16-1 CHAPTER 15 Working Capital Management Alternative working capital policies Cash management Inventory and A/R management Trade credit Bank loans

15-2 Working capital terminology Gross working capital – total current assets Net working capital Current Assets Non-interest bearing current liabilities

15-3 Working Capital terminology Working Capital Policy Level of each type of current asset to hold How to finance current assets

15-4 Working Capital terminology Working capital management Control Cash Inventories Accounts Receivables Short-term liability management.

15-5 Selected ratios for SKI Inc. SKIInd Avg Current ratio1.75x2.25x Debt/Assets58.76%50.00% Turnover of cash & securities16.67x22.22x Days sales outstanding 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%

15-6 How does SKI’s working capital policy compare with its industry? Working capital policy reflected by: Current Ratio Turnover of cash and securities Inventory turnover Days-sales-outstanding Ratios indicate SKI has large amounts of working capital relative to its level of sales. SKI is either very conservative or inefficient.

15-7 Is SKI inefficient or conservative? Conservative (relaxed) policy may be appropriate if it leads to greater profitability. SKI is not as profitable as the average firm in the industry. Suggests company has excessive working capital.

15-8 Examples

15-9 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.

15-10 Moderate financing policy Years Lower dashed line would be more aggressive. $ Perm Current Assets Fixed Assets Temp. C.A. S-T Loans L-T Fin: Stock, Bonds, Spon. C.L.

15-11 Conservative financing policy $ Years Perm Current Assets Fixed Assets Marketable securities Zero S-T Debt L-T Fin: Stock, Bonds, Spon. C.L.

15-12 Cash Conversion Cycle Page 522

15-13 Cash Conversion Cycle Length of time between when a company makes payments to its creditors and when a company receives payments from its customers CCC = + –. Inventory conversion period Receivables collection period Payables deferral period

15-14 Inventory Conversion = Inventory Cost Goods Sold per day (Cost Goods Sold / 365)

15-15 Average Collection = Receivables Sales on credit per day (Sales / 365)

15-16 Payable Deferral Period = Payables Purchases per day (Cost Goods Sold / 365)

15-17 Cash conversion cycle

15-18 Cash doesn’t earn a profit, so why should the firm hold it? 1. Transactions – some cash necessary to operate 2. Precaution – “safety stock”. Reduced by line of credit and marketable securities 3. Compensating balances – for loans and/or services provided 4. Speculation – to take advantage of bargains and to take discounts. Reduced by credit lines and marketable securities

15-19 Goal of cash management Meet objectives Cash for transactions Yet not have excess cash Minimize transactions balances in particular, and also needs for cash to meet other objectives

15-20 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” cash Increase forecast accuracy Hold marketable securities Negotiate a line of credit

15-21 Cash Budget Forecasts cash inflows, outflows, and ending cash balances 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

15-22 Cash Budget: For January and February Net Cash Inflows Jan Feb Collections$67,652$62,755 Purchases 44,604 36,473 Wages 6,690 5,471 Rent 2,500 2,500 Total payments$53,794$44,444 Net CF$13,858$18,311

15-23 SKI’s cash budget (con’t) Net Cash Inflows Jan Feb Cash at start if no borrowing$ 3,000$16,857 Net CF 13,858 18,312 Cumulative cash 16,858 35,169 Less: target cash 1,500 1,500 Surplus$15,358$33,669

15-24 EXCEL MODEL Page 526

15-25 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

15-26 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 results by either investing cash in more productive assets, or by returning cash to its shareholders.

15-27 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.

15-28 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

15-29 Is SKI holding too much inventory? SKI’s inventory turnover (4.82x) is considerably lower than the industry average (7.00x) Firm is carrying a lot of inventory per dollar of sales Excessive inventory increases cost, reduces ROE Additional working capital must be financed

15-30 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 costs)

15-31 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

15-32 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 – Tighter standards tend to reduce sales, but reduce bad debt expense. Fewer bad debts reduce DSO 4. Collection Policy – How tough? Tougher policy will reduce DSO but damage customer relationships

15-33 Does SKI face any risk if it tightens its credit policy? 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

15-34 If SKI reduces its Days-Sales- Outstanding without adversely affecting sales, how would this affect its cash position? Short run: If customers pay sooner, cash holdings increase. Long run: Company could invest cash in more productive assets or pay it out to shareholders.

15-35 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 Required payment around the corner Possible trouble rolling over loans

15-36 Advantages and disadvantages of using short-term financing Advantages Speed Flexibility Lower cost than long-term debt Disadvantages Fluctuating interest expense Risk of default as a result of temporary economic conditions

15-37 What is trade credit? Trade credit is credit furnished by 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

15-38 Terms of trade credit A firm buys $2,970,000 net ($3,000,000 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 = $8,137

15-39 Breaking down trade credit Payables level, if the firm takes discounts Payables = $8,137 (10) = $81,370 Payables level, if the firm takes no discounts Payables = $8,137 (40) = $325,479 Credit breakdown Total trade credit$325,497 Free trade credit- 81,370 Costly trade credit$244,127

15-40 The firm loses 0.01($3,000,000) = $30,000 of discounts to obtain $ 244,127 in extra trade credit: r NOM = $30,000 / $244,127 = = 12.3% $30,000 is paid throughout the year, so the effective cost of costly trade credit is higher Nominal cost of trade credit

15-41 Nominal cost of trade credit formula

15-42 Effective cost of trade credit Periodic rate = 0.01 / 0.99 = 1.01% Periods/year = 365 / (40-10) = Effective cost of trade credit EAR= (1 + periodic rate) N – 1 = (1.0101) – 1 = 13.01%

15-43 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

15-44 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

15-45 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).

15-46 Add-on interest From the calculator output below, we have: r NOM = 12 ( ) = = 14.45% EAR= ( ) 12 – 1 = 15.45% INPUTS OUTPUT NI/YRPMTPVFV