Case Study No.

2
Ski Equipment Inc.
Managing Current Assets

Problem

Dan Barnes, financial manager of Ski Equipment Inc. (SKI), is excited, but apprehensive.
The company’s founder recently sold his 51% controlling block of stock to Kent Koren, who is a
big fan of EVA (Economic Value Added). EVA is found by taking the after-tax operating profit
and subtracting the dollar cost of all the capital the firm uses:
EVA = EBIT(1 – T) – Capital costs
= EBIT(1 – T) – WACC(Capital employed).
If EVA is positive, the firm is creating value. On the other hand, if EVA is negative, the firm is
not covering its cost of capital and stockholders’ value is being eroded. Koren rewards managers
handsomely if they create value, but those whose operations produce negative EVAs are soon
looking for work. Koren frequently points out that if a company can generate its current level of
sales with fewer assets, it would need less capital. That would, other things held constant, lower
capital costs and increase EVA.
Shortly after he took control of SKI, Koren met with SKI’s senior executives to tell them
of his plans for the company. First, he presented some EVA data that convinced everyone that
SKI had not been creating value in recent years. He then stated, in no uncertain terms, that this
situation must change. He noted that SKI’s designs of skis, boots, and clothing are acclaimed
throughout the industry but that something is seriously amiss elsewhere in the company. Costs
are too high, prices are too low, or the company employs too much capital; and he wants SKI’s
managers to correct the problem.
Barnes has long felt that SKI’s working capital situation should be studied—the company
may have the optimal amounts of cash, securities, receivables, and inventories; but it may also
have too much or too little of these items. In the past, the production manager resisted Barnes’s
efforts to question his holdings of raw materials inventories, the marketing manager resisted
questions about finished goods, the sales staff resisted questions about credit policy (which
affects accounts receivable), and the treasurer did not want to talk about her cash and securities
balances. Koren’s speech made it clear that such resistance would no longer be tolerated.
Barnes also knows that decisions about working capital cannot be made in a vacuum. For
example, if inventories could be lowered without adversely affecting operations, less capital
would be required, the dollar cost of capital would decline, and EVA would increase. However,
lower raw materials inventories might lead to production slowdowns and higher costs, while
lower finished goods inventories might lead to the loss of profitable sales. So before inventories
are changed, it will be necessary to study operating as well as financial effects. The situation is
the same with regard to cash and receivables.
Background of the Problem

The problem is taken from the point of view of the Dan Barnes, which is the current
financial manager of Ski Equipment Inc. (SKI). The company’s chief executive post has just
experienced a shift and Barnes is excited about this. The current CEO, Kent Koren, who is a big
fan of EVA (economic value added), used this tool to illustrate to the senior executives that the
company is not creating value. Koren is insistent on addressing this problem and has called on
managers to look into means to beat this predicament. One of Koren’s take on the EVA situation
is the idea that if the company can generate the same number of sales utilizing a fewer assets,
then they would not need a large capital. Apart from, he believes that “costs are too high, prices
are too low, or the company employs too much capital”.

Barnes had always thought that the company’s working capital setup is in need of
scrutiny. Although he was aware of this, he was not able to push forward with this inspection
since various department managers in charge of the working capital assets were not very
cooperative. However, with the advent of the new CEO-ship, Koren has vowed to not tolerate
such resistances. This would now mean that Barnes can now proceed with studying the
company’s EVA and coming up with solutions targeted at improving this figure.

Barnes now has to come up with the optimal setup and decide which of the policies
surrounding working capital components is in need of modification.

Areas of Consideration

Before introducing the areas of consideration, it is best to understand what Barnes is

trying to improve (i.e. EVA) and how he plans to improve it.

EVA or economic value added was a management evaluation tool developed by

management consulting firm, Stern Value Management which as originally incorporated as Stern
Stewart & Co. (Chen, 2020).

The Indian Institute of Business Management laid down four steps in computing the EVA
which are:

1. Calculating the net operating profit after tax (NOPAT);

2. Calculating total invested capital (TC);

3. Determine a cost of capital (WACC); and

4. Calculating EVA – NOPAT – WACC% * (TC)

The EVA takes into account the opportunity cost of spending the invested capital
somewhere else. So if the results of the operation or the profits exceed the possible return of the
invested capital, then it means that the firm is creating value and it is better to invest the capital
in this firm than elsewhere. This value can also be a reflection of management’s actions since it
also serves as measure of value creation for shareholders (MyAccountingCourse.com).

