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

Gross working capital total 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.

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

Total assets turnover

11.35x 12.00x
2.08x

3.00x

16-3

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.
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
Receivables 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
Daysper year
Dayssales
CCC

deferral
g period
Inventoryturnover outstandin
365
CCC
46 - 30
4.82
CCC 76 46 - 30 92 days.
16-10

Cash doesnt earn a profit,

so why should the firm
hold
it?
1. Transactions must have some cash to
2.
3.
4.

operate.
Precaution safety stock. Reduced by
line of credit and marketable securities.
Compensating balances for loans
and/or services provided.
Speculation to take advantage of
bargains and to take discounts.
Reduced by credit lines and marketable
securities.

16-11

The goal of cash

management

To meet the 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.
16-12

Minimizing cash holdings

Use a lockbox
Insist on wire transfers from customers
Synchronize inflows and outflows
Use a remote disbursement account
Reduce need for safety stock of cash

Increase forecast accuracy

Hold marketable securities
Negotiate a line of credit

16-13

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.
16-14

SKIs 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
16-15

SKIs cash budget (cont)

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
16-16

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.
16-17

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.
16-18

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.
16-19

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.
16-20

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.
16-21

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.

16-22

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.
16-23

Elements of credit policy

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.
1.

16-24

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.
16-25

If SKI reduces its DSO without

adversely affecting sales, how
would this affect its cash
Short run: If customers pay sooner,
position?

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.

16-26

Short-term credit

Debt scheduled for repayment within 1

year.
Major sources of short-term credit

Accounts payable (trade credit)

Bank loans
Commercial loans
Accruals

From the firms perspective, S-T credit is

riskier than L-T debt.

Always a required payment around the

corner.
May have trouble rolling over loans.
16-27

Advantages and
disadvantages of using
short-term financing

Advantages

Speed
Flexibility
Lower cost than long-term debt

Disadvantages

Fluctuating interest expense

Firm may be at risk of default as a result of
temporary economic conditions

16-28

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.

16-29

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
16-30

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 $328,767
Free trade credit - 82,192
Costly trade credit $246,575
16-31

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.

16-32

Nominal cost of trade credit

formula
rNOM

Discount%
365days

1 - Discount% Daystaken- Disc.period

1
365

99 40 - 10
0.1229
12.29%

16-33

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%

16-34

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

16-35

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, r NOM =

EAR
16-36

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).

16-37

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

PV

PMT

FV

1.2043
16-38