INTRO ALT WC POLICIES CASH MGMT INV & A/R MGMT TRADE CREDIT BANK LOANS

Chapter 17

Working Capital Management

Alternative Working Capital Policies

Cash Management
Inventory and A/R Management
Trade Credit
Bank Loans

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Working Capital Terminology

• Working capital: current assets.

• Net working capital: current assets minus
current liabilities.
• Net operating working capital: current assets
minus (current liabilities less notes payable).
• 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.
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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%
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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.

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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.

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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.

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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.
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Conservative Financing Policy

Marketable
$ securities Zero S-T
Debt

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

Fixed Assets
Years
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Moderate Financing Policy

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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 Average Payables
CCC = conversion + collection − deferral
period period period

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Cash Conversion Cycle

Inventory Average 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

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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

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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.

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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

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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

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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.

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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.

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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.

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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 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.

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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.

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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.

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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.
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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.

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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.

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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.

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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

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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

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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

Discount % 365 days

rNOM = 
100 − Discount % Days credit − Discount
outstandin g period
1 365
= 
99 40 − 10
= 0.1229
= 12.29%

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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%

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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

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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.

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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 exact effective rate, recognize that the
firm receives $100,000 and must make monthly
payments of $9,000 (like an annuity).

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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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