15-1

CHAPTER 15Working Capital Management

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

15-2

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.

15-3

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%

15-4

How does SKI’s 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.

15-5

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.

15-6

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.

15-7

Moderate financing policy

Years

Lower dashed line would be more aggressive.

$

Perm C.A.

Fixed Assets

Temp. C.A.

S-TLoans

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

15-8

Conservative financing policy

$

Years

Perm C.A.

Fixed Assets

Marketable securities Zero S-T

Debt

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

15-9

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.

CCC = + – .Inventory

conversionperiod

Receivablescollection

period

Payablesdeferralperiod

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Cash conversion cycle

days. 92 30 - 46 76 CCC

30 - 46 4.82365

CCC

perioddeferralPayables

goutstandinsales Days

turnoverInventory per year Days

CCC

perioddeferralPayables

periodcollection

sReceivable

periodconversionInventory

CCC

15-11

Cash doesn’t earn a profit, so why should the firm hold it?

1. Transactions – must have some cash to operate.

2. Precaution – “safety stock”. Reduced by line of credit and marketable securities.

3. Compensating balances – for loans and/or services provided.

4. 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.

15-13

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

15-14

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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SKI’s cash budget:For January and February

Net Cash Inflows Jan Feb

Collections $67,651.95 $62,755.40Purchases 44,603.75 36,472.65Wages 6,690.56 5,470.90Rent 2,500.00 2,500.00Total payments $53,794.31 $44,443.55Net CF $13,857.64 $18,311.85

15-16

SKI’s cash budget (con’t) Net Cash Inflows Jan FebCash at start if no borrowing $ 3,000.00 $16,857.64Net CF 13,857.64 18,311.85Cumulative cash 16,857.64 35,169.49Less: target cash 1,500.00 1,500.00Surplus $15,357.64 $33,669.49

15-17

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.

15-18

Analyze SKI’s 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.

15-19

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.

15-20

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.

15-21

Is SKI holding too much inventory?

SKI’s 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.

15-22

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.

15-23

Do SKI’s customers pay more or less promptly than those of its competitors?

SKI’s DSO (45.6 days) is well above the industry average (32 days). SKI’s 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 policy1. 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.

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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.

15-27

Short-term credit Debt scheduled for repayment within 1

year. Major sources of short-term credit

Accounts payable (trade credit) Bank loans Commercial loans Accruals

From the firm’s perspective, S-T credit is riskier than L-T debt. 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

Disadvantages Fluctuating interest expense Firm may be at risk of default as a result of

temporary economic conditions

15-29

What is trade credit? Trade credit is credit furnished by a

firm’s 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.

15-30

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

15-31

Breaking down trade credit Payables level, if the firm takes discounts

Payables = $8,219.18 (10) = $82,192 Payables level, if the firm takes no

discounts Payables = $8,219.18 (40) = $328,767

Credit breakdownTotal trade credit $328,767Free trade credit - 82,192Costly trade credit $246,575

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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.

Nominal cost of trade credit

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Nominal cost of trade credit formula

12.29%

0.1229

10 - 40

365

991

period Disc. - taken Daysdays 365

%Discount - 1

%Discount rNOM

15-34

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%

15-35

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

15-36

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).

15-38

Add-on interestFrom the calculator output below, we have:

rNOM = 12 (0.012043) = 0.1445 = 14.45%

EAR = (1.012043)12 – 1 = 15.45%

INPUTS

OUTPUT

N I/YR PMTPV FV

12

1.2043

-9 0100