Tools to manage financial health of firms - Capex, FCF, Operating Leverage, CCC

JWI 530 Financial Management I, week6 summary, 2/17/13

We learned about more concepts and tools to manage the financial health of a business: capex, free cash flow, operating leverage, difference between net income and free cash flow and the importance of cash conversion cycle.

I understand the importance of free cash flow and how it can mean the difference between life and death of a firm.

Dr DP


JWI 530 Operations Management, week6 summary
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1. To run a company efficiently, examine things from the perspective of
- cash a business is generating
- what it does with the cash
- costs involved with running and growing the business

2. Three metrics to track how cash physically moves through the business are:
(a) Capital Expenditures: long term investment a company makes in durable assets for generating future business and increasing profits eg, machinery, construction of new plant, land
(b) Free Cash Flow: how much discretionary money a firm has after paying costs needed to run the business
(c) Operating leverage: Ratio of fixed costs to variable costs (change in operating income/change in sales); higher the fixed/variable ratio, higher the operating leverage

3. Net Income - Profit, in principle, over long haul
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Net income reflects how much of every dollar of sales a company keeps as its own profit (JWI 530, W3 L2).
The calculation includes expectations about revenues over a time period into the future. Net Income can be inflated through imaginary numbers from accrual accounting by unscrupulous business owners eg. Enron.

4. Cash Flow - lifeblood to keep business running today
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Cash flow is the lifeblood of a company (JWI 530, W6 L1). Free cash flow is the cash a company has after all expenses and investments are made in order to keep the business running. This metric shows the actual cash-generation power of the business and the amount of cash available for distribution to investors.

Difference between Net Income and Cash Flow
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1. Net income can be manipulated through creative accounting of theoretical expectations which may or may not materialize in the future. Cash flow is harder to manipulate under GAAP. eg. Enron showed high net income but the cash flow did not support the high expectations.
2. Net income is the basis of a firm's share price while how much unrestricted cash a business can deliver in any given period is directly tied to the value of a company.
3. Cash flow is critically important than profits for small business owners who are struggling keep the lights on for an embryonic firm  as well as big businesses that are rapidly losing their market share and barreling towards disaster. A looming negative cash flow situation means the firm will soon not be able to pay their bills. This is what happened to IBM in 1993 when Lou Gerstner parachuted in to stop the bleeding and reverse the ship that was within months of going into bankruptcy. Business owners need to monitor cash budgets in order to make sure they know their cash flow positions.

5. Cash Conversion Cycle (CCC)
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The definition of cash conversion cycle, is “the length of time a company’s cash is tied up in working capital before that money is finally returned when customers pay for the products sold or services rendered”(http://www.nysscpa.org/cpajournal/2007/807/essentials/p42.htm)
Cash Conversion Cycle (CCC) is the number of days it takes a firm in converting its cash in the bank to buying raw materials, creating inventory, selling inventory and receiving more cash from sales. CCC shows how much of a firm's cash flow is tied up in each part of the transaction. Shorter or negative cash-to-cash CCC cycle is better, indicating the firm is managing its capital efficiently. CCC is calculated as follows:
CCC = DIO + DSO - DPO, where
DIO = Days Inventory outstanding
DSO = Days Sales outstanding
DPO = Days Payables outstanding

A positive CCC could mean the firm's capital is tied up in its inventory or the firm may be having trouble with collecting money from customers.

A negative CCC means DPO > DIO + DSO
A firm with negative CCC, such as Amazon, enjoys a unique competitive advantage over its rivals - it does not pay for raw materials or inventory until after the sale of the final products are complete and cash is received from the customer. While most firms have to wait for their cash to turn into inventory and then finished good and finally transformed into more cash returned from customer, Amazon gets the customer's money up front and enjoys a great deal of flexibility in financing the firm's operations. Amazon can use its working capital efficiently to fuel other income generating activities.A lower CCC suggests that a company is more efficient in managing its cash flows, because it turns its working capital over more times per year and generates more sales per dollar
invested. http://www.nysscpa.org/cpajournal/2007/807/essentials/p42.htm

While negative CCC is desirable, one of the disadvantages of a negative CCC is that the suppliers waiting a long time for their money from a firm like Amazon may feel a lot of pressure to switch.