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14-3
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.
Working capital policy is reflected in
current ratio, turnover of cash and
securities, inventory turnover, and DSO.
These ratios indicate SKI has large
amounts of working capital relative to its
level of sales. SKI is either very
conservative or inefficient.
14-4
Is SKI inefficient or just
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.
14-5
Working Capital Management
Short-Term Investment
Cash Management
Account Receivable Management
Inventory Management
Short-Term Financing
Trade Credit
Bank Loans
Commercial Paper
Account Receivable and/or Inventory Financing
14-6
Working Capital Management
Trade-off of Short-Term Investment
Cost 1 Cost 2
___________________________________________________________________________________
Short-Term Assets
Cash and Marketable Opportunity cost Illiquidity and solvency
Securities of funds costs
14-7
Working Capital Management
Trade-off of Short-Term Financing
Cost 1 Cost 2
_________________________________________________________
Short-Term Financing
14-8
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.
14-9
Cash conversion cycle
Inventory Receivables Payables
CCC = conversion + collection – deferral
period period period
Payables
Days per year Days sales
CCC = Inv. turnover + outstanding – deferral
period
365
CCC = + 46 – 30
4.82
CCC = 76 + 46 – 30
CCC = 92 days.
14-10
Cash doesn’t earn a profit, so
why hold it?
1. Transactions – must have some cash 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.
14-11
What is the goal of cash
management?
To meet 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.
14-12
Ways to minimize cash holdings
Use a lockbox.
Insist on wire transfers from customers.
Synchronize inflows and outflows.
Use a remote disbursement account.
Increase forecast accuracy to reduce
need for “safety stock” of cash.
Hold marketable securities (also reduces
need for “safety stock”).
Negotiate a line of credit (also reduces
need for “safety stock”).
14-13
Cash budget:
The primary cash management tool
Purpose: Forecasts cash inflows,
outflows, and ending cash balances.
Used to plan loans needed or funds
available to invest.
Timing: Daily, weekly, or monthly,
depending upon purpose of forecast.
Monthly for annual planning, daily for
actual cash management.
14-14
Data Required for a Cash Budgeting
1. Sales forecast.
2. Information on collections delay.
3. Forecast of purchases and
payment terms.
4. Forecast of cash expenses, taxes,
etc.
5. Initial cash on hand.
6. Target cash balance.
14-15
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 2,500.00 2,500.00
Total payments $53,794.31 $44,443.55
Net CF $13,857.64 $18,311.85
14-16
SKI’s cash budget
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
14-17
Should depreciation be explicitly
included in the cash budget?
No. Depreciation is a noncash
charge. Only cash payments and
receipts appear on cash budget.
However, depreciation does affect
taxes, which appear in the cash
budget.
14-18
What are some other potential
cash inflows besides collections?
Proceeds from the sale of fixed
assets.
Proceeds from stock and bond
sales.
Interest earned.
Court settlements.
14-19
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.
14-20
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.
14-21
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.
14-22
Float
14-23
Float
14-24
Types of Collection Systems
Field-Banking system: collections are made either over the counter or
at a collection office. The main collection problem is moving the funds
from the local banks up to the main accounts at the company’s primary
bank.
Mail-Based System: The process center will receive the mail payments,
open the envelopes, separate the check from the remittance
information, prepare the check for deposit, and send the remittance
information to the accounts receivable department application of
payment.
Electronic System: In a electronic bill presentment and payment (EBPP)
system, customers are sent bills in an electronic format and then can
pay their bills via electronic means.
Lockbox System: Customers mail payments to a post office box, which
is emptied regularly by the firm’s bank. The bank processes each
payment and deposits the payments in the firm’s account.
14-25
Lockbox System: An Example
Firm Y believes that use of a lockbox system can
shorten its accounts receivable collection period by
four days. The firms’ annual sales, all on credit, are
$65 million, billed on a continuous basis. The firms
can earn 9% on its short-term investments. The cost
of the lockbox system is $57,500 per year. Assume a
365-day year.
A. What amount of cash will be made available for
other uses under the lockbox system?
B. What net benefit (or cost) will the firm receive if it
adopts the lockbox system? Should it adopt the
proposed lockbox system?
14-26
Lockbox System: An Example
Solution:
14-27
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 the average amount of inventory
generally reduces carrying costs, increases
ordering costs, and may increase the costs of
running short. 14-28
Is SKI holding too much
inventory?
SKI’s inventory turnover (4.82) is
considerably lower than the industry
average (7.00). 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.
14-29
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.
14-30
Accounts Receivable Management
14-31
Accounts Receivable Management
14-32
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 may damage
customer relationships.
14-33
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.
14-34
If SKI succeeds in reducing DSO without
adversely affecting sales, what effect
would this have on 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.
