Working Capital Management Chapter 16 Working Capital Management Alternative Working Capital Policies Cash Management Inventory and A/R Management Trade Credit Bank Loans

Working Capital Terminology Working capital – 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.

Selected Ratios for SKI Inc. 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%

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.

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.

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.

Moderate Financing Policy Years Lower dashed line would be more aggressive. $ Perm C.A. Fixed Assets Temp. C.A. S-T Loans L-T Fin: Stock, Bonds, Spon. C.L.

Conservative Financing Policy $ Years Perm C.A. Fixed Assets Marketable securities Zero S-T Debt L-T Fin: Stock, Bonds, Spon. C.L.

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.

Cash Conversion Cycle

Minimizing Cash Holdings Use a lockbox Insist on wire transfers and debit/credit cards from customers Synchronize inflows and outflows Reduce need for “safety stock” of cash Increase forecast accuracy Hold marketable securities Negotiate a line of credit

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.

SKI’s Cash Budget for January and February

SKI’s Cash Budget

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.

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.

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.

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.

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.

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.

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.

Elements of Credit Policy Credit Period – How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales. Cash Discounts – Lowers price. Attracts new customers and reduces DSO. Credit Standards – Tighter standards tend to reduce sales, but reduce bad debt expense. Fewer bad debts reduce DSO. Collection Policy – How tough? Tougher policy will reduce DSO but may damage customer relationships.

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.

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.

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.

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.

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 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.

Nominal Cost of Trade Credit Formula

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

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

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.

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).

Add-on Interest From the calculator output below, we have: rNOM = 12 (0.012043) = 0.1445 = 14.45% EAR = (1.012043)12 – 1 = 15.45% INPUTS 12 100 -9 N I/YR PV PMT FV OUTPUT 1.2043