CHAPTER 16 Working Capital Management

Alternative working capital policies Cash management Inventory and A/R management Trade credit Bank loans
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Working capital terminology

Gross working capital total current assets. Net working capital current assets minus non-interest bearing current liabilities. Working capital policy deciding the level of each type of current asset to hold, and how to finance current assets. Working capital management controlling cash, inventories, and A/R, plus short-term liability management.
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Selected ratios for SKI Inc.

SKI Ind Avg Current ratio 1.75x 2.25x Debt/Assets 58.76% 50.00% Turnover of cash & securities 16.67x 22.22x Days sales outstanding 45.63 32.00 Inventory turnover 4.82x 7.00x Fixed assets turnover 11.35x 12.00x Total assets turnover 2.08x 3.00x Profit margin 2.07% 3.50% Return on equity 10.45% 21.00%

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How does SKIs working capital policy compare with its industry?

Working capital policy is reflected in the current ratio, turnover of cash and securities, inventory turnover, and days sales outstanding. These ratios indicate SKI has large amounts of working capital relative to its level of sales. SKI is either very conservative or inefficient.
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Is SKI inefficient or conservative?

A conservative (relaxed) policy may be appropriate if it leads to greater profitability. However, SKI is not as profitable as the average firm in the industry.

This suggests the company has excessive working capital.

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Working capital financing policies

Moderate Match the maturity of the assets with the maturity of the financing. Aggressive Use short-term financing to finance permanent assets. Conservative Use permanent capital for permanent assets and temporary assets.
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Moderate financing policy

$ Temp. C.A. S-T Loans

Perm C.A.

Fixed Assets

L-T Fin: Stock, Bonds, Spon. C.L. Years

Lower dashed line would be more aggressive.

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Conservative financing policy

$
Marketable securities

Zero S-T Debt L-T Fin: Stock, Bonds, Spon. C.L. Years
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Perm C.A.

Fixed Assets

Cash conversion cycle

The cash conversion cycle focuses on the length of time between when a company makes payments to its creditors and when a company receives payments from its customers.

Inventory Receivables Payables CCC = conversion + collection deferral . period period period
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Cash conversion cycle

Inventory Receivables Payables CCC conversion collection deferral period period period Payables Days per year Days sales CCC deferral Inventory turnover outstanding period 365 CCC 46 - 30 4.82 CCC 76 46 - 30 92 days.
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Cash doesnt earn a profit, so why should the firm hold it?
1. 2.

3.
4.

Transactions must have some cash to operate. Precaution safety stock. Reduced by line of credit and marketable securities. Compensating balances for loans and/or services provided. Speculation to take advantage of bargains and to take discounts. Reduced by credit lines and marketable securities.
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The goal of cash management

To meet the above objectives, especially to have cash for transactions, yet not have any excess cash. To minimize transactions balances in particular, and also needs for cash to meet other objectives.

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Minimizing cash holdings

Use a lockbox Insist on wire transfers from customers Synchronize inflows and outflows Use a remote disbursement account Reduce need for safety stock of cash

Increase forecast accuracy Hold marketable securities Negotiate a line of credit

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Cash budget

Forecasts cash inflows, outflows, and ending cash balances. Used to plan loans needed or funds available to invest. Can be daily, weekly, or monthly, forecasts.

Monthly for annual planning and daily for actual cash management.
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SKIs cash budget: For January and February

Net Cash Inflows Jan Feb Collections $67,651.95 $62,755.40 Purchases 44,603.75 36,472.65 Wages 6,690.56 5,470.90 Rent 2,500.00 2,500.00 Total payments $53,794.31 $44,443.55 Net CF $13,857.64 $18,311.85
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SKIs cash budget (cont)

Net Cash Inflows Jan Feb
Cash at start if no borrowing $ 3,000.00 Net CF 13,857.64 Cumulative cash 16,857.64 Less: target cash 1,500.00 Surplus $15,357.64

$16,857.64 18,311.85 35,169.49 1,500.00 $33,669.49

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How could bad debts be worked into the cash budget?

Collections would be reduced by the amount of the bad debt losses. For example, if the firm had 3% bad debt losses, collections would total only 97% of sales. Lower collections would lead to higher borrowing requirements.
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Analyze SKIs forecasted cash budget

Cash holdings will exceed the target balance for each month, except for October and November. Cash budget indicates the company is holding too much cash. SKI could improve its EVA by either investing cash in more productive assets, or by returning cash to its shareholders.

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Why might SKI want to maintain a relatively high amount of cash?

If sales turn out to be considerably less than expected, SKI could face a cash shortfall. A company may choose to hold large amounts of cash if it does not have much faith in its sales forecast, or if it is very conservative. The cash may be used, in part, to fund future investments.
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Inventory costs

Types of inventory costs

Carrying costs storage and handling costs, insurance, property taxes, depreciation, and obsolescence. Ordering costs cost of placing orders, shipping, and handling costs. Costs of running short loss of sales or customer goodwill, and the disruption of production schedules.

