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CHAPTER 14 Working Capital Management


Alternative working capital policies Cash management Inventory management Accounts receivable management Working capital financing policies Trade credit

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.

Selected ratios for SKI Inc.
Current Debt/Assets Turnover of cash & securities DSO (days) Inv. turnover F. A. turnover T. A. turnover Profit margin ROE SKI Ind. Avg. 1.75x 2.25x 58.76% 50.00% 16.67x 22.22x 45.63 32.00 4.82x 7.00x 11.35x 12.00x 2.08x 3.00x 2.07% 3.50% 10.45% 21.00%

Working capital policy is reflected in current ratio. turnover of cash and securities. inventory turnover. SKI is either very conservative or inefficient. These ratios indicate SKI has large amounts of working capital relative to its level of sales. 14-4 . and DSO.How does SKI s working capital policy compare with its industry?    SKI appears to have large amounts of working capital given its level of sales.

However. This suggests the company has excessive working capital.Is SKI inefficient or just conservative?   A conservative (relaxed) policy may be appropriate if it leads to greater profitability. 14-5 . SKI is not as profitable as the average firm in the industry.

period period period 14-6 .Cash conversion cycle  The cash conversion model 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 Receivables Payables CCC = conversion + collection ± deferral .

Cash conversion cycle Inventory Receivables Payables CCC = conversion + collection ± deferral period period period Payables Days sales Days per year CCC = Inv.82 CCC = 76 + 46 ± 30 CCC = 92 days. 14-7 . turnover + outstanding ± deferral period CCC = 365 + 46 ± 30 4.

Compensating balances for loans and/or services provided. so why hold it? 1. Speculation to take advantage of bargains and to take discounts.Cash doesn t earn a profit. 3. 2. Reduced by credit lines and marketable securities. Precaution safety stock . Reduced by line of credit and marketable securities. 14-8 . 4. Transactions must have some cash to operate.

To minimize transactions balances in particular. 14-9 . and also needs for cash to meet other objectives. especially to have cash for transactions.What is the goal of cash management?   To meet above objectives. yet not have any excess cash.

Ways to minimize cash holdings        Use a lockbox. Hold marketable securities (also reduces need for safety stock ). Insist on wire transfers from customers. Increase forecast accuracy to reduce need for safety stock of cash. 14-10 . Synchronize inflows and outflows. Use a remote disbursement account. Negotiate a line of credit (also reduces need for safety stock ).

depending upon purpose of forecast. 14-11 . or monthly. Used to plan loans needed or funds available to invest. Timing: Daily.Cash budget: The primary cash management tool   Purpose: Forecasts cash inflows. outflows. daily for actual cash management. weekly. and ending cash balances. Monthly for annual planning.

00 Total payments $53.311.31 $44.443.65 Wages 6.75 36.55 Net CF $13.794.95 $62.470.500.472.755.40 Purchases 44.690.SKI s cash budget: For January and February Net Cash Inflows Jan Feb Collections $67.651.00 2.603.857.500.64 $18.56 5.85 14-12 .90 Rent 2.

857.00 Surplus $15.857.669.SKI s cash budget Net Cash Inflows Jan Feb Cash at start if no borrowing $ 3.64 Less: target cash 1.00 $33.64 18.311.500.857.49 14-13 .49 1.500.00 Net CF 13.85 35.169.64 $16.64 Cumulative cash 16.000.357.

which appear in the cash budget.Should depreciation be explicitly included in the cash budget?   No. 14-14 . depreciation does affect taxes. Only cash payments and receipts appear on cash budget. Depreciation is a noncash charge. However.

What are some other potential cash inflows besides collections?     Proceeds from the sale of fixed assets. 14-15 . Interest earned. Proceeds from stock and bond sales. Court settlements.

How could bad debts be worked into the cash budget?    Collections would be reduced by the amount of the bad debt losses. Lower collections would lead to higher borrowing requirements. For example. 14-16 . if the firm had 3% bad debt losses. collections would total only 97% of sales.

except for October and November. 14-17 . Cash budget indicates the company is holding too much cash. or by returning cash to its shareholders. SKI could improve its EVA by either investing cash in more productive assets.Analyze SKI s forecasted cash budget    Cash holdings will exceed the target balance for each month.

Why might SKI want to maintain a relatively high amount of cash?    If sales turn out to be considerably less than expected. 14-18 . or if it is very conservative. SKI could face a cash shortfall. The cash may be used. to fund future investments. A company may choose to hold large amounts of cash if it does not have much faith in its sales forecast. in part.

and obsolescence. Costs of running short loss of sales or customer goodwill. and may increase the costs of running short. 14-19 . and handling costs. property taxes. insurance. Reducing the average amount of inventory generally reduces carrying costs. Ordering costs cost of placing orders. increases ordering costs. shipping.Types of inventory costs    Carrying costs storage and handling costs. and the disruption of production schedules. depreciation.