Now that Koren’s target to change is the “capital” component of the formula. And he
believes he can lower the invested capital by utilizing fewer assets or particularly the current
assets. Since cash is also part of current assets, there will be a need to assess how much is the
optimal cash balance that will lead to checking the collection and payment policies of the firm.

 Area of Consideration No. 1 – Financial implication

If inventories are lowered, purchases will be lowered and the cash outflow would be
lowered. Lower handling and storing costs would also be an effect of this. However, if lower
number of raw materials inventory will cause production slowdowns, then costs will become
higher. Other than that, lower finished goods will also lead to possible loss of profitable sales.
Changes that will be made on the policies regarding cash and receivable will impact the
finances of the firm since cash and receivable are the most liquid assets of the company and
changing them or the way these assets are managed, would reflect in the financial reports.

 Are of Consideration No. 2 – Operating effects

If on-hand-inventory balances are lowered by purchasing fewer units, this might cause an
operational delay if these units are not enough to meet the minimum requirements to
manufacture the products. Changes in the policy for inventory and other current assets will call
for orientation of the employees in chare with these assets such as the production manager,
marketing manager, treasurer, and sales staff.

Questions and Answers

a. Barnes plans to use the ratios in Table IC 16-1 as the starting point for discussions
with SKI’s operating executives. He wants everyone to think about the pros and cons
of changing each type of current asset and the way changes would interact to affect
profits and EVA. Based on the data in Table IC 16-1, does SKI seem to be following a
relaxed, moderate, or restricted working capital policy?

Table IC 16-1. Selected Ratios: SKI and Industry Average

SKI Industry
Current 1.75 2.25
Debt/assets 58.76% 50.00%
Turnover of cash and securities 16.67 22.22
Days sales outstanding (365-day basis) 45.63 32.00
Inventory turnover 4.82 7.00
Fixed assets turnover 11.35 12.00
Total assets turnover 2.08 3.00
Profit margin 2.07% 3.50%
Return on equity (ROE) 10.45% 21.00%
 The above table lists out the pertinent ratios of the firm as compared to that of the
industry average ratios. Barnes intends to use this table to demonstrate how changing each of the
current assets will affect the profitability and EVA. Barnes can identify how changing the cash,
receivable and inventory balances would affect the firm as a whole. So this is where the concepts
of the working capital management come into play specifically the cash management, receivable
management and inventory management. In order for the firm’s executive to understand the
effects, Barnes can present each of the current assets in a table and provide columns for the
effects of an increase or a decrease in each of the asset to either the profitability or EVA.
The policy of a firm is regarded as “relaxed” or conservative when the operations are
conducted with too much working capital and involves financing almost all asset investments
with long term capital. On the other hand, it is considered as “restricted” or aggressive when the
operations are conducted on a minimum working capital, uses short-term liabilities to finance not
only but also part or all of the permanent current asset requirement.
Looking at the table, they have low cash and inventory turnover ratios compared to the
industry’s average. This means that they utilized this assets less often compared to the other
companies in the industry and they are holding more of these assets at any given point in time
compared to others.
For example, the inventory turnover ratio, which is solved as Sales/Ave Inventory, is at
4.82 and is relatively lower than the industry’s norm of 7.00. This also means that they hold a lot
of inventory per dollar of sales.
Another observation that can be gleaned from the table is the fact that its days sales
outstanding is (DSO) is longer also. This is solved by dividing the average receivables by sales.
Ski’s DSO of 45.63 days means that, on average, they are able to collect their receivables 45.63
days after the sale. This is longer than the industry’s DSO of 32.00.
Basing on this information, the SKI seems to follow a relaxed or conservative policy.

b. How can we distinguish between a relaxed but rational working capital policy and a
situation where a firm has a large amount of current assets simply because it is
inefficient? Does SKI’s working capital policy seem appropriate?