14-35
Receivable Management Example
14-36
Receivable Management Example
Solution:
14-37
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.
14-38
Moderate financing policy
$ Temp. C.A.
S-T
Loans
Years
Lower dashed line would be more aggressive.
14-39
Conservative financing policy
Marketable
$ securities
Zero S-T
Debt
L-T Fin:
Perm C.A. Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
14-40
Accrued liabilities
Continually recurring short-term
liabilities, such as accrued wages or
taxes.
Is there a cost to accrued liabilities?
They are free in the sense that no
explicit interest is charged.
However, firms have little control over
the level of accrued liabilities.
14-41
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.
14-42
The cost of trade credit
A firm buys $506,985 net ($512,106 gross)
on terms of 1/10, net 30.
The firm can forego discounts and pay on
Day 40, without penalty.
14-43
Breaking down net and gross
expenditures
Firm buys goods worth $506,985. That’s
the cash price.
They must pay $5,121 more if they don’t
take discounts.
Think of the extra $5,121 as a financing
cost similar to the interest on a loan.
Want to compare that cost with the cost of
a bank loan.
14-44
Breaking down trade credit
Payables level, if the firm takes discounts
Payables = $1,389 (10) = $13,890
Payables level, if the firm takes no discounts
Payables = $1,389 (40) = $55,560
Credit breakdown
Total trade credit $55,560
Free trade credit - 13,890
Costly trade credit $ 41,670
14-45
Nominal cost of costly trade credit
The firm loses 0.01($512,106)
= $5,121 of discounts to obtain
$41,670 in extra trade credit:
14-47
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%
14-48
Bank Loans
A firm is choosing among three alternative bank
loans. The firm wishes to minimize the
borrowing costs on a $200,000 borrowing.
Analyze the cost of each of these alternatives:
1. An 18% rate of interest with interest paid at
year-end and no compensating balance
requirement.
2. A 16% rate of interest but carrying a 20%
compensating balance requirement. This loan
also calls for interest to be paid at year-end.
3. A 14% rate of interest that is discounted, plus
a 20% compensating balance requirement.
14-49
Bank Loans
Solutions:
1. Effective rate of interest = 18%.
2. Effective rate of interest
= $32,000/($200,000-$40,000) = 20%.
3. Effective rate of interest
= $28,000/($200,000-$40,000-
$28,000)
= 21.21%
14-50
Commercial paper (CP)
Short-term notes issued by large, strong
companies. B&B couldn’t issue CP--it’s
too small.
CP trades in the market at rates just
above T-bill rate.
CP is bought with surplus cash by banks
and other companies, then held as a
marketable security for liquidity purposes.
14-51
Alternative Financing: Example
Suncoast Boats Inc. estimates that because
of the seasonal nature of its business, it will
required an additional $2m of cash for the
month of July. Suncoast has the following 4
options available for raising the needed
funds:
1. Establish a 1-year line of credit for $2m
with a bank. The commitment fee will be
0.5% per year on the unused portion, and
the interest charge on the used funds will be
11% per annum. Assume that the funds are
needed only in July, and that there are 30
days in July and 365 days in the year.
14-52
Alternative Financing: Example
2. Forgo the trade discount of 2/10, net 40, on $2m
of purchases during July.
3. Issue $2m of 30-day commercial paper at a 9.5%
per annum interest rate. The total transactions fee,
including the cost of a backup credit line, on using
commercial paper is 0.5% of the amount of the
issue.
4. Issue $2m of 60-day commercial paper at a 9%
per annum interest rate, plus a transaction cost of
0.5%. Since the funds are required for only 30
days, the excess funds ($2m) can be invested in
9.4% per annum marketable securities for the
month of August. The total transaction costs of
purchasing and selling the marketable securities is
0.4% of the amount of the issue.
14-53
Alternative Financing: Example
14-54
Alternative Financing: Example
Solutions:
a. 1. Line of credit:
Commitment fee
= (0.005)($2,000,000)(335/365)
= $ 9,178
Interest
= (0.11)(30/365)($2,000,000)
= 18,082
Total = $27,260
14-55
Alternative Financing: Example
Solutions:
2. Trade discount:
a. = = 0.2483 = 24.83%.
14-56
Alternative Financing: Example
Solutions:
3.30-day commercial paper:
Interest = (0.095)($2,000,000)(30/365)
= $15,616
Total = $25,616
14-57
Alternative Financing: Example
Solutions:
4.60-day commercial paper:
Interest = (0.09)($2,000,000)(60/365) = $29,589
Transaction fee = (0.005)($2,000,000) = 10,000
Total Costs = $39,589
Marketable securities interest received
= (0.094)($2,000,000)(30/365) = $15,452
Transactions cost, marketable securities
= (0.004)($2,000,000) = $8,000
Total = $32,137
14-58