82) is considerably lower than the industry average (7. The firm is carrying a lot of inventory per dollar of sales.Is SKI holding too much inventory?   SKI s inventory turnover (4.00). Moreover. so EVA is also lowered. the firm is increasing its costs. this additional working capital must be financed. which reduces its ROE. By holding excessive inventory. 14-20 .

If SKI reduces its inventory. what effect will this have on the cash position?   Short run: Cash will increase as inventory purchases decline. without adversely affecting sales. Long run: Company is likely to take steps to reduce its cash holdings and increase its EVA. 14-21 .

14-22 .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 should consider tightening its credit policy in order to reduce its DSO. SKI s customers are paying less promptly.

2. 3. Cash Discounts Lowers price. 4. Credit Standards Tighter standards tend to reduce sales. 14-23 . Collection Policy How tough? Tougher policy will reduce DSO but may damage customer relationships. but it may discourage sales. but reduce bad debt expense. Fewer bad debts reduce DSO. Attracts new customers and reduces DSO. Credit Period How long to pay? Shorter period reduces DSO and average A/R.Elements of credit policy 1.

a tighter credit policy may discourage sales.Does SKI face any risk if it tightens its credit policy?  Yes. Some customers may choose to go elsewhere if they are pressured to pay their bills sooner. 14-24 .

Both of these actions would increase EVA. the company would hopefully invest the cash in more productive assets. or pay it out to shareholders.If SKI succeeds in reducing DSO without adversely affecting sales. this increases cash holdings. 14-25 . what effect would this have on its cash position?   Short run: If customers pay sooner. Long run: Over time.

Conservative Use permanent capital for permanent assets and temporary assets. 14-26 .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.

Bonds. L-T Fin: Stock.A. C. Spon.Moderate financing policy $ Temp. Years Lower dashed line would be more aggressive.A. 14-27 Fixed Assets . C.L. S-T Loans Perm C.

Conservative financing policy $ Marketable securities Zero S-T Debt L-T Fin: Stock.L. C. Perm C. Bonds. Fixed Assets Years 14-28 .A. Spon.

such as accrued wages or taxes. However.Accrued liabilities   Continually recurring short-term liabilities. Is there a cost to accrued liabilities?   They are free in the sense that no explicit interest is charged. firms have little control over the level of accrued liabilities. 14-29 .

14-30 . but cost can be high. Spontaneous. Trade credit is often the largest source of short-term credit. especially for small firms.What is trade credit?    Trade credit is credit furnished by a firm s suppliers. easy to get.

106 gross) on terms of 1/10. Net daily purchases = $506.985 / 365 = $1. without penalty. net 30.The cost of trade credit   A firm buys $506.389 14-31 . The firm can forego discounts and pay on Day 40.985 net ($512.

121 more if they don t take discounts. Think of the extra $5.Breaking down net and gross expenditures     Firm buys goods worth $506. 14-32 .985.121 as a financing cost similar to the interest on a loan. They must pay $5. That s the cash price. Want to compare that cost with the cost of a bank loan.

13.670 14-33  Payables level.389 (10) = $13. if the firm takes no discounts   Credit breakdown .389 (40) = $55. if the firm takes discounts  Payables = $1.560 .560 Total trade credit Free trade credit Costly trade credit $55.Breaking down trade credit  Payables level.890 Payables = $1.890 $ 41.

106) = $5.121 / $41.Nominal cost of costly trade credit  The firm loses 0.121 is paid throughout the year.29%  The $5. so the effective cost of costly trade credit is higher.670 in extra trade credit: kNOM = $5. 14-34 .670 = 0.121 of discounts to obtain $41.1229 = 12.01($512.

eriod 14-35 .isc.iscount ! ! . ! .Nominal trade credit cost formula k NO iscount ! . v days v ays taken .

1667 Effective cost of trade credit  EAR = (1 + periodic rate)n = (1.1667 1 1 = 13.01 / 0.Effective cost of trade credit    Periodic rate = 0.01% Periods/year = 365 / (40-10) = 12.0101)12.99 = 1.01% 14-36 .

strong companies. then held as a marketable security for liquidity purposes. 14-37 . B&B couldn t issue CP--it s too small.Commercial paper (CP)    Short-term notes issued by large. CP is bought with surplus cash by banks and other companies. CP trades in the market at rates just above T-bill rate.