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

2. Working Capital Terminology
Working capital – current assets.
Net working capital – current assets minus current liabilities.
Net Operating Working Capital (NOWC) – Net Working Capital without the Notes Payable
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.
 1. Working capital. Current assets are often called working capital because these
assets “turn over” (i.e., are used and then replaced all during the year)
NWC: CA must be financed, some are freely financed by AP, the remainder : NWC=CA-CL represents the amount of  money that the firm must obtain from non-free sources to carry its current assets.

3. 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%
Cash Turnover= sales / Avg. cash & securities

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.

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.

6. Working Capital Investment Policies
Relaxed – high level of current assets
low total asset turnover  lower ROE.
Restricted – constrained level of current assets
low level of assets high total assets turnover ratio  high ROE.
also exposes the firm to risks because shortages can lead to work stoppages and unhappy customers.
Moderate – an in-between policy
Restricted leads to low level of assets => high Asset Turnover => high ROE
However, there is also higher risk
Relaxed minimizes risk on the expense of a reduced ROE
Example:  retailers such as Wal-Mart and Home Depot have inventory
management systems in which bar codes on all merchandise are read at the cash
register. This information is transmitted electronically to a computer that records
the remaining stock of each item, and the computer automatically places an order
with the supplier’ s computer when the stock falls to a specified level. This process
lowers the “ safety stocks”  that would otherwise be necessary to avoid running out
of stock, which lowers inventories to profit-maximizing levels

7. Working Capital Financing Policies
Companies go through cycles and seasons…
Permanent Current Assets: Current assets that a firm must carry even at the trough of its cycles.
Temporary Current Assets: Current assets that fluctuate with seasonal or cyclical variations in sales.
Current Assets Financing Policy: The way current assets are financed.
Working capital can be financed form short-term financing such as accounts payable to long-term financing such as equity and long-term debt. Companies go through cycles and seasons. All companies sales tend to do well when the economy is booming and therefore during such good times they build up their current assets. During bad times they reduce their current assets but they never reach zero.
Permanent Current Assets are the current assets available inside the firm during the bad times. Extra current assets that exist during booms are temporary current assets
In Moderate long-term assets are financed with long-term debt. Short-term assets such as the temporary current assets are financed with short-term debt.
The problems with an aggressive policy: No renewal of financing & rising interest rates (interest rate becomes more than FCF). The tempting thing about such financing is that short-term interests are lower than long-term ones and some firms are willing to take these risks for the lower rates. Nevertheless, very risk (e.g. crisis) because cash flows from assets don’t match those going to liabilities.
Short-term debt is usually easier to get than long-term debt. Short-term debt has more flexibility and allows the firm to make use of the possibility of dropping interest rates
Each firm should find it’s more comfortable level of policy

8. 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.
Subject to dangers from loan renewal as well as problems with rising interest rates. However, short-term interest rates are generally lower than long-term rates.
Conservative – Use permanent capital for permanent assets and temporary assets.

9. Moderate Financing policy

10. Moderately aggressive 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.

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

12. 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 is the cycle from producing or buying an item till the firm sells it
Inventory Conversion Period: The time it take to sell the inventory
Receivables Collection Period: The time it takes for customers to pay the company (DSO). Also called Average Collection Period (ACP)
Payables Deferral Period: the time it takes the company to pay its suppliers

13. Cash Conversion Cycle
Inventory Conversion Period: The average time required to sell inventory. For a manufacturing firm, it would be the time required to convert raw materials into finished goods and then to sell them.
DSO or ACP:  The length of time customers are given to pay for goods following a sale.
Payable Deferral Period:  The average length of time between the purchase of materials and the payment of cash for them.

15. Cash Conversion Cycle Why care about CCC?
The shorter the cash conversion cycle, the better because that will lower interest charges.
Note that if the firm could sell goods faster, collect receivables faster, or defer its payables longer without hurting sales or increasing operating costs, its CCC would decline, its interest charges would be reduced, and its profits and stock price would be improved

16. Cash Conversion Cycle

17. Cash Conversion Cycle
What does this mean? It borrows after Day 30 to pay its suppliers and therefore has to pay interest for 92 days until it gets it’s money from its customers.
The shorter the CCC, the lower the interest the company has to pay. The shorter CCC is, the higher the profit and the better the stock performed
Payables Deferral Period = payables/(COGS/365)

20. Its COGS represents 80% of sales.

22. Can you have a negative cash conversion cycle?

23. 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.
Why do this? If you will need cash, you should plan on how to get it early on. If you have excess cash, you need to plan how to use it

24. Cash Budget
Target Cash Balance: The desired cash balance that a firm plans to maintain in order to conduct business.
it plans to borrow to meet this target or to invest surplus funds if it generates more cash than is needed.

