Calculating Net Operating Cash Flow number

Calculating Net Operating Cash Flow number 

CASH FLOW STATEMENT

Operating Activities

Net Income before Extraordinaries

+ Depreciation, Depletion & Amortization

+ Other Funds

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Funds from Operations

+/-  Changes in Working Capital

Receivables

Inventories

Accounts Payable

+/- Other Assets/Liabilities

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Net Operating Cash Flow

Main adjustments when calculating the Net Operating Cash Flow number are:

1.  Depreciation and Amortization

This reduced the operating profits in the income statement, but, as it is not a cash flow, it is added back to operating cash flow.

2.  Profit/losses on disposals.  

A profit or loss on the sale (disposal) of an asset compared to the asset's value on the balance sheet (or book value).  The cash received from the sale is included in the investing section of the cash flow statement.   The profit or loss on the sale is included in the operating profit.  The profit or loss (the difference between the cash received and the asset value on the balance sheet) is used to adjust the company's operating cash flow.  A loss is added back to operating profit and a profit is taken away.

3.  Increases/decreases in debtors (sales made on credit).

If a company is growing its sales then often its outstanding debtors will grow as well.   If debtors grow faster than sales, then the company is giving more credit to its customers - not ideal.  If debtors goes down compared to sales then the company is tightening its credit - perhaps by chasing debtors harder.  This affects operating cash flow but does not affect operating profit.

4.  Increases/ decreases in creditors (purchases made on credit_

Companies can make purchases on credit.   This increases their trade creditors balance.  The balance will decrease as payments are made.   An increase in this balance means that the company gets a temporary cash benefit to operating cash flow.  If the balance reduces - if suppliers want paying faster - cash flows out of the company which reduces operating cash flow.

5.  Increases/decreases in stock levels (inventory)

Building up inventory requires cash to be spent.  If more stock is added than is sold, a company's inventory balances will increase and this will show as a cash flow out of the company and reduced operating cash flow.  It will not affect operating profit.  If a company is selling its inventory faster than it is buying raw material, this balance will decrease and the change will be shown as a cash flow added back to operating profit.  Operating with inventory levels that are too low can generate expensive problems, example, when there is a sudden dramatic increase in demand.   In general, expect inventory levels to go up and down with sales levels.

6.  Amount paid into a final salary pension fund is more/less than pension cost expensed in the income statement.  

In recent years, final salary pension schemes have become problematic for some companies as the money in the pension fund has not been enough to pay the promised pensions in the future.  This has meant that cash top up payments in excess of the regular expense have been required.  This is shown by a reduction in a company's operating cash flow and is a deduction from the starting operating profit figure.   

Changes in working capital (Receivables, Inventories and Accounts Payable)

Working capital refers to the amount of cash a company needs to undertake its day-to-day activities.  

If working capital is increasing, then this shows the amount of cash a company might need to borrow - from a bank overdraft facility - to finance its day-to-day activities as it waits for cash to flow in.   The smaller a company's working capital requirement, the better its cash flow and financial position tends to be.

The Working Capital Management: Success in managing debtors, stock and creditors affect cash.

The four largest elements affecting working capital are usually

• debtors, 
• stock, 
• creditors and 
• cash.

Success in managing the first three affect cash, which can be reinvested in the business or distributed.



Debtors

Many local businesses are plaqued by slow payment of invoices and it is a problem in many other countries too.

A statutory right to interest has been in place for a number of years but nothing seems to make much difference.

An improvement can significantly affect working capital.

It is a great problem for managers, who sometimes are frightened of upsetting customers and feel that there is little that they can do.

This is  completely the wrong attitude.

Customer relations must always be considered, but a great deal can be done.

Some practical steps for credit control are summarized below:

• Have the right attitude; ask early and ask often.
• Make sure that payment terms are agreed in advance.
• Do not underestimate the strength of your position.
• Give credit control realistic status and priority.
• Have well-thought out credit policies.
• Concentrate on the biggest and most worrying debts first.
• Be efficient; send out invoices and statements promptly.
• Deal with queries quickly and efficiently.
• Make full use of the telephone, your best aid.
• Use legal action if necessary.

This may sound obvious but it usually works.

Be efficient, ask and be tough if necessary.

