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Copyright 2002 by Harcourt, Inc. All rights reserved.

Definitions

Gross W.C.: Total current assets.Net W.C.: Current assetsCurrent

liabilities.W.C. Policy: Decisions as to (1) the

level of each type of current asset,and (2) how current assets will be

financed.W.C. Management: Controlling cash,

inventories, and A/R, plus S-T liabilitymanagement.

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SKI appears to have large amounts of workingcapital given its level of sales.

Selected Ratios--SKI Inc.

SKI IndustryCurrent 1.75x 2.25xQuick 0.83x 1.20xDebt/Assets 58.76% 50.00%

Turnover of cash & securities 16.67x 22.22xDSO (365-day basis) 45.63 32.00Inv. turnover 4.82x 7.00xF. A. turnover 11.35x 12.00xT. A. turnover 2.08x 3.00x

Profit margin 2.07% 3.50%ROE 10.45% 21.00%

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How does SKIs working capital policy

compare with the industry?

Working capital policy is reflected in

current ratio, quick ratio, turnover ofcash and securities, inventoryturnover, and DSO.

These ratios indicate SKI has largeamounts of working capital relativeto its level of sales. SKI is eithervery conservative or inefficient.

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Is SKI inefficient or just conservative?

A conservative (relaxed) policy maybe appropriate if it leads to greaterprofitability.

However, SKI is not as profitable asthe average firm in the industry.This suggests the company hasexcessive working capital.

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Cash Conversion Cycle

CCC = + .Inventoryconversionperiod

Receivablescollectionperiod

Payablesdeferralperiod

The cash conversion model focuses on thelength of time between when a companymake payments to its creditors and when a

company receives payment from itscustomers.

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Cash Conversion Cycle

CCC = + 45.630

CCC = 75.7 + 45.630

CCC = 91.3 days.

3654.82

Daysper year

Inv.turnover

Payablesdeferral

period

Dayssales

outstanding

CCC = + -

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Cash doesnt earn a profit, so why

hold it?

1. Transactions: Must have some cashto operate.

2. Precaution: Safety stock. Butlessened by line of credit, marketablesecurities.

3. Compensating balances: For loans

and/or services provided.4. Speculation: To take advantage of

bargains, to take discounts, etc.Reduced by credit lines, securities.

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Whats the goal of cash management?

To meet above objectives,especially to have cash for

transactions, yet not have anyexcess cash.

To minimize transactions balances

in particular, and also needs forcash to meet other objectives.

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Reducing Cash and Securities without

Harming Operations

Securities could be sold off and

combined with existing cash usedto reduce debt, to buy back stock,or to invest in operating assets.

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Cash Budget: The Primary Cash

Management Tool

Purpose: Forecasts cash inflows,

outflows, and ending cash balances.Used to plan loans needed or fundsavailable to invest.

Timing: Daily, weekly, or monthly,depending upon purpose of forecast.Monthly for annual planning, daily foractual cash management.

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Data Required for Cash Budget

1. Sales forecast.

2. Information on collections delay.3. Forecast of purchases and payment

terms.

4. Forecast of cash expenses, taxes, etc.5. Initial cash on hand.

6. Target cash balance.

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SKIs Cash Budget for January and

February

Net Cash InflowsJanuary February

Collections $67,651.95 $62,755.40Purchases 44,603.75 36,472.65

Wages 6,690.56 5,470.90

Rent 2,500.00 2,500.00Total payments $53,794.31 $44,443.55

Net CF $13,857.64 $18,311.85

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Cash Budget (Continued)

January February

Cash at start ifno borrowing $ 3,000.00 $16,857.64

Net CF (slide 13) 13,857.64 18,311.85

Cumulative cash $16,857.64 $35,169.49Less: target cash 1,500.00 1,500.00

Surplus $15,357.64 $33,669.49

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Should depreciation be explicitly

included in the cash budget?

No. Depreciation is a noncash

charge. Only cash payments andreceipts appear on cash budget.

However, depreciation does affect

taxes, which appear in the cashbudget.

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What are some other potential cash

inflows besides collections?

Proceeds from the sale of fixed

assets.

Proceeds from stock and bondsales.

Interestearned.

Court settlements.

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How could bad debts be worked into

the cash budget?

Collections would be reducedby

the amount of the bad debt losses.

For example, if the firm had 3% baddebt losses, collections would total

only 97% of sales.

Lower collections would leadtohigher borrowing requirements.

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SKIs forecasted cash budget indicates

that the companys cash holdings willexceed the targeted cash balanceevery month, except for October and

November.

Cash budget indicates the companyis holding too much cash.

SKI could improve its EVA by eitherinvesting cash in more productiveassets, or by returning cash to itsshareholders.

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What reasons might SKI have formaintaining a relatively high amount

of cash?

If sales turn out to be considerablyless than expected, SKI could face acash shortfall.

A company may choose to hold largeamounts of cash if it does not have

much faith in its sales forecast, or if itis very conservative.The cash may be used, in part, to fund

future investments.

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Categories of Inventory Costs

Carrying Costs: Storage andhandling costs, insurance, propertytaxes, depreciation, andobsolescence.

Ordering Costs: Cost of placing

orders, shipping and handling costs.

