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CHAPTER 16 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. Gross working capital – total current assets. Net working capital – current assets minus current liabilities.

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CHAPTER 16 Working Capital Management

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  1. CHAPTER 16Working Capital Management Alternative working capital policies Cash management Inventory and A/R management Trade credit Bank loans

  2. Working capital terminology • Gross working capital – total current assets. • Net working capital – current assets minus 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.

  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, 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. Inventory conversion period Receivables collection period Payables deferral period CCC = + – . 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.

  6. Cash conversion cycle

  7. Working capital financing policies • Conservative – Use permanent capital for permanent assets and temporary assets. • Aggressive – Use short-term financing to finance permanent assets. • Moderate – Match the maturity of the assets with the maturity of the financing.

  8. Temp C.A. $ Zero S-T Debt L-T Fin: Stock, Bonds, Spon. C.L. Perm C.A. Fixed Assets Years Conservative financing policy

  9. $ 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. Moderate financing policy

  10. Cash doesn’t earn a profit, so why should the firm hold it? • Transactions – must have some cash to operate. • Precaution – “safety stock”. Reduced by line of credit and marketable securities. • Speculation – to take advantage of bargains and to take discounts. 4. The cash may be used, in part, to fund future investments.

  11. 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.

  12. 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.

  13. 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 profit. • Moreover, this additional working capital must be financed, so profit is also lowered.

  14. 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.

  15. Elements of credit policy • Credit Period – How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales. • 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.

  16. Short-term credit • Debt scheduled for repayment within 1 year. • Major sources of short-term credit • Accounts payable (trade credit) • Bank loans • 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.

  17. Advantages and disadvantages of using short-term financing • Advantages • Speed • Flexibility • Lower cost than long-term debt • Disadvantages • Fluctuating interest expense

  18. 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. • ie.A firm buys $3,000,000 net on terms of 1/10, net 30. • The firm can forego discounts and pay on Day 30, without penalty.

  19. Nominal cost of trade credit formula

  20. Bank loans (Add-on interest) • The firm can borrow $100,000 for 1 year at an 8% nominal rate. • Interest = 0.08 ($100,000) = $8,000 • Face amount = $100,000 + $8,000 = $108,000 • Monthly payment = $108,000/12 = $9,000

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