Stock

The aim should be 

• to keep stock as low as is realistically feasible and 
• to achieve as high a rate of stock turnover as is realistically feasible.

In practice, it is usually necessary to compromise between 

• the wish to have stock as low as possible, and 
• the need to keep production and sales going with a reasonable margin of safety.

Exactly how the compromise is struck will vary from case to case.  

Purchasing and production control are highly skilled functions and great effort may be expended on getting it right.

"Just in time deliveries" is the technique of arranging deliveries of supplies frequently and in small quantities.  In fact, just in time to keep production going.

It is particularly successful in japan where, for example, car manufacturers keep some parts for production measured only in hours.

It is not easy to achieve and suppliers would probably like to make large deliveries at irregular intervals.  

It may pay to approach the problem with an attitude of partnership with key suppliers, and to reward them with fair prices and continuity of business.

Finished goods should be sold, delivered and invoiced as quickly as possible.

Creditors

It is not ethical advice, but there is an obvious advantage in paying suppliers slowly.

This is why slow payment is such a problem and, as has already been stated, the control of debtors is so important.

Slow payment is often imposed by large and strong companies on small and weak suppliers.

Slow payment does not affect the net balance of working capital,but it does mean that both cash and creditors are higher than would otherwise be the case.

Apart from moral considerations, there are some definite disadvantages in a policy of slow payment:

• Suppliers will try to compensate with higher prices or lower service.
• Best long-term results are often obtained by fostering mutual loyalty with key suppliers; it pays to consider their interests.
• If payments are already slow, there will be less scope for taking longer to pay in response to a crisis.

For these reasons it is probably not wise to adopt a consistent policy of slow payment, at least with important suppliers.

It is better to be hard but fair and to ensure that this fair play is rewarded with 

• keen prices, 
• good service and 
• perhaps prompt payment discounts.

There may be scope for timing deliveries to take advantage of payment terms.  

For example, if the terms are 'net monthly account', a 30 June delivery will be due for payment on 31 July.  At 1 July delivery will be due for payment on 31 August.

The Management of Working Capital. Is it important?

The effective management of working capital can be critical to the survival of the business and it is hard to think of anything more important then that.

Many businesses that fail are profitable at the time of their failure and failure often comes as a surprise to the managers.

The reason for the failure is a shortage of working capital.

Furthermore, effective management of working capital is likely to improve profitability significantly.

The percentage return on capital employed increases as capital employed is reduced.

Effective management of working capital can reduce the capital employed.

It increases profits as well as enabling mangers to sleep soundly without worries.

The four largest elements affecting working capital are usually

• debtors, 
• stock, 
• creditors and 
• cash.

Success in managing the first three affect cash, which can be reinvested in the business or distributed.

Working Capital

This is the difference between current assets and current liabilities.

It is extremely important.

• A business without sufficient working capital cannot pay its debts as they fall due. 
• In this situation it might have to stop trading even if it is profitable.

Possible alternatives might include:

• raising more capital,
• taking out a long-term loan, or
• selling some fixed assets.

Never forget the importance of working capital

Working capital is the difference between assets realizable in the short term and liabilities payable in the short term.

It includes cash held and money owed.

Quickly realizable assets are the next best thing to cash.

If you can get the working capital right, you should be safe.

Try hard to achieve this.

Components of Cash Conversion Cycle

Cash Conversion Cycle (CCC)

Cash Conversion cycle is the time taken by a trading or manufacturing concern to realise cash from its inventory and account receivables after meeting its outflows owing to short term payables including trade creditors. 

It is expressed in terms of number of days and can be defined as follows in form of a formula:-

CCC= Days’ Inventory Outstanding (DIO) + Days’ Sale Outstanding (DSO) – Days’ Purchase Outstanding (DPO)

Components of Cash Conversion Cycle - DIO, DSO and DPO

Days’ Sale Outstanding (DSO)

DSO is the measure to assess the number of days a concern gives credit to its customers. Let us explain it with a formula:
DSO= Average receivables/ daily sale
Where
Average receivables: Opening balance + Closing Balance/2
Daily sales: Total annual sale/365

DSO can be calculated for every month as well. In fact when there is a revamp of credit terms then DSO should be computed for every month to understand the implication and drop or hike in DSO, as the case may be.

