Cash CycleThe duration of the cash cycle is the time between the date the inventory (or raw materials) is paid for and the date the cash is collected from the sale of the inventory. A company's cash cycle is important because it affects the need for financing. The cash cycle is calculated as:

days in inventory + days in receivables - days in payables

Financing requirements will increase if either of the following occurs:

• Sales increase while the cash cycle remains fixed in duration. Increased sales increase the value of assets in the cycle.

• Sales remain flat but the cash cycle increases in duration.

While financially it makes sense to reduce the length of the cash cycle, such a reduction should not be done without considering the impact on operations. For example, one must consider the impact on customer and supplier relations as well as the impact on order fill rates.

Revenue, Expenses, and InventoryA firm's income is calculated by subtracting its expenses from its revenue. However, not all costs are considered expenses; accounting standards and tax laws prohibit the expensing of costs incurred in the production of inventory. Rather, these costs must be allocated to inventory accounts and appear as assets on the balance sheet. Once the finished goods are drawn from inventory and sold, these costs are reported on the income statement as the cost of goods sold (COGS). If one wishes to know how much product the firm actually produced, the cost of goods produced in an accounting period is determined by adding the change in inventory to the COGS.

AssetsAssets can be classified as current assets and long-term assets. It is useful to know the number of days of certain assets and liabilities that a firm has on hand. These numbers are easily calculated from the financial statements as follows:

Accounts Receivable (A/R)

Number of days of A/R = ( accounts receivable / annual credit sales ) ( 365 ).
This also is known as the collection period.

Inventory

Number of days of inventory = ( inventory / annual COGS ) ( 365 ).
This also is known as the inventory period.

On the liabilities side:

Payables

Number of days of accounts payable = ( accounts payable / COGS ) ( 365 ), assuming that all accounts payable are for the production of goods. This also is known as the payables period.

Financial Ratios

A firm's performance can be evaluated using various financial ratios. Ratios are used to measure leverage, margins, turnover rates, return on assets, return on equity, and liquidity. Additional insight can be gained by comparing ratios among firms in the industry.

Bank Loans

Bank loans can be classified according to their durations. There are short-term loans (one year or less), long-term loans (also known as term loans), and revolving loans that allow one to borrow up to a specified credit level at any time over the duration of the loan. Some revolving loans automatically renew at maturity; these loans are said to be "evergreen."

Sources and Uses of Cash It can be worthwhile to know where a firm's cash is originating and how it is being used. There are two sources of cash: reducing assets or increasing liabilities or equity. Similarly, a company uses cash either by increasing assets or decreasing liabilities or equity.

Sustainable Growth

A company's sustainable growth rate is calculated by multiplying the ROE by the earnings retention rate.

Firm Value, Equity Value, and Debt Value

The value of the firm is the value of its assets, or rather, the present value of the unlevered free cash flow resulting from the use of those assets. In the case of an all-equity financed firm, the equity value is equal to the firm value. When the firm has issued debt, the debt holders have a priority claim on their interest and principal, and the equity holders have a residual claim on what remains after the debt obligations are met. The sum of the value of the debt and the value of the equity then is equal to the value of the firm, ignoring the tax benefits from the interest paid on the debt. Considering taxes, the effective value of the firm will be higher since a levered firm has a tax benefit from the interest paid on the debt. If there is outstanding preferred stock, the firm value is the sum of the equity value, debt value, and preferred stock value, plus the value of the interest tax shield.

The debt holders and stock holders each have a claim on the cash flows of the firm. In a given time period, the debt holders have a claim equal to the interest payments during that period plus any principal payments that are due. The stock holders then have a claim equal to the unlevered free cash flow in that period plus the cash generated by the interest tax shield, minus the claims of the debt holders.