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 SKI’s 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.

17-9
Cash Conversion Cycle

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

17-13
SKI’s Cash Budget

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.
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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 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 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 – 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 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.

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

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.

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Nominal Cost of Trade Credit Formula

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

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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.

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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

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