Feb 27, 2011
Tags: Corporate Finance, Financial Modeling, Financial Modelling, Investment Banking, Company Valuation
In the last post we discussed the concept of Working Capital and intoduced the cash collection cycle. The cash collection cycle is an important driver of profitability for a company. When building a financial model of a company or performing a valuation it is important to understand the impact of a company's cash collection cycle. Companies can temporarily bolster cash reserves by manipulating their cash collection cycle around their end of financial year to appear more profitable and efficient, and can end up going insolvent from not managing their cash collection cycle effectively.
Recapping the last post, the cash collection cycle is composed of the following: Receivables days + Inventory days - Creditor days.
Each item is important, and there are different consequences for managing working capital to have a cash collection cycle of different lengths:
- Receivables Days: If receivables days are long, this means that a company is taking a long time to collect money for its customers after providing them with a product. The advantage of running a long receivables days policy is that more customers are able to make a purchase immediately and this allows customers to manage their own cash flow better so they can pay their bill for the sale when they are ready and able to. The disadvantages of running a long receivables days policy is that this means that the company is taking credit risk against its customers, and therefore needs to allocate more resources/systems to manage the eventual collection of cash. Additionally this means that the company needs to find an alternate source of cash to fund the inventory or costs it has incurred in making the sale. If a company has a short cash collection cycle then this reduces credit risk for a company and means it generates cash from sales more quickly, but it can be counter-productive as it means that competitors may be able to lure customers away with more attractive sales terms.
- Inventory Days: If a company has a long inventory days period, this means that it keeps a substantial amount of stock compared to the amount it sells in a year. The advantage of this policy is that when a customer wants to make a purchase then it is highly likely the company will have the products available to sell to the customer. Additionally, as a general rule numerous businesses (in particular retail) achieve a higher rate of sales if customers come to the opinion that your point of stale (retail shop front, warehouse etc) is a good place to go in order to find the product they are looking for. Having a higher inventory level helps this effect. An additional benefit of running high inventory levels is that your suppliers are more likely to want to continue doing business with you and may also become more stable suppliers because they are able to depend on regular larger orders. Numerous companies try to run very low inventory days policies in order to optimise cash collection. An inventory management model called 'just in time' inventory management involves obtaining inventory from suppliers only at the point in time that it is needed for a sale or for part of a manufacturing process. This sort of model is more common when a company has substantial market influence or is the biggest player in its supply chain, and can therefore dictate terms. Disadvantages of running a low inventory days policy include the risk of not having inventory available when it is needed and stressing your suppliers' businesses.
- Creditor Days: If a company runs a long creditor days policy this means that it takes a long time for the company to pay its suppliers. This helps in the cash collection process as it delays the payment of costs. Creditors can therefore be viewed as a form of interest free funding, and therefore from a pure capital allocation perspective it is generally viewed as positive to have a longer creditor days policy. Detriments of having a long creditor days policy include stressing suppliers or potentially being forced to come up with a substantial amount of cash if suppliers refuse to continue offering the same creditor terms. Suppliers may even just not want to deal with a company anymore if it won't pay its bills on time. A further detrimental effect of running a very long creditor days policy is that banks view a very stretched creditor day cycle as a sign that a company is stressed, which can lead to more restrictive banking covenants or even withdrawal of bank funding. The primary disadvantage of running a short creditor days period is that it has a detrimental effect on cash generation.
Contributed by Paul Mason