Chapter 16
Working Capital
Management
 Alternative Working Capital Policies
 Cash Management
 Inventory and A/R Management
 Trade Credit
 Bank Loans
16-1
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.
16-2
Selected Ratios for SKI Inc.
Current ratio
Debt/Assets
Turnover of cash & securities
Days sales outstanding
Inventory turnover
Fixed assets turnover
Total assets turnover
Profit margin
Return on equity
SKI
1.75x
58.76%
16.67x
45.63
4.82x
11.35x
2.08x
2.07%
10.45%
Ind Avg
2.25x
50.00%
22.22x
32.00
7.00x
12.00x
3.00x
3.50%
21.00%
16-3
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.
16-4
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.
16-5
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.
16-6
Moderate Financing Policy
$
Temp. C.A.
S-T
Loans
Perm C.A.
Fixed Assets
L-T Fin:
Stock,
Bonds,
Spon. C.L.
Years
Lower dashed line would be more aggressive.
16-7
Conservative Financing Policy
$
Marketable
securities
Perm C.A.
Zero S-T
Debt
L-T Fin:
Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
16-8
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
16-9
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
16-10
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
16-11
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.
16-12
SKI’s Cash Budget for January and
February
Collections
Purchases
Wages
Rent
Total payments
Net cash flows
Net Cash Inflows
January
February
$67,651.95
$62,755.40
44,603.75
36,472.65
6,690.56
5,470.90
2,500.00
2,500.00
$53,794.31
$44,443.55
$13,857.64
$18,311.85
16-13
SKI’s Cash Budget
Net Cash Inflows
January
February
Cash at start if no
borrowing
Net cash flows
Cumulative cash
Less: Target cash
Surplus
$ 3,000.00
13,857.64
16,857.64
1,500.00
$15,357.64
$16,857.64
18,311.85
35,169.49
1,500.00
$33,669.49
16-14
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.
16-15
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.
16-16
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.
16-17
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.
16-18
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 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.
16-19
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.
16-20
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.
16-21
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.
16-22
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.
16-23
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.
16-24
What is trade credit?



Trade credit is credit furnished by a firm’s
suppliers.
Trade credit is often the largest source of shortterm credit, especially for small firms.
Spontaneous, easy to get, but cost can be
high.
16-25
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
16-26
Breaking Down Trade Credit

Payables level, if the firm takes discounts

Payables level, if the firm takes no discounts

 Payables = $8,219.18(10) = $82,192
 Payables = $8,219.18(40) = $328,767
Credit breakdown
Total trade credit
Free trade credit
Costly trade credit
$328,767
- 82,192
$246,575
16-27
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.
16-28
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%
14-29
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%
16-30
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
16-31
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.
16-32
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).
16-33
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
N
OUTPUT
I/YR
100
-9
0
PV
PMT
FV
1.2043
16-34