Days’ Purchase Outstanding (DPO)

DPO gives average credit term (days of credit) enjoyed by a concern from its trade creditors. In term of formula, it can be stated as follows:
DPO= Average payables/ Daily purchases
Where,
Average payables= Opening balance+ Closing Balance/2
Daily purchases= Total purchases/365
Just like DSO, DPO can also be computed monthly or any period of time as required.

Importance and usage of DSO and DPO

Now that we have discussed the meaning of DSO and DPO, let us understand their implication on a business and cash conversion cycle. 

Ideally, every trading concern must try to have a bigger DPO and smaller DSO, which essentially implies that they recover cash from debtors in shorter duration and pay off their creditors later.

For e.g. ABC Company has a DSO of 30 days and DPO of 40. This gives an advantage of 10 extra days to ABC Company to meet its payables and it enjoys healthy liquidity to meet its other production and day to day expenses as well.

DSO comparisons also help in effective credit control. If without any re-negotiations, a company observes that its DSO has risen then it means that the collection process is not working well. This situation can be rectified in many ways including putting processes like advance reminders and water tight system of invoicing in place for the starters. If a company has indeed renegotiated terms with both debtors and creditors, then the month on month DSO and DPO comparisons would show the result in line with such re-negotiations.

Days’ Inventory Outstanding (DIO)

The third pillar of CCC deals with inventory. DIO is the average days a trading concern takes to convert its inventory into sale and is stated as follows:
DIO= Average Inventory/ Day’s Cost of goods sold
Where,
Average inventory= Opening Balance + Closing Balance/2
Day’s cost of goods Sold (COGS)= Cost of goods sold/365
If the accounting period for which DIO is to be computed is shorter, then day’s COGS will be computed for such other period and 365 days will get replaced accordingly.

An Example

Cash Conversion Cycle (CCC) 

= (DIO + DSO) – DPO 
= (44 + 33) - 61

= 16 days

The above computation shows that the average days of credit granted by XYZ Corp is almost half at 33 days as compared to the credit days lent by it, which is 61 days.

The average days it takes XYZ Corp to sell its stock is 44 days and the number of days in which it converts its inventory and debtors into cash is just 16 days.

These figures picture a very liquid position of XYZ Corp where it is able to meet its able to generate working capital very efficiently.     

Ideally, every trading concern must try to have a bigger DPO and smaller DSO, which essentially implies that they recover cash from debtors in shorter duration and pay off their creditors later.

http://www.investorwhiz.com/concepts/understanding-working-capital

Understanding Working Capital

1. The above figure shows a typical working capital cycle. 
2. Cash is used to purchase raw materials . 
3. The raw materials are then turned into finished goods and sold to customers, usually for a credit period. 
4. Ultimately payment is received in cash from the customer and the cycle repeats. 

Sometimes working Capital can turn negative but before jumping to conclusion about it let us discuss it in length.

What Does Negative Working Capital Mean?

Now the first conclusion about negative working capital would be low efficiency and fact that an entity needs external funding even for day to day operations. 

But having excess of short term liabilities over short-term assets is not always unfavourable. 

• A sudden surge in creditors or dip in debtors can be result of one-off bulk payments and adjustments that make working capital negative but for a short period of time.  

A negative working capital which sustains over extended period is definitely a cause of concern.

• It could be because the finished product is being sold at very low margins or loss. This strategy is sometimes followed by companies who are looking at either increasing their market share or introducing new products. 
• Another instance is sizeble bad debts where debtors have gone bankrupt or refused to pay.  In such a situation the debtors will have a write-off which would result in a dip in current assets. 
• Loss in inventory by accident can also lead to negative working capital. 

But for example- financing a fixed asset by cash will make a hit at current assets position but it is a sign of efficiency where you are able to make investment in fixed assets by using internally generated funds!

• So this is an instance of a favourable negative working capital.

Working capital is a critical factor to consider in assessing the financial health of any business vis. a vis. the efficient use of its resources. 

http://www.investorwhiz.com/concepts/understanding-working-capital

Working Capital Management Principal and Approaches

Working Capital (Cash Conversion Cycle)

http://www.qfinance.com/cash-flow-management-best-practice/how-to-better-manage-your-financial-supply-chain?full

Improve Cash Flow - Part 2 of 2

Previously we looked at generating cash from operations, capital expenditure and financing.  Here, we look at working capital.  This is a measure of the operating efficiency and liquidity of a business.

