Working Capital Management

Chapter 16
Working Capital Management
Alternative Working Capital Policies

Cash Management
Inventory and A/R Management
Trade Credit
Bank Loans
16-1
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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.
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 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
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
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
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. L-T Fin:

Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
Lower dashed line would be more aggressive.
16-7
Conservative Financing Policy
Marketable
$ securities Zero S-T
Debt
L-T Fin:
Stock,
Perm C.A. 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 Average Payables

CCC  conversion  collection  deferral
period period period
16-9
Cash Conversion Cycle
Inventory Average Payables

CCC  conversion  collection  deferral
period period period
Days per year Payables
Days sales
CCC    deferral
Inventory turnover outstandin g period
365
CCC   46  30
4.82
CCC  76  46  30  92 days
16-10
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
16-11
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.
16-12
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
16-13
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
16-14
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.
16-15
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.
16-16
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.
16-17
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.
16-18
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.
16-19
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
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
Elements of Credit Policy
1. 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: Restrictive standards tend to
reduce sales, but reduce bad debt expense. Fewer
bad debts reduce DSO.
4. Collection Policy: How tough? Restrictive policy
will reduce DSO but may damage customer
relationships.
16-22
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
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
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.
16-25
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
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
16-27
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
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
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%
16-30
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
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
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
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
16-34

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Chapter 16

Alternative Working Capital Policies

• Working capital: current assets.

SKI Ind Avg

• Current assets investment policy is reflected in the

• A conservative (relaxed) policy may be appropriate

• Moderate: Match the maturity of the assets with

Perm C.A. L-T Fin:

• The cash conversion cycle focuses on the length of

Inventory Average Payables

Inventory Average Payables

• Forecasts cash inflows, outflows, and ending cash

• Collections would be reduced by the amount of the

• Cash holdings will exceed the target balance for

• If sales turn out to be considerably less than

• Types of inventory costs

• SKI’s inventory turnover (4.82x) is considerably

• Short run: Cash will increase as inventory purchases

• SKI’s DSO (45.6 days) is well above the industry

1. Credit Period: How long to pay? Shorter period

• Yes, a restrictive credit policy may discourage sales.

• Short run: If customers pay sooner, this increases

• Trade credit is credit furnished by a firm’s suppliers.

• A firm buys $3,000,000 net ($3,030,303 gross) on

• Payables level, if the firm takes discounts

Total trade credit $328,767

• The firm loses 0.01($3,030,303) = $30,303 of

Discount % 365 days

• Periodic rate = 0.01/0.99 = 1.01%

• The firm can borrow $100,000 for 1 year at an 8%

• Simple interest means no discount or add-on.

• For a 1-year simple interest loan, rNOM = EAR.

• 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

From the calculator output below, we have:

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