Chapter 17

Working Capital
Management
Alternative Working Capital Policies
Cash Management
Inventory and A/R Management
Trade Credit
Bank Loans
17-1
Working Capital Terminology

Working capital 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.

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 SKIs working capital
policy compare with its industry?
Working capital 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
working capital.

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:
Stock,
Perm C.A. 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 Receivable s Payables

CCC conversion collection deferral
period period period

17-9
Cash Conversion Cycle

Inventory Receivable s Payables

CCC conversion collection deferral
period period period
Payables
Days per year Days sales
CCC deferral
Inventory turnover outstandin g 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
SKIs Cash Budget for January and
February
Net Cash Inflows
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
SKIs Cash Budget

Net Cash Inflows

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 SKIs 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?

SKIs inventory turnover (4.82x) is considerably

lower than the industry average (7.00x).
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.

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.
Long run: Company is likely to take steps to
reduce its cash holdings and increase its EVA.

17-20
Do SKIs customers pay more or less
promptly than those of its competitors?

SKIs DSO (45.6 days) is well above the

industry average (32 days).
SKIs 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 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.

17-22
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.
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.
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 firms

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

rNO M
1 Discount % Days taken Disc. 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 appropriate 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