Chapter 16

Working Capital
Management

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 Overview

• Alternative Working Capital Policies

• Cash Management

• Inventory and A/R Management

• Trade Credit

• Bank Loans

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 Working Capital Terminology

• Working capital: current assets.

• Net working capital: current assets minus current liabilities.
• Net operating working capital: operating current assets – operating current
liabilities.
• 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.

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 Selected Ratios for SKI Inc.
SKI Ind. Avg
Current ratio 2.25x
1.75x
Debt/Assets
58.76% 50.00%
Turnover of cash & securities 22.22x
16.67x
Days sales outstanding 32.00
45.63
Inventory turnover 7.00x
4.82x
Fixed assets turnover 12.00x
11.35x
Total assets turnover 3.00x
2.08x
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 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.

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 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.

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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.

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 Moderate Financing Policy

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 Conservative Financing Policy

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 Cash Conversion Cycle (1 of 2)

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.

CCC = Inventory conversion period + Average collection

period − Payables deferral period

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 Cash Conversion Cycle (2 of 2)

CCC = Inventory conversion period + Average collection period  Payables

deferral period

CCC = Days per year/Inventory turnover + Days sales outstanding  Payables

deferral period

CCC = 365/4.82 + 46  30

CCC = 76 + 46  30 = 92 days

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 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

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 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.

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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
NetBrigham
cash flows
& Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned,
copied or duplicated, or posted to a publicly accessible website, $13,857.64
in whole or in part. $18,311.85 14
 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
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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.

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 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.

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 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.

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 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.

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 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 cost of goods sold.

• 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.

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 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 needed.

• 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.

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 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.

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 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.

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 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.

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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.

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 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.

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 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

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 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
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 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.

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 Nominal Cost of Trade Credit Formula

rNOM = [Discount %/(100  Discount %)]

 [365 days/(Days credit outstanding  Discount period)]

= 1/99  365/(40  10)

= 0.1229

= 12.29%

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 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%

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 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

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 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.

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 Add-on Interest (1 of 2)

• 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).

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 Add-on Interest (2 of 2)

From the calculator output below, we have:

rNOM = 12 (0.012043)
= 0.1445 = 14.45%
EAR = (1.012043)12 – 1 = 15.45%

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