FINANCE FOR EXECUTIVES Managing for Value Creation Gabriel

FINANCE FOR EXECUTIVES Managing for Value Creation Gabriel Hawawini Claude Viallet ASSESSING LIQUIDITY AND OPERATIONAL EFFICIENCY 1

EXHIBIT 3. 1 a: OS Distributors’ Balance Sheets. Figures in millions of dollars DEC. 31, 1995 DEC. 31, 1996 DEC. 31, 1997 ASSETS · CURRENT ASSETS $104. 0 $137. 0 Cash 1 $6. 0 $12. 0 $8. 0 Accounts receivable 44. 0 48. 0 56. 0 Inventories 52. 0 57. 0 72. 0 1. 0 Prepaid expenses 2 ·NONCURRENT ASSETS 56. 0 51. 0 53. 0 Financial assets & intangibles 0. 0 Property, plant, & equip. (net) 56. 0 51. 0 53. 0 Gross value 3 $90. 0 $93. 0 Accumulated depreciation (34. 0) (39. 0) (40. 0) TOTAL ASSETS 2 $119. 0 $160. 0 $170. 0 $190. 0

EXHIBIT 3. 1 b: OS Distributors’ Balance Sheets. Figures in millions of dollars DEC. 31, 1995 DEC. 31, 1996 DEC. 31, 1997 LIABILITIES AND OWNERS’ EQUITY · CURRENT LIABILITIES $54. 0 Short-term debt Owed to banks Current portion of long-term debt Accounts payable Accrued expenses 4 $15. 0 3 $75. 0 $22. 0 $23. 0 $7. 0 $14. 0 $15. 0 8. 0 37. 0 40. 0 48. 0 2. 0 4. 0 · NONCURRENT LIABILITIES 42. 0 Long-term debt 5 42. 0 · Owners’ equity 6 64. 0 TOTAL LIABILITIES AND OWNERS’ EQUITY $66. 0 34. 0 64. 0 $160. 0 70. 0 38. 0 70. 0 $170. 0 77. 0 $190. 0

EXHIBIT 3. 2 a: The Managerial Balance Sheet Versus the Standard Balance Sheet. THE MANAGERIAL BALANCE SHEET INVESTED CAPITAL OR NET ASSETS Cash CAPITAL EMPLOYED Short-term debt Working capital requirement (WCR) Operating assets less Operating liabilities Long-term financing Net fixed assets 4 Long-term debt plus Owners’ equity

EXHIBIT 3. 2 b: The Managerial Balance Sheet Versus the Standard Balance Sheet. THE STANDARD BALANCE SHEET TOTAL ASSETS Cash Operating assets Accounts receivable plus Inventories plus Prepaid expenses LIABILITIES AND OWNER’S EQUITY Short-term debt Operating liabilities Accounts payable plus Accrued expenses Long-term financing Net fixed assets 5 Long-term debt plus Owners’ equity

EXHIBIT 3. 3: The Firm’s Operating Cycle and Its Impact on the Firm’s Balance Sheet. D = Change in the balance sheet account 6

EXHIBIT 3. 4: The Firm’s Operating Cycle, Showing Cash-to-Cash Period. 7

EXHIBIT 3. 5: Extracts from Carrefour’s Balance Sheets and Income Statements. Figures in millions of dollars YEAR 1994 1995 RECEIVABLES $68 84 INVENTORIES $1, 939 2, 172 PAYABLES $5, 296 5, 484 WCR 1 CASH 2 SALES –$3, 289 – 3, 228 $3, 123 3, 281 $27, 260 28, 922 Source: Company’s Annual Report. 1 WCR = Working capital requirement = Receivables + Inventories – Payables 2 Includes cash lent to other companies. 8

EXHIBIT 3. 6: OS Distributor’s Managerial Balance Sheets. All data from the balance sheets in Exhibit 3. 1; figures in millions of dollars DEC. 31, 1995 DEC. 31, 1996 DEC. 31, 1997 INVESTED CAPITAL OR NET ASSETS • Cash • Working capital requirement (WCR)1 59. 0 • Net fixed assets TOTAL INVESTED CAPITAL OR NET ASSETS $ 6. 0 49% 56. 0 5% 46% $121. 0 100% $12. 0 63. 0 50% 51. 0 10% 77. 0 40% $126. 0 100% $ 8. 0 56% 53. 0 6% 38% $138. 0 100% CAPITAL EMPLOYED • Short-term debt • Long-term financing Long-term debt Owners’ equity TOTAL CAPITAL EMPLOYED 1 WCR $ 15. 0 106. 0 88% $42. 0 64. 0 12% $121. 0 100% $ 22. 0 104. 0 83% $34. 0 70. 0 17% $ 23. 0 17% 115. 0 83% $38. 0 77. 0 $126. 0 100% $138. 0 100% = (Accounts receivable + Inventories + Prepaid expenses) – (Accounts payable + Accrued expenses). These amounts are given in Exhibit 3. 1. 9

