Working Capital Management

INTRO ALT WC POLICIES CASH MGMT INV & A/R MGMT TRADE CREDIT BANK LOANS
Chapter 17
Working Capital Management
Alternative Working Capital Policies

Cash Management
Inventory and A/R Management
Trade Credit
Bank Loans
17-1
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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.
17-2
Selected Ratios for SKI Inc.
SKI Ind. Avg

Current ratio 1.75x 2.25x
Debt/Assets 58.76% 50.00%
Turnover of cash & securities 16.67x 22.22x
Days sales outstanding 45.63 32.00
Inventory turnover 4.82x 7.00x
Fixed assets turnover 11.35x 12.00x
Total assets turnover 2.08x 3.00x
Profit margin 2.07% 3.50%
Return on equity 10.45% 21.00%
17-3
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.
17-4
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.
17-5
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.
17-6
Moderate Financing Policy
$ 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.
17-7
Conservative Financing Policy
Marketable
$ securities Zero S-T
Debt
L-T Fin:
Perm C.A. Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
17-8
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.
Inventory Average Payables
CCC  conversion  collection  deferral
period period period
17-9
Cash Conversion Cycle
Inventory Average Payables

CCC  conversion  collection  deferral
period period period
Payables
Days per year Days sales
CCC    deferral
Inventory turnover outstanding period
365
CCC   46  30
4.82
CCC  76  46  30  92 days
17-10
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
17-11
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.
17-12
SKI’s Cash Budget for January and February
January February
Collections
$67,651.95 $62,755.40
Purchases
44,603.75 36,472.65
Wages 6,690.56 5,470.90
Rent
2,500.00 2,500.00
Total payments
$53,794.31 $44,443.55
Net cash flows
$13,857.64 $18,311.85 17-13
SKI’s Cash Budget
January February
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 1,500.00
Surplus
$15,357.64 $33,669.49
17-14
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.
17-15
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.
17-16
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.
17-17
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.
17-18
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.
17-19
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. 17-20
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.
17-21
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.
17-22
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.
17-23
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.
17-24
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.
17-25
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
17-26
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
17-27
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.
17-28
Nominal Cost of Trade Credit Formula
Discount % 365 days

rNOM  
100  Discount % Days credit  Discount
outstanding period
1 365
 
99 40  10
 0.1229
 12.29%
17-29
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%
17-30
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
17-31
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.
17-32
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).
17-33
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%
INPUTS 12 100 -9 0
N I/YR PV PMT FV
OUTPUT 1.2043
17-34

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INTRO ALT WC POLICIES CASH MGMT INV & A/R MGMT TRADE CREDIT BANK LOANS

Working Capital Management

Alternative Working Capital Policies

Working Capital Terminology

• Working capital: current assets.

Selected Ratios for SKI Inc.

SKI Ind. Avg

How does SKI’s current assets investment policy

• Current assets investment policy is reflected in

Is SKI inefficient or conservative?

• A conservative (relaxed) policy may be

Working Capital Financing Policies

• Moderate: Match the maturity of the assets

Moderate Financing Policy

Perm C.A. L-T Fin:

Conservative Financing Policy

Cash Conversion Cycle

• The cash conversion cycle focuses on the

Cash Conversion Cycle

Inventory Average Payables

Minimizing Cash Holdings

• Forecasts cash inflows, outflows, and ending

SKI’s Cash Budget for January and February

SKI’s Cash Budget

How could bad debts be worked into the

• Collections would be reduced by the amount of

Analyze SKI’s Forecasted Cash Budget

• Cash holdings will exceed the target balance

Why might SKI want to maintain a relatively high

• If sales turn out to be considerably less than

• Types of inventory costs

Is SKI holding too much inventory?

• SKI’s inventory turnover (4.82x) is considerably

If SKI reduces its inventory without adversely affecting

• Short run: Cash will increase as inventory

Do SKI’s customers pay more or less promptly

• SKI’s DSO (45.6 days) is well above the

Elements of Credit Policy

1. Credit Period: How long to pay? Shorter

Does SKI face any risk if it restricts its credit policy?

• Yes, a restrictive credit policy may discourage

If SKI reduces its DSO without adversely affecting

• Short run: If customers pay sooner, this

What is trade credit?

• Trade credit is credit furnished by a firm’s

Terms of Trade Credit

• A firm buys $3,000,000 net ($3,030,303 gross)

Breaking Down Trade Credit

• Payables level, if the firm takes discounts

Nominal Cost of Trade Credit

• The firm loses 0.01($3,030,303) = $30,303 of

Nominal Cost of Trade Credit Formula

Discount % 365 days

Effective Cost of Trade Credit

• Periodic rate = 0.01/0.99 = 1.01%

• The firm can borrow $100,000 for 1 year at an

Simple Annual Interest

• Simple interest means no discount or add-on.

• For a 1-year simple interest loan, rNOM = EAR.

• Interest = 0.08($100,000) = $8,000

From the calculator output below, we have:

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