Working capital is the difference between current assets and current liabilities.  In other words the amount of cash required to finance inventory and trade receivables net of trade payables.  Cash tied up in inventory or money owed by customers cannot be used to pay short-term obligations, and therefore businesses need to release cash from these sources where possible.

Minimize inventory levels.
There are many methods of inventory management.  A well known technique is JIT ("just-in-time"), used mainly in manufacturing.   Goods are produced only to meet customer demand.  All inventory arrives from suppliers just in time for the next stage in the production process.  This technique minimizes inventory levels.

Minimize and control cash owed by customers.
It is important to follow procedures and be organized in collecting customer debts.  

Maximize the payment period to suppliers.
Delaying payments to suppliers will not generate cash but it will delay its outflow.  Many businesses use supplier credit as a source of finance.  Large and powerful customers are often accused of dictating extended payment terms, which add pressure to a small business's cash flow.  Extended credit should be negotiated as opposed to taken, to avoid problems in the future.  Businesses rely on their suppliers to keep their operations flowing, so payment terms should always be agreed in advance.

"Creditors have better memories than debtors; creditors are a superstitious sect, great observers of set days and times!"

Release working capital to pay short-term obligations.

Working Capital Cycle & Working Capital Management

Working Capital

This measures the funds that are readily available to operate a business.

Working capital comprises the total net current assets of a business, which are its stocks, debtors and cash - minus its creditors.



Why it is important

It is vital for a company to have sufficient working capital to meet all its requirements. The faster a business expands, the greater will be its working capital needs.

If current assets do not exceed current liabilities, a company may well run into trouble paying creditors who want their money quickly.

Indeed, the leading cause of business failure is not lack of profitability, but rather lack of working capital, which helps to explain why some experts advise: 'Use someone else's money every chance you get and don't let anyone else use yours.'



How it works in practice

Working capital is also called net current assets or current capital.

Working capital = Current assets - Current liabilities

Current assets are cash and assets that can be converted to cash within one year or a normal operating cycle; current liabilities are monies owed that are due within one year.



What is working capital cycle

The working capital cycle describes capital (usually cash) as it moves through a company:

• it first flows from a company to pay for supplies, materials, finished goods inventory, and wages to workers who produce goods and services.


• It then flows into a company as goods and services are sold and as new investment equity and loans are received.

Each stage of the cycle consumers time.

The more time the stages consume, the greater the demand on working capital.

Cash ----> pay for supplies, materials, finished goods inventory and wages to workers who produce goods and services ---> goods and services are sold and new investment equity and loans are received ---> Cash



Tricks of the trade

- Good management of working capital includes action like collecting receivables faster and moving inventory more quickly; generating more cash increases working capital.

- While it can be tempting to use cash to pay for fixed assets like computers or vehicles, doing so reduces the amount of cash available for working capital.

- If working capital is tight, consider other ways of financing capital investment, such as loans, fresh equity, or leasing.

- Early warning signs of insufficient working capital include:

• pressure on existing cash;
  
• exceptional cash generating activities such as offering high discounts for early payment;
  
• increasing lines of credit;
  
• partial payments to suppliers and creditors;
  
• a preoccupation with surviving rather than managing;
  
• frequent short-term emergency requests to the bank, for example, to help pay wages, pending receipt of a cheque.

- Several ratios measure how effectively and efficiently working capital is being used. (Key Working Capital Ratios : Stock Turnover(in days), Receivables Ratio(in days) , Payables Ratio(in days) , Current Ratio, Quick Ratio, Working Capital Ratio)



Also read:

http://www.studyfinance.com/

Working Capital Management

• Why Firms Hold Cash
• Float
• Ways to Manage Cash

Working capital management involves the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.

http://www.planware.org/workingcapital.htm

• Working Capital Cycle
• Sources of Additional Working Capital
• Handling Receivables (Debtors)
• Managing Payables (Creditors)
• Inventory Management
• Key Working Capital Ratios
• Introducing PlanWare
• Copyright & Legal Stuff