A relaxed but rational working capital can is a setup wherein the larger amounts of
working capital to better serve customers who expect to receive their equipment in a shorter
period of time and to avoid being short of the necessary assets. Maintaining high amount of
receivables can also be means to foster good relationships with customers. However, the
rationale behind this would only be to offset the higher cost of carrying this much of working
capital higher sales or higher prices and its return on equity (ROE) should be higher or at least
equal with the of firms with other working capital policies.
Looking at the Table IC 16-1, SKI’s profit margin of 2.07% is lower than its industry’s
counterparts. Ski’s working capital policy needs to be reviewed. Since they are not as profitable
as the other firms, they need to take steps in reducing its working capital.
 c. SKI tries to match the maturity of its assets and liabilities. Describe how SKI could
adopt a more aggressive or a more conservative financing policy.

Based on the discussions on the different policies, if the firm intends to take implement a
more conservative or more aggressive financing policy means holding lower amount of working
capital. Ski will need to focus more on short-term credit and use this as primary source of
financing for all current assets, both temporary and permanent, and part of fixed assets if it
wanted to take on a highly aggressive stance. This would expose the firm to fluctuating interest
rates and loan renewals. But this will be offsetted by the fact that short-term credit interest rates
are relatively lower and some firms are willing to sacrifice safety for the chance of higher profits.
A more conservative policy, on the other hand, is the current situation that that the
company is in right now. This is more focused on long-term credit and although employing a
small amount of short term credit to meet its peak requirements, but it also meets a part of its
seasonal needs by storing liquidity in the form of marketable securities. This is a very safe,
conservative financing policy.

d. Assume that SKI’s payables deferral period is 30 days. Now calculate the firm’s cash
conversion cycle.

The Corporate Finance Institute’s (CFI) website defined the conversion cycle as a metric
for the firm to measure how many days it takes for the company’s inventory be converted to
cash. This formula has three components:
 Days Inventory Outstanding (DIO) or inventory conversion period - average number
of days that a company holds its inventory before selling it
 Days Sales Outstanding (DSO) or receivables collection period - average number of
days for a company to collect payment after a sale
 Days Payable Outstanding (DPO) or payables deferral period - average number of
days for a company to pay its invoices from trade creditors
In a formula, these components will fall into:
DIO + DSO – DPO = Cash Conversion Cycle
From Table IC 16-1, the only information given for inventory is the inventory turnover.
Since the figure is at 4.82, it means that during the year, the firm has converted its inventory to
sales for 4.82 times. And by dividing the number of days in a year by 4.82, we will get to know
how long the firm took to convert its inventory to sales each time. So when we divide 365 days
by 4.82, we will get 75.73 days or approximately 76 days.
DSO was already given earlier at 45.63 days or approximately 46 days. DPO is assumed
at 30 days.
Incorporating these figures, we would get:
DIO + DSO – DPO = Cash Conversion Cycle
 76 days + 46 days – 30 days = 92 days
Therefore, it takes the firm approximately 92 days to convert cash to resources to cash
again.

e. What might SKI do to reduce its cash and securities without harming operations?
Since the account cash and securities, SKI can focus on reducing the securities. The
company needs to identify which of these securities yield the lowest. They should choose to sell
of these low-performing assets and the money generated can be used to pay off debt, buy back
shares of stock or to purchase and invest in assets used in operations.

In an attempt to better understand SKI’s cash position, Barnes developed a cash budget. Data
for the first 2 months of the year are shown in Table IC 16-2. (Note that Barnes’s preliminary
cash budget does not account for interest income or interest expense.) He has the figures for the
other months, but they are not shown in Table IC 16-2.

Table IC 16-2. SKI’s Cash Budget for January and February

Nov Dec Jan Feb Mar Apr
I. Collections and Purchases Worksheet
(1) Sales (gross) $71,21 $68,212.00 $65,213.00 $52,475.00 $42,90 $30,524
8 9
Collections
(2) During month of sale (0.2) 12,781.75 10,285.10
(0.98)(month’s sales)
(3) During first month after sale 47,748.40 45,649.10
(0.7)(previous month’s sales)
(4) During second month after 7,121.80 6,821.20
sale (0.1)(sales 2 months
ago)
(5) Total collections (Lines 2 + 3 $67,651.95 $62,755.40
+ 4)
Purchases
(6) (0.85)(forecasted sales 2 $44,603.75 $36,472.65 $25,945.40
months from now)
(7) Payments (1-month lag) 44,603.75 36,472.65

