Developing a Basic Financial Model – Part IV – Working Capital Historical Relationships

In continuing in our series of fundamental concepts of financial modeling, I will now turn to the initial steps of understanding how to forecast financial information. It is important that the reader has some familiarity of the three major financial statements (income statement, balance sheet and cash flow statement) that I covered in the prior three articles. If not, please read those first prior to continuing.

Working Capital Historical Relationships

We often see in disclaimer language that “past performance is not indicative of future results” or other types of language similar to that to let the reader know not to put too much stock in the historical outcomes of a particular situation. This is commonly seen in relation to stock price performance or asset manager historical returns. In the case of forecasting financial information of specific companies, this is not necessarily true. In fact, in investment banking or private equity, historical relationships help to drive the expectations of future performance.

For example, let us assume that there is a company in a relatively mature stage of growth, meaning that the future growth is likely to be more along the lines of a bit above the inflation rate for the next several years. The last two years have showed that the days outstanding for accounts receivable (“DSO”) was 32 (the days from the point of booking a sales turns to cash). In the absence of specific information related to the company, whether a macro event or industry overhaul, there is likely no reason to assume that there would be a significant change from that.

DSO is calculated by taking the average accounts receivable over a time period, like annual, and dividing the result by the total daily sales value for the most recent period. In other word, if annual, the denominator would be the sales figure divided by 365 and the numerator would be the average of the accounts receivable calculated for the current year and the prior year. If the total accounts receivables for the past two years was $50 and $65, and the total sales for the most recent period was $1,050, the DSO would be approximately 20, or on average, accounts receivable is outstanding 20 days before coming to the company as cash.

The same concept would apply to days payables outstanding (“DPO”) or days inventory outstanding (“DIO” – although, a more common concept is inventory turns). DPO is calculated similarly to DSO, except the accounts payable becomes the numerator and the denominator is cost of sales divided by 365. You can easily see the similarities between the DSO and DPO because one is a method to track when cash comes in (DSO) and the other tracks when you have to pay (DPO). These are two components of the cash cycle (also known as the cash conversion cycle).

The cash cycle is a way companies can track how quickly cash comes into the company, and when an analyst is forecasting results for a company, the historical information is very important to understand. In simple terms, the cash cycle follows the purchase of raw materials (often building up payables) to creating a saleable product to the collection of receivables. The cash cycle is = days inventory + days receivable – days payable or DIO + DSO – DPO. The DIO is calculated similarly to DPO in using the cost of sales as the denominator with the average inventory as the numerator (the inventory turns is calculated by taking the total costs of sales as the numerator and the average inventory as the denominator and the result yields how often a company is “turning” its inventory, or selling its products).

To continue with our prior example of DSO = 20 days, if we assume that average inventories was $28, average accounts payable was $37 and the cost of sales in the most recent period was $750, then DIO = 14 and DPO = 18. This translates to a cash conversion cycle of 16 days (20 + 14 – 18). This means that a company is getting cash every 16 days from the current operations. What this really tells you is that the time period of 16 days is what a company must finance prior to getting cash. As a slight tangent, there are instances, although rare, where companies have been able to “self-finance,” or not rely on a credit facility or other source of funding to finance its working capital. If you change the numbers above and have DSO or 11, DIO of 10 and DPO of 22, you can see that the cash cycle is approximately 0 (rounded to -1). This is an instance where an entity is developing inventory to sell faster and receiving cash from accounts receivable faster than that company is paying to its vendors. That is a great position, but it is not a common situation.

Other current assets include prepaid assets, which many financial analysts will see as a percentage of total sales. Other current liabilities include accrued expenses or other accrued liabilities, which financial analysts may view as a percentage of total cost of sales. For example, if prepaid expenses at the end of the year have been on average 3% of total sales, in the absence of specific information, any deviation from that going forward is probably not warranted. The similar logic holds for current liabilities.

I want to make two quick points before ending this section. The first is that for companies who are new and rapidly growing, it is acceptable to look at all working capital relationships as a percentage of total sales. In many instances, if you attempt to forecast receivables, inventory or payables using historical information for a company only in business for one or two years, you will get misleading data. To better understand this, think of a new company who will be building up inventory ahead of a marketing launch and who may be offering better receivables terms to purchasers in order to generate sales. Additionally, a new company is likely to have more stringent terms on payables so you will be double penalized from a cash cycle perspective. As a company goes from upstart to established entities, the various ratios will reach equilibrium and then using the DIO, DPO or DSO analyses is more prudent.

The second point is that some companies will include short-term borrowings or current portion of short-term debt in the current liabilities section. For working capital analyses, these should not be included. The only counter-argument to this is that is there is a specific working capital line that is associated with financing working capital (not just based on the balances but actually used to finance working capital) some would choose to include that in certain working capital calculations. In my experience in financial forecasting, I have separated that component of debt and I do not view it as a current liability but as part of a company’s capital structure (i.e., long-term financing and not a current liability like payables or accrued expenses). But, as long as the methodology is clearly defined, the financial modeler can choose either path, as the results should not differ.

Financial Freedom is Possible With Financial Planning

Most people will not accomplish financial freedom without doing some financial planning. Financial planning can be done with a financial advisor, through online research or reading a few books. Most people are worried about their financial future but never take any steps to plan. Some people excuses are being to too young or not knowing enough financial information. It is never too early to plan for your future. Most people are not born wealthy and have to find ways to create wealth. One of the ways to create wealth is by making good business decisions.

