longer Asset Conversion Cycles tend to have more permanent working investment and more business risk.

Financing of Long-term Needs: o The tools are Cash Flow Projections.

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THE ROE EQUATION ROE = Net Profit After Tax Net Worth

Net Profit After Tax Net Worth

(ROE)

= =

NPAT x Sales (ROS) x

Sales Total Assets

(ATO)

x x =

Total Assets Net Worth

(ALEV)

NPAT Total Assets (ROE) = (ROA)

Total Assets Net Worth (ALEV)

The Fact Sheet used for Analysis breaks down ROE, ROS, ATO and ALEV into their different components to highlight the elements of Profitability, Efficiency and Equity mix, both horizontally (over certain periods) and vertically (for the period in question).

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