II. Cash Gain or Loss for Month

(8) Collections (from Section I) $67,651.95 $62,755.40
(9) Payments for purchases 44,603.75 36,472.65
(from Section I)
(10 Wages and salaries 6,690.56 5,470.90
)
(11 Rent 2,500.00 2,500.00
)
(12 Taxes    
)
(13 Total payments $53,794.31 $44,443.55
)
(14 Net cash gain (loss) during
) month
(Line 8 – Line 13) $13,857.64 $18,311.85

III. Cash Surplus or Loan

Requirement
(15 Cash at beginning of month
)
if no borrowing is done $3,000.00 $16,857.64
(16 Cumulative cash [cash at
) start + gain
or – loss = (Line 14 + Line 15)] 16,857.64 35,169.49

(17 Target cash balance 1,500.00 1,500.00

)
(18 Cumulative surplus cash or $15,357.64 $33,669.49
) loans outstanding to maintain
$1,500 target cash balance
(Line 16 – Line 17)

f. In his preliminary cash budget, Barnes has assumed that all sales are collected and,
thus, that SKI has no bad debts. Is this realistic? If not, how would bad debts be dealt
with in a cash budgeting sense? (Hint: bad debts will affect collections but not
purchases.)
Although ideal, a situation wherein there is zero bad debts is unrealistic. There is always
this inherent risk or uncertainty that the credit the company extended will be collected. This is
the unfortunate cost of doing business with customers on credit (Tuovila, 2019).
In the context of budgeting, since the bad debts expense is anchored on the uncertainty
that the credit will be collected; bad debts would lower down the amount of collection of credit
sales or receivables. The cash surplus will be lower by an amount equal to the actual bad debts or
the amount perceived by the company as bad debts or uncollectible.

g. Barnes’ cash budget for the entire year, although not given here, is based heavily on
his forecast for monthly sales. Sales are expected to be extremely low between May
and September but then increase dramatically in the fall and winter. November is
typically the firm’s best month, when SKI ships equipment to retailers for the holiday
season. Interestingly, Barnes’ forecasted cash budget indicates that the company’s
cash holdings will exceed the targeted cash balance every month except for October
and November, when shipments will be high but collections will not be coming in until
later. Based on the ratios shown earlier, does it appear that SKI’s target cash balance
is appropriate? In addition to possibly lowering the target cash balance, what actions
 might SKI take to better improve its cash management policies, and how might that
affect its EVA?
The company’s policies on holding cash are reflected in the company’s turnover of cash
and securities (presented in Table IC 16-1) and its projected cash budget (presented in Table IC
16-2). Both this tables suggest that the company is holding too much cash. SKI’s cash turnover
ratio says that it has only used the firm’s cash and securities in a full cycle only 16 times in a
year while the rest of industry was able to use these six times more. This would mean the cash
and securities were just sitting idle for most of the time.
SKI could improve its EVA by developing means to reduce its unnecessary cash
holdings. SKI may opt to invest the cash in more-productive assets or returning the same to its
shareholders. If proved to be profitable, the new investments’ return will increase the operating
income without affecting its cost which would ultimately increase EVA. On the other hand,
declaring and paying dividends or buying off stocks as treasury would also decrease the cash
balances. This would, however, decrease the capital components of the firm and will have the
overall cost of capital fall while increasing EVA.

h. Is there any reason to think that SKI may be holding too much inventory? If so, how
would that affect EVA and ROE?
The same with the cash and securities’ situation, the inventory’s situation needs to be
looked into as well. SKI’s turnover ratio of 4.82 is small compared to industry’s 7.00. Same
conclusion can be drawn from this one. This means that the company is holding inventory more
than what is necessary. In doing so, it increases holding or storage costs which ultimately lead to
lower ROE. Apart from, any additional inventory would mean more financing, and in this regard,
EVA is lowered as well.

i. If the company reduces its inventory without adversely affecting sales, what effect
should this have on the company’s cash position (1) in the short run and (2) in the
long run? Explain in terms of the cash budget and the balance sheet.
In an attempt to reduce the inventory, SKI should lower its purchases. This would benefit
the firm’s cash position in the short run thus reducing the amount of financing or the target cash
balance needed. In the long run, the company’s cash balance will blow up and they will have
enough “excess cash” to make investments in more productive assets or fixed assets such as
property, plant and equipment. Alternatively, the firm can distribute this excess to its
shareholders through declaring higher dividends or repurchasing its shares as treasury.