Starting a business can seem impossible for some people. Today’s information age is making it possible for people to become entrepreneurs through online businesses and internet marketing. There is a direct relationship between success and people’s dreams, hopes and desires. It will require money in order to be successful and to accomplish dreams. It would help to create a financial plan that evaluates current income. This is a way to determine how fast goals will be able to be met with your current income. There is a possibility that you not making enough money. If this is the case then you will have to find other ways to create wealth.

Many people are getting involved in internet marketing to create financial freedom for their family. Internet marketing is allowing people to work from home and to replace income from their job. Also, internet marketers are able to provide extras for their families like family vacation and paying for college tuition. It is not easy to create wealth with internet marketing and will take hard work. As well as, you will need to be focus to be successful and focus is a characteristic that many people lack. Focus will have a big impact on accomplishing goals and dreams for one’s life.

Most people want to achieve success and creating a financial plan will help to create wealth. Creating wealth will inspire a person to plan other events for their family. As well as, living comfortable will allow more freedom and the ability to be prepared for an emergency. Furthermore, financial freedom is attainable with an internet marketing business and a sound financial plan.

Achieving SOX Compliance Through Security Information Management

Introduction: Brief Overview of SOX The Sarbanes-Oxley Act of 2002, also known as the Public Company Accounting Reform and Investor Protection Act of 2002, and commonly referred to as SOX, is a federal law designed to improve disclosures and closely supervise accounting practices for publicly traded companies and public accounting firms. The legislation, spawned from high profile fraud and scandal dating back to the late 1990s, represents one of the largest reform measures in the history of US business.

The regulation mandates strict operating and reporting practices for all publicly traded U.S. companies, foreign filers in US markets, and public accounting firms. The sections of SOX that impact the public company’s IT department include:

  • Section 302 — Corporate Responsibility for Financial Reports. Public company officers must confirm the reliability of quarterly and annual financial statements.
  • Section 404 — Management Assessment of Internal Controls. All publicly traded companies must submit an annual report to the SEC on the effectiveness of their internal accounting controls. The independent company auditor must also attest to the accuracy of the report. (While not explicitly defined, IT general controls are included in the scope of Section 404 compliance).
  • Section 409 — Real-Time Issuer Disclosures. Public companies must stay abreast of and declare material changes in their financial condition or operations within 48 hours. (While not specifically defined, a major breach in information security has the potential to cause a significant deficiency or material weakness in the internal control structure.)

The primary focus for SOX compliance has been Section 404. Management must consider the extent to which threats and vulnerabilities in the corporate computing environment can represent a significant deficiency or material weakness in the internal control structure. They must ensure that the systems, services, devices, and data involved in the production of corporate financial records and financial reporting are appropriately isolated, that physical and logical access is appropriately restricted, and that all controls are thoroughly tested and documented on a routine basis.

The SOX Challenge: Improving the Accuracy and Reliability of Financial Reporting Though SOX can positively affect corporate governance by improving the internal control structure, compliance presents significant challenges, particularly for IT organizations. The IT general controls are very closely scrutinized during the annual audit, because virtually all of the company’s financial data resides on network servers. IT departments must provide detailed information to internal and external auditors about the IT general controls protecting financial reporting data and processes. Network administrators need the ability to use existing technology to manage and report on access controls related to the target environment, and provide documented evidence of the reliability of those controls.

SOX mandates accountability and requires each organization to examine the effectiveness of their approach to information security. To be effective, an information security solution must demonstrate that IT general controls are managed and monitored over time. The solution should also ensure that all systems, services, devices, data, and every personnel that touches financial data and reporting processes are secured.

Financial information security is a complex task requiring a broad security strategy. Organizations must not only achieve SOX compliance — but also maintain it continuously.

Publicly traded companies must to do the following in support of Section 404:

  • Ensure that the IT security administration monitors and logs security activity and identified security violations.
  • Review a sample of problems or incident reports, to consider if the issues were addressed in a timely manner.
  • Determine if the organization’s procedures include audit trail facilities for incident tracking.
  • Review a sample of problems recorded on the problem-management system to consider if a proper audit trail exists and is used.
  • Ensure that system-event data are sufficiently retained to provide chronological information and logs to enable the review, examination, and reconstruction of system and data processing.

Identify all systems, services, devices, data, and personnel that participate in the production of financial data and financial reporting

  • Isolate this target environment from the rest of the corporate computing network
  • Restrict physical and logical access to the target
  • Monitor physical and logical access to the target
  • Monitor the target for unusual and/or anomalous activity
  • Create an incident response plan specific to the target
  • Test and review the incident response plan
  • Routinely test controls in place and prepare summary reporting for the internal audit team

Though no single software product can enable full Section 404 compliance, the right SIM technology can help public companies efficiently manage the IT general controls. An effective security management solution provides public companies the tools to implement, maintain, and report on information security controls with minimal utilization of resources.

SOX mandates that corporate governance now include the appropriate management of information security. Senior management and even board-level directors now bear personal responsibility for oversight of compliance. Executive management needs to work closely with IT organizations on risk assessment and the implementation of security policies and operations. Overall, a security program that integrates people, policies, process, and technology is the best approach to managing Section 404 compliance.

Register now to read the full report outlining in detail how an effective Security Information Management solution can enable SOX compliance [].