Chapter 16 Working Capital Management Alternative Working Capital Policies Cash Management Inventory and A/R Management Trade Credit Bank Loans 16-1 © 2013 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 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 Net working capital: current assets minus current liabilities 16-2 © 2013 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% 16-3 © 2013 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 16-4 © 2013 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 16-5 © 2013 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 16-6 © 2013 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 Fixed Assets L-T Fin: Stock, Bonds, Spon C.L Years Lower dashed line would be more aggressive 16-7 © 2013 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 Perm C.A Zero S-T Debt L-T Fin: Stock, Bonds, Spon C.L Fixed Assets Years 16-8 © 2013 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 Inventory Average Payables CCC = conversion + collection − deferral period period period 16-9 © 2013 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 Inventory Average Payables CCC = conversion + collection − deferral period period period Payables Days per year Days sales CCC = + − deferral outstandin g Inventory turnover period 365 + 46 − 30 4.82 CCC = 76 + 46 − 30 = 92 days CCC = 16-10 © 2013 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 16-20 © 2013 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 16-21 © 2013 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 Credit Period: How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales Cash Discounts: Lowers price Attracts new customers and reduces DSO Credit Standards: Restrictive standards tend to reduce sales, but reduce bad debt expense Fewer bad debts reduce DSO Collection Policy: How tough? Restrictive policy will reduce DSO but may damage customer relationships 16-22 © 2013 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 16-23 © 2013 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 16-24 © 2013 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 • Spontaneous, easy to get, but cost can be high Trade credit is often the largest source of shortterm credit, especially for small firms 16-25 © 2013 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 16-26 © 2013 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 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 16-27 © 2013 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 16-28 © 2013 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 Discount % 365 days rNOM = × 100 − Discount % Days credit − Discount outstandin g period 365 = × 99 40 − 10 = 0.1229 = 12.29% 14-29 © 2013 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 − = (1.0101)12.1667 − = 13.01% 16-30 © 2013 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 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 © 2013 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 16-32 © 2013 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) 16-33 © 2013 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 – = 15.45% INPUTS 12 N OUTPUT I/YR 100 -9 PV PMT FV 1.2043 16-34 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part [...]... 16-13 © 2013 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 Cash at start if no borrowing Net cash flows Cumulative cash Less: Target cash Surplus January February $ 3,000.00 $16,857.64 13,857.64 18,311.85 $16,857.64 $35,169.49 1,500.00 1,500.00 $15,357.64 $33,669.49 16-14 © 2013 Cengage. .. EVA 16-24 © 2013 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 • Spontaneous, easy to get, but cost can be high Trade credit is often the largest source of shortterm credit, especially for small firms 16-25 © 2013 Cengage Learning... costly trade credit is higher 16-28 © 2013 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 Discount % 365 days rNOM = × 100 − Discount % Days credit − Discount outstandin g period 1 365 = × 99 40 − 10 = 0.1229 = 12.29% 14-29 © 2013 Cengage Learning All Rights Reserved... − 1 = 13.01% 16-30 © 2013 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 16-31 © 2013 Cengage Learning All... $9,000 (like an annuity) 16-33 © 2013 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 N OUTPUT I/YR 100 -9 0 PV PMT FV 1.2043 16-34 © 2013 Cengage Learning All Rights Reserved... credit 16-11 © 2013 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. .. 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 16-19 © 2013 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... 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 © 2013 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... 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 16-20 © 2013 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... • • 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 © 2013 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 1 Credit Period: How long to