1. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Working Capital Management Alternative Working Capital Policies Cash Management Inventory and A/R Management Trade Credit Bank Loans Chapter 16 16-1

2. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 16-2

3. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Selected Ratios for SKI Inc. SKIInd Avg Current ratio1.75x2.25x Debt/Assets58.76%50.00% Turnover of cash & securities16.67x22.22x Days sales outstanding45.6332.00 Inventory turnover4.82x7.00x Fixed assets turnover11.35x12.00x Total assets turnover2.08x3.00x Profit margin2.07%3.50% Return on equity10.45%21.00% 16-3

4. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 16-4

5. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 16-5

6. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 16-6

7. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Moderate Financing Policy 16-7 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.

8. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Conservative Financing Policy 16-8 $ Years Perm C.A. Fixed Assets Marketable securities Zero S-T Debt L-T Fin: Stock, Bonds, Spon. C.L.

9. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 16-9

10. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Cash Conversion Cycle 16-10

11. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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 16-11

12. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 16-12

13. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. SKI’s Cash Budget for January and February 16-13 JanuaryFebruary Collections$67,651.95$62,755.40 Purchases44,603.7536,472.65 Wages6,690.565,470.90 Rent 2,500.00 Total payments$53,794.31$44,443.55 Net cash flows$13,857.64$18,311.85

14. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. SKI’s Cash Budget 16-14 JanuaryFebruary 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 Surplus$15,357.64$33,669.49

15. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 16-15

16. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 16-16

17. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 16-17

18. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 16-18

19. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 16-19

20. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 16-20

21. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 16-21

22. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 16-22

23. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 16-23

24. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 16-24

25. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 16-25

26. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 16-26

27. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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 16-27 Total trade credit$328,767 Free trade credit- 82,192 Costly trade credit$246,575

28. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 16-28

29. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Nominal Cost of Trade Credit Formula 14-29

30. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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 16-30

31. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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 16-31

32. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 16-32

33. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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 exact effective rate, recognize that the firm receives $100,000 and must make monthly payments of $9,000 (like an annuity). 16-33

34. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Add-on Interest From the calculator output below, we have: r NOM = 12 (0.012043) = 0.1445 = 14.45% EAR= (1.012043) 12 – 1 = 15.45% 16-34 INPUTS OUTPUT NI/YRPMTPVFV 12 1.2043 100 -90