25. SKI’s Cash Budget for January and February

26. SKI’s Cash Budget
Target Cash Balance: the minimum amount of cash the company needs to have in order to conduct business
Having such a budget would be shared with the bankers to get a line of credit. The lenders would want to see the firm’s cash situation
Important elements to question about the budget: how accurate is the forecast likely to be? What would be the effect of significant errors?
Management and the bankers would ask questions such as changes in sales, what happens if customers don’t pay
Those cash flows are the total for the whole month. Things during the month might not be uniform.

27. 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.

28. 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.
Economic Value Added = EBIT(1-T)-WACC(Capital employed)

29. 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.

30. Cash Budget Example..

32. Cash & Marketable Securities
What does “Cash” on a balance sheet usually mean?
“cash” as reported on balance sheets generally includes short- term securities, which are also called “cash equivalents.”
Why would firms hold marketable securities?
Operating short-term securities to provide liquidity and funding for operations
Other short-term securities: excess securities just in case

33. Cash & Marketable Securities
Currency
Demand deposits
How to optimize your level of demand deposits?
Hold marketable securities rather than demand deposits for liquidity
Borrow on short notice through lines of credit
Forecast payments and receipts better
Use credit cards, debit cards, and wire transfers
Synchronize cash inflows and outflows
Marketable Securities
The level of currency depends highly on the type of business. The rise of credit cards and debit cards has reduced the need to hold a lot of it
Demand deposits are used to make transactions (e.g. paying for labor and raw material, purchasing fixed assets). Firms try to minimize such deposits since they don’t earn any interest on them
Sources of liquidity while earning an interest on their money. Trade-off between high return and high liquidity
The better a firm has access to a line of credit, the less it needs cash & marketable securities

34. 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.
Inventory management is very important. It is very much tied to sales. Holding too much inventory is costly as well as holding too little inventory in terms of lost sales

35. 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.

36. 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.

37. 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.

38. 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.
Longer credit periods also expose the firm to the probability the customer never pays (bankrupt)
Why is this important? 1) major effect on sales 2) effects DSO 3) effects bad debt losses

39. 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.

40. 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.

42. What is trade credit?
Trade Credit: Debt arising from credit purchases and recorded as an account payable by the buyer.
Trade credit is often the largest source of short-term credit, especially for small firms.
Spontaneous, easy to get, but cost can be high.
Why is it costly?
Cost is high because suppliers can offer discounts on paying early

43. 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.

44. 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

45. 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
= = 12.29%
The $30,303 is paid throughout the year, so the effective cost of costly trade credit is higher.

46. Nominal Cost of Trade Credit Formula
The first term is the cost per period for the trade credit
The 2nd term is how many periods per year

47. Effective Cost of Trade Credit
Periodic rate = 0.01/0.99 = 1.01%
Periods/year = 365/(40 – 10) =
Effective cost of trade credit
Free trade credit: credit taken during the discount period
Costly trade credit: credit taken after the discount period whose cost is equal to the lost discount
Firms should always use the free component but for the costly component they should check if they can get funds cheaper

49. Bank Loans What is a promissory note?
A document specifying the terms and conditions of a loan, including the amount, interest rate, and repayment schedule.
Line of Credit is an agreement between the bank and the borrower indicating the maximum amount of credit the bank will extend to the borrower.
An example would be that the bank will allow the borrower to take up to 100,000 during the next year. However, this is informal and nonbinding. A bank can change his mind.
Revolving Credit Agreement is a formal and binding line of credit. Borrowers usually pay a fee for the unused portion of the commitment.

50. Promissory note features
Amount.
Maturity.
Interest rate.
Interest only versus amortized.
Frequency of interest payments.
Add-on loans.
Auto loans and other consumer installment loans are generally set up on an “add-on basis,” which means that interest charges over the life of the loan are calculated and then added to the face amount of the loan.
Collateral.
Restrictive covenants.
Loan guarantees.

51. Line of Credit Vs. Revolving Credit
An arrangement in which a bank agrees to lend up to a specified maximum amount of funds during a designated period.
Informal and nonbinding
Revolving credit Agreement.
A formal, committed line of credit extended by a bank or another lending institution.
Important difference: The bank has a legal obligation to honor a revolving credit agreement, and it receives a commitment fee. Neither the legal obligation nor the fee exists under informal lines of credit.

52. 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 monthly interest
Installment loan, add-on, 12 months
Interest rates change across borrowers and over time even for the same borrower. Depending on interest rates in the market and on the riskiness of the borrower

53. Simple Interest Simple interest means no discount or add-on.
Used for most business loans.
Interest must be paid monthly, and the principal is payable “on demand” if and when the bank wants to end the loan.
Simple interest rate per day= nominal rate days in a year
Interest charge for month=(rate per day)(Amount of loan)(Days in a month)

54. Simple Interest Assume 360 Day year and 30-day month
Simple interest rate per day= nominal rate days in a year
= =
Interest charge for a month=
( )(100,000)(30) =

55. 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).

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

57. Other Current Liabilities
Accruals
Continually recurring short-term liabilities, especially accrued wages and accrued taxes
Secured loans
Loans backed by collateral
Accruals have no interest. What is an accrual?