Finance management cengage 2013 chapter 016

Working Capital ManagementAlternative Working Capital Policies Cash Management Inventory and A/R Management Trade Credit Chapter 16... Working Capital Terminology• Working capital: curre

Working Capital Management

Alternative Working Capital Policies

Cash Management Inventory and A/R Management

Trade Credit

Chapter 16

Working Capital Terminology

• Working capital: current assets.

• Net working capital: current assets minus current

liabilities.

• Net operating working capital: current assets minus

(current liabilities less notes payable).

• Current assets investment 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.

SKI Ind Avg

Turnover of cash & securities 16.67x 22.22x

Days sales outstanding 45.63 32.00

Fixed assets turnover 11.35x 12.00x

Total assets turnover 2.08x 3.00x

How does SKI’s current assets investment policy

compare with its industry?

• Current assets investment 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 current assets.

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

L-T Fin:

Stock, Bonds, Spon C.L.

Conservative Financing Policy

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.

period deferral

Payables period

collection Average period

conversion Inventory

Cash Conversion Cycle

days 92

30 46

76 CCC

30

46 4.82

365 CCC

period deferral

Payables g

outstandin Days sales turnover

Inventory

year per

Days CCC

period deferral

Payables period

collection Average period

conversion Inventory CCC

=

− +

=

− +

=

− +

=

− +

=

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

• 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

January February Collections $67,651.95 $62,755.40

SKI’s Cash Budget

January February Cash at start if no borrowing $ 3,000.00 $16,857.64

Net cash flows 13,857.64 18,311.85

Cumulative cash $16,857.64 $35,169.49

Less: Target cash 1,500.00 1,500.00

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 large amount 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.

– This will reduce financing or target cash balance.

• Long run: Company is likely to take steps to reduce its

cash holdings and increase its EVA.

– The “excess” cash can be used to make investments in more productive assets such as plant and equipment resulting in an increase in operating income increasing its EVA.

– Alternately, can distribute “excess” cash to its shareholders through higher dividends or repurchasing shares resulting

in a lower cost of capital increasing 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

1 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: Restrictive standards tend to

reduce sales, but reduce bad debt expense Fewer bad debts reduce DSO.

4 Collection Policy: How tough? Restrictive policy

will reduce DSO but may damage customer relationships.

Does SKI face any risk if it restricts its credit policy?

• Yes, a restrictive 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 This will reduce financing or target cash balance needed.

• 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.

18 219 ,

8

$

365 /

000 ,

000 ,

3

$ purchases

daily

Net

=

=

Breaking Down Trade Credit

• Payables level, if the firm takes discounts

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:

r NOM = $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

% 29 12

1229

0

10 40

365 99

1

period

Discount g

outstandin Days credit

days

365

% Discount 100

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

% 01 13

1 (1.0101)

1 rate)

Periodic 1

( AR

=

– 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

r NOM = EAR = $8,000/$100,000 = 8.0%

• For a 1-year simple interest loan, r NOM = EAR.

1.2043