Chapter 16 Working Capital Management

1. Chapter 16Working 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.

3. Selected Ratios for SKI Inc.

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

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.

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

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

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.

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

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.

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

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

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.

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.

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?

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 = 0.1229 = 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

47. 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

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.

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.