CHAPTER 15 Working Capital Management

1. CHAPTER 15Working 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 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.

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 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.

7. $ 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

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

9. 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.

10. Cash conversion cycle

11. 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. • Compensating balances – for loans and/or services provided. • Speculation – to take advantage of bargains and to take discounts. Reduced by credit lines and marketable securities.

12. The goal of cash management • To meet the above objectives, especially to have cash for transactions, yet not have any excess cash. • To minimize transactions balances in particular, and also needs for cash to meet other objectives.

13. Minimizing cash holdings • Use a lockbox • Insist on wire transfers from customers • Synchronize inflows and outflows • Use a remote disbursement account • Reduce need for “safety stock” of cash • Increase forecast accuracy • Hold marketable securities • Negotiate a line of credit

14. 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.

15. SKI’s cash budget:For January and February Net Cash Inflows Jan Feb Collections $67,651.95$62,755.40 Purchases 44,603.75 36,472.65 Wages 6,690.56 5,470.90 Rent 2,500.002,500.00 Total payments $53,794.31$44,443.55 Net CF $13,857.64 $18,311.85

16. SKI’s cash budget (con’t) Net Cash Inflows Jan Feb Cash at start if no borrowing $ 3,000.00 $16,857.64 Net CF 13,857.64 18,311.85 Cumulative cash 16,857.64 35,169.49 Less: target cash 1,500.00 1,500.00 Surplus $15,357.64 $33,669.49

17. 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.

18. 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.

19. 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.

20. 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.

21. 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.

22. 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.

23. 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.

24. 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.

25. 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.

26. 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.

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

28. Advantages and disadvantages of using short-term financing • Advantages • Speed • Flexibility • Lower cost than long-term debt • Disadvantages • Fluctuating interest expense • Firm may be at risk of default as a result of temporary economic conditions

29. 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.

30. 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. Net daily purchases = $3,000,000 / 365 = $8,219.18

31. 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 Total trade credit $328,767 Free trade credit - 82,192 Costly trade credit $246,575

32. 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.

33. Nominal cost of trade credit formula

34. 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 • EAR = (1 + periodic rate)N – 1 = (1.0101)12.1667 – 1 = 13.01%

35. 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

36. 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

37. 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).

38. 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% 12 100 -9 0 INPUTS N I/YR PV PMT FV OUTPUT 1.2043