Tracing Cash And Net Working Capital

In this section, we examine the components of cash and net working capital as they change from one year to the next. We have already discussed various aspects of this subject in Chapters 2, 3, and 4. We briefly review some of that discussion as it relates to short-term financing decisions. Our goal is to describe the short-term operating activities of the firm and their impact on cash and working capital.

To begin, recall that current assets are cash and other assets that are expected to convert to cash within the year. Current assets are presented on the balance sheet in order of their accounting liquidity—the ease with which they can be converted to cash and the time it takes to convert them. Four of the most important items found in the current asset section of a balance sheet are cash and cash equivalents, marketable securities, accounts receivable, and inventories.

Analogous to their investment in current assets, firms use several kinds of short-term debt, called current liabilities. Current liabilities are obligations that are expected to require cash payment within one year (or within the operating period if it is longer than one year). Three major items found as current liabilities are accounts payable, expenses payable (including accrued wages and taxes), and notes payable.

Because we want to focus on changes in cash, we start off by defining cash in terms of the other elements of the balance sheet. This lets us isolate the cash account and explore the impact on cash from the firm's operating and financing decisions. The basic balance sheet identity can be written as:

Net working capital + Fixed assets = Long-term debt + Equity [19.1]

Net working capital is cash plus other current assets, less current liabilities, that is:

Net working capital = (Cash + Other current assets) - Current liabilities [19.2]

If we substitute this for net working capital in the basic balance sheet identity and rearrange things a bit, we see that cash is:

Cash = Long-term debt + Equity + Current liabilities [19.3]

- Current assets other than cash - Fixed assets

This tells us in general terms that some activities naturally increase cash and some activities decrease it. We can list these various activities, along with an example of each, as follows:

Activities that increase cash

Increasing long-term debt (borrowing over the long term) Increasing equity (selling some stock)

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CHAPTER 19 Short-Term Finance and Planning 641

Increasing current liabilities (getting a 90-day loan)

Decreasing current assets other than cash (selling some inventory for cash)

Decreasing fixed assets (selling some property)

Activities that decrease cash

Decreasing long-term debt (paying off a long-term debt)

Decreasing equity (repurchasing some stock)

Decreasing current liabilities (paying off a 90-day loan)

Increasing current assets other than cash (buying some inventory for cash)

Increasing fixed assets (buying some property)

Notice that our two lists are exact opposites. For example, floating a long-term bond issue increases cash (at least until the money is spent). Paying off a long-term bond issue decreases cash.

As we discussed in Chapter 3, those activities that increase cash are called sources of cash. Those activities that decrease cash are called uses of cash. Looking back at our list, we see that sources of cash always involve increasing a liability (or equity) account or decreasing an asset account. This makes sense because increasing a liability means that we have raised money by borrowing it or by selling an ownership interest in the firm. A decrease in an asset means that we have sold or otherwise liquidated an asset. In either case, there is a cash inflow.

Uses of cash are just the reverse. A use of cash involves decreasing a liability by paying it off, perhaps, or increasing assets by purchasing something. Both of these activities require that the firm spend some cash.

Sources and Uses

Here is a quick check of your understanding of sources and uses: If accounts payable go up by $100, does this indicate a source or a use? What if accounts receivable go up by $100?

Accounts payable are what we owe our suppliers. This is a short-term debt. If it rises by $100, we have effectively borrowed the money, which is a source of cash. Receivables are what our customers owe to us, so an increase of $100 in accounts receivable means that we have loaned the money; this is a use of cash.

Ross et al.: Fundamentals VII. Short-Term Financial 1S. Short-Term Finance of Corporate Finance, Sixth Planning and Management and Planning

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