EXHIBIT 3. 7: The Behavior of Working Capital Requirement over Time for a Firm with Seasonal Sales. WCR is assumed to be set at 25 percent of sales 10

EXHIBIT 3. 8 a: OS Distributor’s Net Investment in Its Operating Cycle and Its Financing. All data from the balance sheets in Exhibit 3. 1; figures in millions of dollars DECEMBER 31, 1995 NET INVESTMENT IN THE OPERATING CYCLE OR WORKING CAPITAL REQUIREMENTS (WCR) WCR = [Accounts receivable + Inventories + Prepaid expenses] – [Accounts payable + Accrued expenses] [$44 + $52 + $2] – [$37 + $2] = $59 THE FINANCING OF THE OPERATING CYCLE Net long-term financing (NLF) = Long-term debt + Owners’ equity – Net fixed assets Net short-term financing (NSF) = Short-term debt – Cash NLF/WCR = percentage of working capital requirement financed long term NSF/WCR = percentage of working capital requirement financed short term $42 + $64 – $56 = $50 $15 – $6 = $9 $50/$59 = 84. 7% $9/$59 = 15. 3% 100. 0% WORKING CAPITAL REQUIREMENT AND ITS FINANCING WCR NSF $9 $59 NLF $50 11 15. 3% 84. 7%

EXHIBIT 3. 8 b: OS Distributor’s Net Investment in Its Operating Cycle and Its Financing. All data from the balance sheets in Exhibit 3. 1; figures in millions of dollars DECEMBER 31, 1996 NET INVESTMENT IN THE OPERATING CYCLE OR WORKING CAPITAL REQUIREMENTS (WCR) WCR = [Accounts receivable + Inventories + Prepaid expenses] – [Accounts payable + Accrued expenses] [$48 + $57 + $2] – [$40 + $4] = $63 THE FINANCING OF THE OPERATING CYCLE Net long-term financing (NLF) = Long-term debt + Owners’ equity – Net fixed assets Net short-term financing (NSF) = Short-term debt – Cash NLF/WCR = percentage of working capital requirement financed long term NSF/WCR = percentage of working capital requirement financed short term $34 + $70 – $51 = $53 $22 – $12 = $10 $53/$63 = 84. 1% $10/$63 = 15. 9% 100. 0% WORKING CAPITAL REQUIREMENT AND ITS FINANCING WCR NSF $10 15. 9% $63 NLF $53 84. 1% 12

EXHIBIT 3. 8 c: OS Distributor’s Net Investment in Its Operating Cycle and Its Financing. All data from the balance sheets in Exhibit 3. 1; figures in millions of dollars DECEMBER 31, 1997 NET INVESTMENT IN THE OPERATING CYCLE OR WORKING CAPITAL REQUIREMENTS (WCR) WCR = [Accounts receivable + Inventories + Prepaid expenses] – [Accounts payable + Accrued expenses] [$56 + $72 + $1] – [$48 + $4] = $77 THE FINANCING OF THE OPERATING CYCLE Net long-term financing (NLF) = Long-term debt + Owners’ equity – Net fixed assets Net short-term financing (NSF) = Short-term debt – Cash NLF/WCR = percentage of working capital requirement financed long term NSF/WCR = percentage of working capital requirement financed short term $38 + $77 – $53 = $62 $23 – $8 = $5 $62/$77 = 80. 5% $15/$77 = 19. 5% 100. 0% WORKING CAPITAL REQUIREMENT AND ITS FINANCING WCR NSF $15 19. 5% $77 NLF $62 80. 5% 13

