Summary FIN3702 Working_capital_management_notes MUST READ.

WORKING CAPITAL MANAGEMENT Study unit 1: Analysing the company’s cash flow Depreciation – the systematic charging of a portion of the costs of fixed assets against annual revenues over time. WTA -Wear and tear allowance determined by SARS. They apply to both new and used assets. Depreciable value of an asset is its cost plus outlays for installation; an adjustment is expected for salvage value. Land and buildings are not depreciable. Depreciable life of an asset – The time period over which the asset is depreciated. Financial managers prefer faster receipts of cash flows so they prefer a shorter depreciable life. Depreciation methods  Straight line  Diminishing balance  Sum of the years digits Depreciation is written off proportionately for a part of the year if not acquired at the beginning of the year. Developing the statement of cash flow Note that cash equivalents (marketable securities) are considered the same as cash because of their high liquidity. Both cash and cash equivalents are a reservoir of liquidity that is increased by cash inflows and decreased by cash outflows. 3 Cash flows Operating flows – cash flows directly related to sale and production of the firms products and services. Investment flows – cash flows associated with purchase and sale of both fixed assets and equity investments in other firms. Financing flows – cash flows that result from debt and equity finance transactions; includes the incurrence and repayment of debt, cash inflow from the sale of stock, as well as cash outflows to repurchase stock or pay cash dividends. Incurring debt = inflow Repaying debt = outflow Selling the firms shares = inflow 1 Classifying inflows and outflows INFLOWS (sources) OUTFLOWS (uses) Decrease in any asset Increase in any asset Increase in any liability Decrease in any liability Net profits after taxes Nett loss Depreciation and other non-cash charges Dividends paid Sale of shares Repurchase or retirement of shares A decrease in an asset such as the firms cash balance is an inflow of cash because cash that has been tied up in the asset is released and can now be used. An increase in inventory is an outflow of cash. Depreciation is a non-cash charge as it does not involve the actual outlay of cash during the period and is only an expense that is deducted on the statement of comprehensive income. So adding depreciation back to the firm’s net profits after taxes provides an estimate of the cash flow from operations. Cash flow from operations = Net profit after tax + Depreciation and other non-cash charges. So even if the firm has a loss adding back depreciation can result in a positive cash flow. Because depreciation is treated as a separate cash inflow, only gross rather than net changes in noncurrent assets appear on the statement of cash flows so as to avoid double counting of depreciation. Changes in retained earnings are not included on the statement of cash flows and appear as net profits or losses after taxes and dividends paid. Operating cash flow – (OCF) the cash flow a firm generates from its normal operations; calculated as Net operating profits after taxes plus depreciation NOPAT + Depreciation NOPAT represents the firms earnings before interest and after taxes so it is calculated as follows NOPAT = EBIT x (1-T) By substitution OCF = (EBIT x (1-T)) + Depreciation Finance definition excludes interest cost as an oprating cash flow Free cash flow – (FCF) the amount of cash flow available to investors (creditors and owners) after the firm has met all operating needs and paid for investments in net fixed assets and net current assets. FCF = OCF – Net non-current investment – Net current asset investment = OCF- NNCI - NCAI NNCI = change in net non-current + Depreciation Negative NNCI represents a net cash inflow attributable to the sale of more assets than acquired.