j. Barnes knows that SKI sells on the same credit terms as other firms in its industry. Use
the ratios presented earlier to explain whether SKI’s customers pay more or less
promptly than those of its competitors. If there are differences, does that suggest that
SKI should tighten or loosen its credit policy? What four variables make up a firm’s
credit policy, and in what direction should each be changed by SKI?
 The days sales outstanding of SKI which is computed at 45.63 days represent the number
of days that the customers will take to pay what they owe to the company. This figure is
relatively longer than the rest of the industry which is, on average, 32 days. The way to combat
this is to tighten the credit policy to foster faster collection and to lower the DSO.
The four variables that make up a firm’s credit policy are (1) discount amount and period,
(2) credit period, (3) credit standards, and (4) collection policy.
Discounts represent reduction in sales price and this reduction would entice more
customers and would equate to more sales. Aside from that, discount rates combined with
discount period encourages prompt payment which would ultimately reduce DSO and level of
receivables would decline.
Credit period refers to the period given to customers to pay for their purchases. The
shorter credit period allowed is tantamount to lower DSO and lower level of receivables held.
However, shortening the credit period might discourage the customers from dealing with the
company if they are able to find alternative firms with longer credit period elsewhere. This will
be affected so when a competing firm offers shorter credit period. The effect of the credit period
on the bad debts expense cannot be ascertained.
Part and parcel for a firm or a potential customer to be qualified for credit is SKI’s credit
standards. Pass these qualifications, and a customer is granted credit. These dictate the minimum
acceptable financial position required of customers to receive credit. Also, a firm may impose
differing credit limits depending on the customer’s financial strength. Tightening these standards
or imposing more stringent qualifications would discourage sales, decrease receivables but will
decrease bad debts expense. The level of receivables held would be decreased due to the lower
level of sales and also the probability that customers now qualifying for credit would take less
time to pay. Bad debt expenses should decrease due to raising customers’ minimum acceptable
financial positions.
Finally, collection policy refers to the procedures that the firm follows to collect past-due
accounts. These can range from a simple letter or phone call to turning the account over to a
collection agency. A tight collection policy would decrease the level of receivables held, as
customers would decrease the length of time they took to pay their bills. A tight collection policy
would also cause a decrease in the amount of bad debt losses the firm incurred.
A tightening of credit policy would tend to discourage or decrease sales, decrease the
level of receivables held, and decrease the amount of bad debt expenses.

k. Does SKI face any risks if it tightens its credit policy?

Any change in policy surrounding credit policies would expose the firm to various risks.
If the SKI would tighten its credit policy, this would discourage sales. Some customers would
opt to do business elsewhere if they feel pressured by the stringent qualifications or the stricter
credit terms.

l. If the company reduces its DSO without seriously affecting sales, what effect would
this have on its cash position (1) in the short run and (2) in the long run? Answer in
 terms of the cash budget and the balance sheet. What effect should this have on EVA
in the long run?
Interestingly, shortening DSO has the same effects as lowering the levels of inventory. In
doing so, the company’s cash position would be in a better place since they are collecting more
promptly than usual means additional cash collections. A better cash position means lower
amount of financing needed or target cash needed. As time goes by, the company may opt to
invest this accumulated “excess cash” in more productive assets, or pay it out to the shareholders
through dividends. Both of these actions action would benefit the company since EVA would be
increased.

m. Assume that SKI buys on terms of 1/10, net 30, but that it can get away with paying on
the 40th day if it chooses not to take discounts. Also assume that it purchases $3
million of components per year, net of discounts. How much free trade credit can the
company get, how much costly trade credit can it get, and what is the percentage cost
of the costly credit? Should SKI take discounts? Why or why not?

Assuming that the net purchases are at 3 million dollars, we can squeeze the gross
purchases figure by the dividing this amount by 99% (since the figure was already deducted with
the 1% discount). Doing so would lead to amount the gross purchases to $3,030,303. Assuming
further a 365-day year, the net daily purchases would be $8,219.17808.