(More)

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Costs of Running Short: Loss ofsales, loss of customer goodwill, andthe disruption of production

schedules.Reducing the average amount ofinventory generally reduces carryingcosts, increases ordering costs, andmay increase the costs of running short.

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Is SKI holding too much inventory?

SKIs inventory turnover (4.82) isconsiderably lower than the industry

average (7.00). The firm is carrying alot of inventory per dollar of sales.

By holding excessive inventory, the

firm is increasing its costs, whichreduces its ROE. Moreover, thisadditional working capital must befinanced, so EVA is also lowered.

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If SKI reduces its inventory, withoutadversely affecting sales, what effectwill this have on its cash position?

Short run: Cash will increase asinventory purchases decline.

Long run: Company is likely to

take steps to reduce its cashholdings and increase its EVA.

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Do SKIs customers pay more or lesspromptly than those of its

competitors?

SKIs DSO (45.6 days) is well above

the industry average (32 days).

SKIs customers are paying lesspromptly.

SKI should consider tightening itscredit policy in order to reduce itsDSO.

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1. Credit Period: How long to pay? Shorterperiod reduces DSO and average A/R, butit may discourage sales.

2. Cash Discounts: Lowers price. Attractsnew customers and reduces DSO.

3. Credit Standards: Tighter standards tendto reduce sales, but reduce bad debt

expense. Fewer bad debts reduce DSO.4. Collection Policy: How tough? Tougher

policy will reduce DSO but may damagecustomer relationships.

Elements of Credit Policy

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Does SKI face any risk if it tightens its

credit policy?

YES! A tighter credit policy maydiscourage sales. Some customersmay choose to go elsewhere if theyare pressured to pay their bills

sooner.

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If SKI succeeds in reducing DSOwithout adversely affecting sales,what effect would this have on its

cash position?

Short run: If customers pay sooner,this increases cash holdings.

Long run: Over time, the company

would hopefully invest the cash inmore productive assets, or pay it outto shareholders. Both of theseactions would increase EVA.

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Working Capital Financing Policies

Moderate: Match the maturity of theassets with the maturity of the

financing.

Aggressive: Use short-term financingto finance permanent assets.

Conservative: Use permanent capitalfor permanent assets and temporaryassets.

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Years

$

Perm C.A.

Fixed Assets

Temp. C.A.

Lower dashed line, more aggressive.

} S-TLoans

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

Moderate Financing Policy

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Conservative Financing Policy

Fixed Assets

Years

$

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

Spon. C.L.

Marketable Securities

Zero S-Tdebt

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What is short-term credit, and what are

the major sources?

S-T credit: Any debt scheduled for

repayment within one year.Major sources:

Accounts payable (trade credit)

Bank loansCommercial paper

Accruals

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Is S-T credit riskier than L-T?

To the company, yes. Requiredrepayment always looms. Mayhave trouble rolling overloans.

Advantages of short-term credit:

Low cost--visualize yield curve.

Can get funds relatively quickly.Can repay without penalty.

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Is there a cost to accruals? Do firmshave much control over amount of

accruals?

Accruals are freein that no explicitinterest is charged.

Firms have little controlover the

level of accruals. Levels areinfluenced more by industrycustom, economic factors, and taxlaws.

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What is trade credit?

Trade creditis credit furnished by afirms suppliers.

Trade credit is often the largestsource of short-term credit,especially for small firms.

Spontaneous, easy to get, but costcan be high.

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B&B buys $512,106 gross, or $506,985net, on terms of 1/10, net 30, and payson Day 40. How much free and costly

trade credit, and whats the cost ofcostly trade credit?

Net daily purchases = $506,985/365

= $1,389.

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Gross/Net Breakdown

Company buys goodsworth$506,985. Thats the cash price.

They must pay $5,121 more if theydont take discounts.

Think of the extra $5,121 as afinancing costsimilar to the interest

on a loan.Want to compare that cost with the

cost of a bank loan.

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Payables level if take discount:

Payables = $1,389(10) = $13,890.

Payables level if dont take discount:

Payables = $1,389(40) = $55,560.

Credit Breakdown:

Total trade credit = $55,560Free trade credit = 13,890Costly trade credit = $41,670

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Nominal Cost of Costly Trade Credit

But the $5,121 is paid all dur ing theyear, not at year-end, so EAR rate ishigher.

Firm loses 0.01($512,106) = $5,121 ofdiscounts to obtain $41,670 inextra trade credit, so

kNom= = 0.1229 = 12.29%.$5,121

$41,670

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Nominal Cost Formula, 1/10, net 40

Pays 1.01% 12.167 times per year.

%.29.121229.0

1667.120101.030

365

99

1period

Discount

taken

Days

days365

%Discount1

%DiscountkNom

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Periodic rate = 0.01/0.99 = 1.01%.

Periods/year = 365/(4010) = 12.1667.

EAR = (1 + Periodic rate)n

1.0= (1.0101)12.16671.0 = 13.01%.

Effective Annual Rate, 1/10, net 40

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Commercial Paper (CP)

Short term notes issued by large,strong companies. B&B couldntissue CP--its too small.

CP trades in the market at rates justabove T-bill rate.

CP is bought with surplus cash bybanks and other companies, then heldas a marketable security for liquiditypurposes.

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