Terminology Primer

Elements of the Cash Conversion Cycle

DSI + DSO – DPO = Cash Conversion Cycle

 Days Sales in Inventory (DSI) = Inventory $ balance / cost of goods sold

DSI measures how much inventory is on hand at the end of the period, relative to the average
cost of inventory sold during that period.
Example calculation: $10 million in inventory / ($35 million/365) = approximately 104 days

 Days Sales Outstanding (DSO) = Accounts Receivables $ balance / sales per day
DSO measures how quickly a company collects on payments owed by customers.
Example calculation: $2 million in receivables / ($50 million/365) = approximately 15 days

 Days Payables Outstanding (DPO) = Accounts Payables $ balance / purchases (COGS) per
day
DPO measures how quickly a company pays its suppliers.
Example calculation: $1.5 million in payables / ($35 million/365) = approximately 16 days

Elements of Credit Policy

A firm’s credit policy generally incorporates two elements: credit period and discount terms.

The credit period is the length of time buyers are given to pay for purchases. Discounts are given
for early payment, and discount terms usually include the discount percentage and how rapidly payment
must be made for the customer to qualify for the discount. For example, the credit terms 2/10, net 30
signify that the customer is eligible for a 2% discount if payment is made within 10 days; otherwise, the
customer must pay in full within 30 days.

A line of credit is an informal agreement between a bank and a borrower indicating the maximum
credit the bank will extend to the borrower. The line of credit is typically committed by the lender for no
more than one year at a time.

Value Creation or Total Value Created (Ross refers to Free Cash Flow as Cash Flow from Assets)

The value created consists of two components (1) the value of the underlying business itself,
assuming no changes or growth as of the end of 2012; and (2) the value created by each opportunity.
The free cash flows generated over the explicit forecast of three years (the life span of each phase) are
discounted back to 2012. The terminal value is calculated as the present value of the perpetuity beyond
the end of the explicit forecast. The model assumes a terminal value growth rate of zero. The zero
growth implies that in periods beyond the explicit forecast, the free cash flow simply equals the EBIAT
[or EBIT*(1-T)]. The terminal value is also discounted back to 2012. The sum of the discounted cash
flow is the total value created as of 2012.

Simulation assumes 12% discount rate when calculating present value

Free Cash Flow = EBIT*(1-T) - capex + depreciation - change in net working capital

Note that none of the opportunities requires new investment in fixed assets. The model assumes that
depreciation on SNC’s fixed asset base is exactly offset by new capital expenditures. Net PPE is held
constant for all years. Free cash flow is then driven by EBIAT or EBIT*(1-T) and changes in net working
capital.