Working Capital

Management
Chapter 15

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Overview

Alternative Working Capital Policies

Cash Management

Inventory and A/R Management

Trade Credit

Bank Loans

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Working Capital Terminology

▪ Working capital: current assets.

▪ Net working capital: current assets minus
current liabilities.
▪ Net operating working capital: operating current
assets – operating current liabilities.
▪ Current assets investment 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.

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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%

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 How does SKI’s current assets investment policy
compare with its industry?

▪ Current assets investment 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.

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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 current
assets.

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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.

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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.

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Conservative Financing Policy

Marketable
$ securities Zero S-T
Debt

L-T Fin:
Perm C.A. Stock,
Bonds,
Spon. C.L.

Fixed Assets

Years

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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.

CCC = Inventory conversion period + Average

collection period - Payables deferral period

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Cash Conversion Cycle

CCC = Inventory conversion period + Average collection period

− Payables deferral period

CCC = Days per year/Inventory turnover

+ Days sales outstanding − Payables deferral period

CCC = 365/4.82 + 46 − 30

CCC = 76 + 46 − 30 = 92 days

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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.

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 SKI’s Cash Budget for January and February

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

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 SKI’s Cash Budget

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

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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.

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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.

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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.

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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.

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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 large amount 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.

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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.
• This will reduce financing or target cash balance.
▪ Long run: Company is likely to take steps to
reduce its cash holdings and increase its EVA.
• The “excess” cash can be used to make
investments in more productive assets such as
plant and equipment resulting in an increase in
operating income increasing its EVA.
• Alternately, can distribute “excess” cash to its
shareholders through higher dividends or
repurchasing shares resulting in a lower cost of
capital increasing its EVA.

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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.

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Elements of Credit Policy

[Link] Period: How long to pay? Shorter period

reduces DSO and average A/R, but it may
discourage sales.
[Link] Discounts: Lowers price. Attracts new
customers and reduces DSO.
[Link] Standards: Restrictive standards tend to
reduce sales, but reduce bad debt expense.
Fewer bad debts reduce DSO.
[Link] Policy: How tough? Restrictive policy
will reduce DSO but may damage customer
relationships.

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Does SKI face any risk if it restricts its credit policy?

▪ Yes, a restrictive 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.

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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. This will reduce
financing or target cash balance needed.
▪ 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.

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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.

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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.

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Nominal Cost of Trade Credit Formula

rNOM = [Discount %/(100 − Discount %)]

 [365 days/(Days credit outstanding −
Discount period)]

= 1/99  365/(40 − 10)

= 0.1229

= 12.29%

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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%

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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.

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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 exact effective rate, recognize that
the firm receives $100,000 and must make
monthly payments of $9,000 (like an annuity).

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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

© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 End of Chapter 15

© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website or school-approved learning management system for classroom use.
Cover image attribution: “Finance District” by Joan Campderrós-i-Canas (adapted) [Link]