EXHIBIT 3. 9 a: Some Benchmark Ratios of Working Capital Requirement to Sales for a Sample of U. S. Sectors 1. SECTOR 1996 Highest 1992– 96 Lowest 1992– 96 Electronic components Aircraft Measurement instruments Steel works Motor vehicles Machinery & equipment Textiles Chemicals Wood products & buildings Apparel products Department stores Plastic products Computing equipment Retail: Nongrocery stores Paper 24% 22% 21% 20% 19% 17% 16% 15% 14% 12% 11% 25% 22% 20% 21% 20% 17% 16% 17% 19% 15% 17% 15% 12% 22% 19% 21% 18% 19% 18% 17% 14% 15% 13% 14% 12% 10% AVERAGE: ALL SCORES 10% 11% 10% 1 Source: 14 WORKING CAPITAL REQUIREMENT AS PERCENTAGE OF SALES Calculated by the authors using Compustat data.

EXHIBIT 3. 9 b: Some Benchmark Ratios of Working Capital Requirement to Sales for a Sample of U. S. Sectors 1. SECTOR WORKING CAPITAL REQUIREMENT AS PERCENTAGE OF SALES 1996 Drugs Wholesale: Durables Soaps & perfumes Food Wholesale: Nondurables Telephone Oil & natural gas Publishing Beverages Electric services Grocery stores Natural gas: Distribution Services 2 Air transportation 3 2 The 15 10% 8% 7% 5% 3% 2% 2% 1% 0% 0% – 1% – 13% Highest 1992– 96 13% 10% 8% 7% 6% 3% 3% 2% 1% 2% – 11% Lowest 1992– 96 10% 7% 7% 5% 5% – 2% 2% 1% 0% 0% 0% – 1% – 5% – 13% services sector covers a variety of industries, including advertising, cleaning, data processing, research and development, and management consultancy. 3 The air transportation sector covers scheduled and nonscheduled air transportation as well as air courier services and airports and terminal services.

EXHIBIT 3. 10: OS Distributor’s Management of Its Operating Cycle. All data from the balance sheets in Exhibit 3. 1 and the income statements in Exhibit 2. 2; figures in millions of dollars OBJECTIVE DEC. 31, 1997 Working capital requirement (WCR)1 Sales To evaluate the overall efficiency with which the firm’s operating cycle is managed $59 = 15% $390 $77 = 16% $420 Cost of goods sold (COGS) Inventories To evaluate the efficiency with which inventories are managed $328 = 6. 3 times $52 $400 = 5. 6 times $72 Accounts receivable Average daily sales 2 To evaluate the efficiency $44 $56 with which accounts = 41 days = 43 days $390/365 $480/365 receivable are managed Accounts payable Average daily purchases 2, 3 To evaluate the efficiency $37 $48 with which accounts = 41 days = 42 days $332/365 $415/365 payable are managed 1 WCR is found in Exhibit 3. 6. assume the year has 365 days. 3 Purchases are equal to COGS plus the change in inventories (see equation 3. 11). In 1994, inventories were $48, thus purchases (1995) = $328 + ($52 – $48) = $332. Purchases (1996) = $353 + ($57 – $52) = $358; and purchases (1997) = $400 + ($72 – $57) = $415. 2 We 16 DEC. 31, 1995

EXHIBIT 3. 12: OS Distributor’s Net Working Capital (NWC) and Current and Quick Ratios. All data from the balance sheets in Exhibit 3. 1; figures in millions of dollars DEC. 31, 1995 • NWC = [Current assets – Current liabilities]1 • NWC = [Long-term financing 2 – Net fixed assets]3 • Current ratio = Current assets Current liabilities • Quick ratio = Cash + Accts receivable Current liabilities 1 This DEC. 31, 1996 DEC. 31, 1997 $104 – $54 = $50 $119 – $66 = $53 $137 – $75 = $62 ($42 – $64) – $56 = $50 ($34 + $70) – $51 = $53 ($38 + $77) – $53 = $62 $104 = 1. 93 $54 $119 = 1. 80 $66 $6 + $44 = 0. 93 $54 $12 + $48 = 0. 91 $66 $137 = 1. 83 $75 $8 + $56 = 0. 85 $75 is the traditional definition of net working capital. financing = Long-term debt + Owners’ equity. 3 According to this definition, net working capital is the same as net long-term financing (see equation 3. 4). 2 Long-term 17

EXHIBIT A 3. 1: Financing Investments Using a Matched Strategy. 18

EXHIBIT A 3. 2: Financing Investments Using a Conservative Strategy. 19

EXHIBIT A 3. 3: Financing Investments Using an Aggressive Strategy. 20