a.

Barnes plans to use the ratios shown below 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 how changes would interact to affect profits
and EVA. Based on the data in the table, does SKI seem to be following a relaxed,
moderate, or restricted working capital policy?

A company is implementing a relaxed working capital policy, if it has large amounts of

current assets in relation to sales, as is the case with SKI. This is used as a safe measure
against lower sales due to a more restrictive credit policy or having insufficient amounts of
stock and/or cash. Unfortunately, SKI has cash and inventory turnover ratios that are both
lower than the industry average. As we can see its sales to inventories is 4.82 significantly
lower than the 7.0 of the industry. Similarly, its DSO is higher than average. This indicates a
high number of receivables to sales. Therefore, SKI seems to be implementing a relaxed
working capital policy.

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

As previously discussed, a firm will opt for high amounts of cash and inventories as a
safety measure. If this is done in a optimum way the firm’s ROE should be unaffected
and therefore close to the industry’s average. This means that the carrying cost of the
“extra” working capital is offset by higher prices and/or higher sales. SKI’s ROE is again
significantly lower than the industry’s average. This indicates a suboptimum level of
working capital and should be reduced.

c. Now, calculate the firm’s cash conversion cycle. Assume a 365 day year.

To calculate a firm’s cash conversion cycle we will be

Inventory conversion period+ Receivables collection period – Payablesdefferal period=CashConversion

o. Assume that SKI purchases $200,000 (net of discounts) of materials 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. How much free trade credit can the company get from its equipment supplier,
how much costly trade credit can it get, and what is the nominal annual interest rate of
the costly credit? Should SKI take discounts?

If SKI’s net purchases are $200,000 annually, its gross purchases with a 1% discount are
$200,000/0.99 = $202,020.20. Net daily purchases are $200,000/365 = $547.95.

If SKI opts for the discount, it must pay on the 10 th day for purchases made on the 1st and so
forth. This leaves us with an average of 10 days’ worth of purchases in payables.
 Payables=10 x 547 .95=$ 5 , 479.5 0
If SKI decides not to proceed with the discount, it can then pay every 40 days.

Payables=40 x 547.95=$ 21,918 .

Summarizing, $21,918 of total credit minus the $5,479.50 of free trade credit, SKI has a
costly trade credit of $16,438.50 .

To obtain this amount of costly credit, SKI has let go of 0,01 x 202,020.20 = $2,020.20 annual
discounts. Therefore, the nominal annual interest rate of costly credit is:

2,020
r= =0,1229=12,29 %
16,439

We can also find the nominal annual interest rate of costly credit using the following
formula:

discount % 365 days

rnorm= x
1−discount % d ays taken−discount period

1 365
rnorm= x =0,1229=12,29 %
99 40−10

Both formulas give the same annual interest rate. However, since this “cost” does not incur
at the end of the year, but rather through the year, the effective annual rate will be higher.
Breaking down the first term of the second formula we get the periodic rate ( SKI uses $1 to
get $99 of dollars). The second term gives us the periods per years. We may can now
calculate the effective annual rate :

n 12,1667
EAR=( 1+ periodic rate ) −1=( 1,0101 ) =13,01 % .

In conclusion, if SKI can find financing with a rate lower than 13,01% it should do so and
keep the discount.
p. SKI tries to match the maturity of its assets and liabilities. Describe how SKI could adopt
either a more aggressive or a more conservative financing policy.

SKI may choose between three alternative current asset financing polices: an aggressive, a
relaxed or a moderate one.

A moderate policy, which SKI currently follows, matches the maturities of asset and
liabilities, to the degree that is possible that is. An exact match is unlikely due to the
uncertainty of assets’ life spans and the use of equity, which does not have a maturity. This
strategy mitigates the risk of not being able to pay off maturing liabilities.

An aggressive policy finances fixed assets with long-term capital but uses short-term,
nonspontaneous credit for permanent current assets. There are various degrees of
aggressiveness, based on the percentage of permanent currents assets financed this way.
The most aggressive and risky approach finances even parts of fixed assets with short-term
debt, this can subject SKI to loan renewal problems and/or rising interest rates.

Lastly, a conservative strategy uses permanent capital to finance all fixed assets and part of
seasonal demands. Understandably, this is the safest possible approach but could decrease
SKI’s ROE furthermore or increase interest expenses(???????)

q. What are the advantages and disadvantages of using short-term debt as a source of
financing?

Arguably, the case of short-term vs long-term debt is not an easy one. Short-term debt has
many advantages and disadvantages.

Regarding the former, the cost of short-term debt is lower than that of long-term debt. This
is because the yield curve normally has an upward slope. A firm may also opt for short-term
debt if it considers current interest rates high and/or expects them to decline. Short-term
loans are also easier to negotiate. The time span of the loan is relatively small and does not
require a rigorous and too forward-looking due-diligence process. Furthermore, it offers
greater flexibility. Seasonal and cyclical needs for funds are easier and cheaper to cover this
way. Prepayment is always an option, as it carries low- to-no cost unlike long-term loans.
Lastly, in contrast to long-term loans where covenants are the norm, short-term loans
impose far fewer restrictions.

On the downside, a short-term debt approach carries significant risk. For starters, it may
expose a firm to higher interest rates and therefore expenses. High inflation rates, as is
currently the case, mean that even prime interest rates will rise significantly. The risk of
bankruptcy is increased. Even a temporary recession or other misfortune can render the firm
temporarily unable to serve its debt, and a weak financial position may force the lender to
not extend the loan.