Reducing inventory levels generally reduces carrying costs, increases ordering costs, and may increase the costs of running short.
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Is SKI holding too much inventory?

SKIs inventory turnover (4.82x) is considerably lower than the industry average (7.00x). The firm is carrying a lot of inventory per dollar of sales. By holding excessive inventory, the firm is increasing its costs, which reduces its ROE. Moreover, this additional working capital must be financed, so EVA is also lowered.
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If SKI reduces its inventory, without adversely affecting sales, what effect will this have on the cash position?

Short run: Cash will increase as inventory purchases decline. Long run: Company is likely to take steps to reduce its cash holdings and increase its EVA.

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Do SKIs customers pay more or less promptly than those of its competitors?

SKIs DSO (45.6 days) is well above the industry average (32 days).

SKIs customers are paying less promptly.

SKI should consider tightening its credit policy in order to reduce its DSO.

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Elements of credit policy

Credit Period How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales. 2. Cash Discounts Lowers price. Attracts new customers and reduces DSO. 3. Credit Standards Tighter standards tend to reduce sales, but reduce bad debt expense. Fewer bad debts reduce DSO. 4. Collection Policy How tough? Tougher policy will reduce DSO but may damage customer relationships.
1.
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Does SKI face any risk if it tightens its credit policy?

Yes, a tighter credit policy may discourage sales.

Some customers may choose to go elsewhere if they are pressured to pay their bills sooner. SKI must balance the benefits of fewer bad debts with the cost of possible lost sales.
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If SKI reduces its DSO without adversely affecting sales, how would this affect its cash position?

Short run: If customers pay sooner, this increases cash holdings. Long run: Over time, the company would hopefully invest the cash in more productive assets, or pay it out to shareholders. Both of these actions would increase EVA.
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Short-term credit

Debt scheduled for repayment within 1 year. Major sources of short-term credit

From the firms perspective, S-T credit is riskier than L-T debt.

Accounts payable (trade credit) Bank loans Commercial loans Accruals

Always a required payment around the corner. May have trouble rolling over loans.
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Advantages and disadvantages of using short-term financing

Advantages

Speed Flexibility Lower cost than long-term debt Fluctuating interest expense Firm may be at risk of default as a result of temporary economic conditions

Disadvantages

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What is trade credit?

Trade credit is credit furnished by a firms suppliers. Trade credit is often the largest source of short-term credit, especially for small firms. Spontaneous, easy to get, but cost can be high.

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Terms of trade credit

A firm buys $3,000,000 net ($3,030,303 gross) on terms of 1/10, net 30. The firm can forego discounts and pay on Day 40, without penalty. Net daily purchases = $3,000,000 / 365 = $8,219.18

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Breaking down trade credit

Payables level, if the firm takes discounts

Payables = $8,219.18 (10) = $82,192 Payables = $8,219.18 (40) = $328,767 Total trade credit Free trade credit Costly trade credit $328,767 - 82,192 $246,575
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Payables level, if the firm takes no discounts

Credit breakdown

Nominal cost of trade credit

The firm loses 0.01($3,030,303) = $30,303 of discounts to obtain $246,575 in extra trade credit:
rNOM = $30,303 / $246,575 = 0.1229 = 12.29%

The $30,303 is paid throughout the year, so the effective cost of costly trade credit is higher.

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Nominal cost of trade credit formula

rNOM Discount % 365 days 1 - Discount % Days taken - Disc. period 1 365 99 40 - 10 0.1229 12.29%

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Effective cost of trade credit

Periodic rate = 0.01 / 0.99 = 1.01% Periods/year = 365 / (40-10) = 12.1667 Effective cost of trade credit

EAR

= (1 + periodic rate)N 1
= (1.0101)12.1667 1 = 13.01%

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Bank loans

The firm can borrow $100,000 for 1 year at an 8% nominal rate. Interest may be set under one of the following scenarios:

Simple annual interest Installment loan, add-on, 12 months

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Simple annual interest

Simple interest means no discount or add-on.

Interest = 0.08($100,000) = $8,000 rNOM = EAR = $8,000 / $100,000 = 8.0%

For a 1-year simple interest loan, rNOM = EAR

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Add-on interest

Interest = 0.08 ($100,000) = $8,000 Face amount = $100,000 + $8,000 = $108,000 Monthly payment = $108,000/12 = $9,000 Avg loan outstanding = $100,000/2 = $50,000 Approximate cost = $8,000/$50,000 = 16.0% To find the appropriate effective rate, recognize that the firm receives $100,000 and must make monthly payments of $9,000 (like an annuity).
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Add-on interest
From the calculator output below, we have:
rNOM EAR = 12 (0.012043) = 0.1445 = 14.45% = (1.012043)12 1 = 15.45% 12 N OUTPUT I/YR
1.2043
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INPUTS

100 PV

-9 PMT

0 FV