If the discount is taken, then SKI must pay this supplier at the end of Day 10 for
purchases made on Day 1, on Day 11 for purchases made on Day 2, and so on. Thus, in a steady
state, SKI will on average have 10 days’ worth of purchases in payables, so,
Payables = 10($8,219.178) = $82,192.

If the discount is not taken, then SKI will wait 40 days before paying, so
Payables = 40($8,219.178) = $328,767.

Therefore:
Trade credit if discounts are not taken: $328,767 = Total trade credit
Trade credit if discounts are taken: $(82,192) = Free trade credit
Difference: $246,575 = Costly trade credit

To obtain $246,575 of costly trade credit, SKI must give up 0.01($3,030,303) = $30,303 in lost
discounts annually. Since the forgone discounts pay for $246,575 of credit, the nominal annual
interest rate is 12.29% which is solved as follows:

$ 30,303
nominal interest rate= =.12289567068≈ 12.29 %
$ 246,575
 There is a formula that can be used to immediately obtain the nominal annual interest rate
of costly trade credit.
discount rate 365 days
Nominal cost of credit= x
1−discount rate days taken−discount period

Substituting the formula with the current assumptions:

1% 365 days
Nominal cost of credit= x
1−1 % 40−10
1 % 365
¿ x
9 9 % 30
¿ 0.0101010 x 12.16666667
¿ 0. 12289562166
Nominal cost of credit ≈ 12.29 %
Note that the result from this formula is the same as the nominal annual interest
computed earlier.
1%
The first term of the formula which is the or 0.01010 is the periodic cost of the
99 %
credit. This means that the SKI spends $1 to get to use $99.
365
The second term (i.e. =12.166666667 ≈12.1667 ) is the number “savings periods” per
30
year. To calculate the exact effective annual interest rate:
effective interest rate=( 1+rate per period )number of periods−1
12.1667
¿ ( 1+0.0101010 ) −1
12.1667
¿ ( 1.0101010 ) −1
¿ 1.1300696856750526963917485405297−1
¿ . 1300696856750526963917485405297
effective interest rate≈ 13.01 %

In the event that SKI’s funds are not enough to pay off its supplier before the discount
period, they can try to obtain financing from its bank (or from other sources) provided that the
interest rate would be lower than 13.01% and use the proceeds from the loan to pay its suppliers
during the discount period.

n. Suppose SKI decided to raise an additional $100,000 as a 1-year loan from its bank,
for which it was quoted a rate of 8%. What is the effective annual cost rate assuming
simple interest and add-on interest on a 12-month installment loan?
For a simple interest loan, the effective annual cost is the same as the simple interest rate,
which is 8%. The effective annual cost for an add-on interest, 12-month installment loan would
be calculated as follows:
Total amount to be repaid = $100,000 + 1.08 = $108,000.
Monthly payments = $108,000/12 = $9,000.
 With a financial calculator, enter N = 12, PV = 100000, PMT = 9000, FV = 0, and then
press I/YR = 1.2043%. However, this is a monthly rate, the EARAdd-on would be calculated as:
= (1 + 0.012043)12 – 1
= 1.1545 – 1
= 0.1545
= 15.45%.

References
Chen, J. (2020, February 10). Economic Value Added (EVA). Retrieved July 22, 2020, from
Investopedia: https://www.investopedia.com/terms/e/eva.asp#:~:text=Economic
%20value%20added%20(EVA)%20is,taxes%20on%20a%20cash%20basis.

Corporate Finance Institute. (n.d.). What is the Cash Conversion Cycle? Retrieved July 24, 2020,
from Corporate Finance Institute Website:
https://corporatefinanceinstitute.com/resources/knowledge/accounting/cash-conversion-
cycle/

IIBM. (n.d.). Economic Value Added (EVA). Retrieved July 23, 2020, from Indian Insititute of
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subjects/finance-management/economic-value-added-eva/

My Accounting Course . (n.d.). What is Economic Value Added (EVA)? Retrieved July 24, 2020,
from My Accounting Course: https://www.myaccountingcourse.com/accounting-
dictionary/economic-value-added

Tuovila, A. (2019, August 8). Bad Debt. Retrieved July 24, 2020, from Investopedia:
https://www.investopedia.com/terms/b/baddebt.asp