Transcript CHAPTER 15 Managing Current Assets

CHAPTER 15
Working Capital Management
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Alternative working capital policies
Cash management
Inventory and A/R management
Trade credit
Bank loans
15-1
Working capital terminology
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Gross working capital – total current assets.
Net working capital – current assets minus
non-interest bearing current liabilities.
Working capital 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.
15-2
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%
15-3
How does SKI’s working capital
policy compare with its industry?
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Working capital 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.
15-4
Is SKI inefficient or conservative?
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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.
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This suggests the company has excessive
working capital.
15-5
Working capital financing policies
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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.
15-6
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.
15-7
Conservative financing policy
$
Marketable
securities
Perm C.A.
Zero S-T
Debt
L-T Fin:
Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
15-8
Cash conversion cycle
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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
Receivables Payables
CCC = conversion + collection – deferral .
period
period
period
15-9
Cash conversion cycle
Inventory Receivables Payables
CCC  conversion  collection  deferral
period
period
period
Payables
Days per year
Days sales
CCC 
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 deferral
Inventory turnover outstanding
period
365
CCC 
 46 - 30
4.82
CCC  76  46 - 30  92 days.
15-10
Cash doesn’t earn a profit, so
why should the firm hold it?
1.
2.
3.
4.
Transactions – must have some cash to
operate.
Precaution – “safety stock”. Reduced by
line of credit and marketable securities.
Compensating balances – for loans and/or
services provided.
Speculation – to take advantage of
bargains and to take discounts. Reduced
by credit lines and marketable securities.
15-11
The goal of cash management
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To meet the above objectives,
especially to have cash for
transactions, yet not have any excess
cash.
To minimize transactions balances in
particular, and also needs for cash to
meet other objectives.
15-12
Minimizing cash holdings
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Use a lockbox
Insist on wire transfers from customers
Synchronize inflows and outflows
Use a remote disbursement account
Reduce need for “safety stock” of cash
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Increase forecast accuracy
Hold marketable securities
Negotiate a line of credit
15-13
Cash budget
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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.
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Monthly for annual planning and daily for
actual cash management.
15-14
SKI’s cash budget:
For January and February
Collections
Purchases
Wages
Rent
Total payments
Net CF
Net Cash Inflows
Jan
Feb
$67,651.95
$62,755.40
44,603.75
36,472.65
6,690.56
5,470.90
2,500.00
2,500.00
$53,794.31
$44,443.55
$13,857.64
$18,311.85
15-15
SKI’s cash budget (con’t)
Net Cash Inflows
Jan
Feb
Cash at start if
no borrowing
$ 3,000.00
Net CF
13,857.64
Cumulative cash
16,857.64
Less: target cash
1,500.00
Surplus
$15,357.64
$16,857.64
18,311.85
35,169.49
1,500.00
$33,669.49
15-16
How could bad debts be
worked into the cash budget?
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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.
15-17
Analyze SKI’s forecasted cash budget
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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.
15-18
Why might SKI want to maintain a
relatively high amount of cash?
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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.
15-19
Inventory costs
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Types of inventory costs
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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.
15-20
Is SKI holding too much inventory?
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SKI’s inventory turnover (4.82x) is considerably
lower than the industry average (7.00x).
 The firm is carrying a lot 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.
15-21
If SKI reduces its inventory, without
adversely affecting sales, what effect
will this have on the cash position?
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Short run: Cash will increase as
inventory purchases decline.
Long run: Company is likely to take
steps to reduce its cash holdings and
increase its EVA.
15-22
Do SKI’s customers pay more or less
promptly than those of its competitors?
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SKI’s DSO (45.6 days) is well above the
industry average (32 days).
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SKI’s customers are paying less promptly.
SKI should consider tightening its credit
policy in order to reduce its DSO.
15-23
Elements of credit policy
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 – Tighter standards tend to
reduce sales, but reduce bad debt expense.
Fewer bad debts reduce DSO.
4. Collection Policy – How tough? Tougher
policy will reduce DSO but may damage
customer relationships.
1.
15-24
Does SKI face any risk if it
tightens its credit policy?
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Yes, a tighter credit policy may
discourage sales.
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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.
15-25
If SKI reduces its DSO without
adversely affecting sales, how
would this affect its cash position?
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Short run: If customers pay sooner,
this increases cash holdings.
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.
15-26
Short-term credit
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Debt scheduled for repayment within 1 year.
Major sources of short-term credit
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Accounts payable (trade credit)
Bank loans
Commercial loans
Accruals
From the firm’s perspective, S-T credit is
riskier than L-T debt.
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Always a required payment around the corner.
May have trouble rolling over loans.
15-27
Advantages and disadvantages
of using short-term financing
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Advantages
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Speed
Flexibility
Lower cost than long-term debt
Disadvantages
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Fluctuating interest expense
Firm may be at risk of default as a result of
temporary economic conditions
15-28
What is trade credit?
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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.
15-29
Terms of trade credit
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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
15-30
Breaking down trade credit
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Payables level, if the firm takes discounts
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Payables level, if the firm takes no discounts
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Payables = $8,219.18 (10) = $82,192
Payables = $8,219.18 (40) = $328,767
Credit breakdown
Total trade credit
Free trade credit
Costly trade credit
$328,767
- 82,192
$246,575
15-31
Nominal cost of trade credit
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The firm loses 0.01($3,030,303)
= $30,303 of discounts to obtain
$246,575 in extra trade credit:
rNOM
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= $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.
15-32
Nominal cost of trade credit formula
rNOM
Discount %
365 days
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1 - Discount % Days taken - Disc. period
1
365
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99 40 - 10
 0.1229
 12.29%
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Effective cost of trade credit
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Periodic rate = 0.01 / 0.99 = 1.01%
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Periods/year = 365 / (40-10) = 12.1667
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Effective cost of trade credit
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EAR
= (1 + periodic rate)N – 1
= (1.0101)12.1667 – 1 = 13.01%
15-34
Bank loans
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The firm can borrow $100,000 for 1
year at an 8% nominal rate.
Interest may be set under one of the
following scenarios:
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Simple annual interest
Installment loan, add-on, 12 months
15-35
Simple annual interest
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“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
15-36
Add-on interest
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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 appropriate effective rate, recognize
that the firm receives $100,000 and must make
monthly payments of $9,000 (like an annuity).
15-37
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
15-38