Current Asset Management

1
Current Asset Management

• Chapter 21

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Working Capital Terms

• Working capital (gross working capital)
• Current assets used in operations
• Net working capital
• Current ______ minus current ______
• Net operating working capital (NOWC)
• Operating CA minus operating CL
• (Cash AR Inv) (AP Accruals)
• Working capital management
• Establishing policy and day-to-day control of
  cash, inv, AR, accruals, and AP
• Policy How much of CA plus financing

3
Mini Case Overview

• Ski Equipment Inc. (SKI) has not been creating
  s/h wealth in recent years. Company wants to
  analyze working capital situation. Company knows
  decisions cannot be made in a vacuum. For
  example, if inventories can be lowered, then less
  capital would be required, the dollar cost of
  capital would decline, and EVA would increase.
  However, lower raw materials inventories might
  lead to production slowdowns and higher costs,
  while lower finished goods inventories might lead
  to the loss of profitable sales. So, must study
  operating as well as financial effects of
  inventory changes. Same situation for cash and
  receivables.

4
Selected Ratios
5
Working Capital Policy

• How does SKIs working capital policy compare
  with the industry?
• Reflected in current ratio, quick ratio, turnover
  of cash and securities, inventory turnover, and
  DSO
• Current and quick low but
• Inv. Turnover (Sales/Inv) is LOW
• Lot of inv for each sales
• DSO (Rec/Sales) is HIGH
• Lot of A/R for each sales
• SKI has large amounts of working capital relative
  to its level of sales
• SKI follows a relaxed (fat cat) policy

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Alternative Policies
Current Assets ()
Relaxed
Moderate
Restricted
Sales ()
7
Working Capital Policy

• Is SKI inefficient or just conservative?
• A relaxed policy may be appropriate if it reduces
  risk more than profitability
• SKI is much less profitable than the average firm
  in the industry. Suggesting????

8
Cash Conversion Cycle

• CCC
• Time between payments made for materials and
  labor and payments received from sales
• CCC Inventory Conversion Period Receivables
  Collection Period Payables Deferral Period
• CCC Inventory/(Sales/360)
  Receivables/(Sales/360) Payables/(Cost of
  Goods Sold/360)

9
Cash Conversion Cycle

• SKI Example (rewrite formula)
• CCC (Days Per Year/Inventory Turnover) Days
  Sales Outstanding Payables Deferral Period
• CCC (365/4.82) 45.6 30
• CCC 75.7 45.6 30
• CCC 91.3 days
• What does CCC tell us about working capital
  management?
• Can CCC effect EVA? How?

10
Cash Management

• Cash doesnt earn interest, so why hold it?
• Transactions
• Precaution (safety stock)
• Compensating balances
• Speculation
• bargains, discounts, etc.
• Goal Enough to meet these needs but not one
  dollar more

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Minimizing Cash Holdings

• Use lockboxes
• Insist on wire transfers
• Synchronize flows
• Increase forecast accuracy
• Use marketable securities
• Get line of credit
• Use float
• Difference between cash as shown on the firms
  books and on its banks books
• How can you manage float? Ethical?

12
Cash Budget

• Purpose
• Predict loan needs and funds available for
  temporary investment from forecasts of cash
  inflows, outflows, and ending cash balances
• Timing
• Monthly for annual planning, daily for actual
  cash management

13
SKIs Cash Budgetfor Jan and Feb
14
Cash Budget (Continued)
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Cash Budget

• Depreciation?
• Tax effects
• What are some other potential cash inflows
  besides collections?
• Suppose SKIs cash budget indicates that the
  companys actuals will exceed targets every
  month, except for October and November
• Improve EVA by either
• _______ its excess cash in more productive assets
  
• ________ to the firms shareholders

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Cash Budget

• What reasons might SKI have for maintaining a
  relatively high amount of cash?
• If sales turn out to be considerably less than
  expected -- cash shortfall
• Not much faith in its sales forecast
• Very conservative
• Fund a planned fixed asset acquisition

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Inventory Management

• Categories of Inventory Costs
• ______ Costs
• Storage and handling costs, insurance, property
  taxes, depreciation, and obsolescence
• _______ Costs
• Cost of placing orders, shipping, and handling
  costs
• Costs of ___________
• Loss of sales, loss of customer goodwill, and the
  disruption of production schedules

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Inventory Management

• Reducing the average amount of inventory held
  generally
• Reduces carrying costs
• Increases ordering costs
• Increases probability of stock out

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Inventory Management

• Is SKI holding too much inventory?
• SKIs inventory turnover (4.82) is considerably
  lower than the industry average (7.00)
• Implication?
• Excess inventory
• Carrying costs high - operating costs high - EVA
  low
• Also, must be financed, so EVA is further lowered

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Inventory Management

• If SKI reduces its inventory, without adversely
  affecting sales, what effect will this have on
  its cash position?
• Short run?
• Long run?

21
Accounts Receivable Management

• Do SKIs customers pay more or less promptly than
  those of its competitors?
• SKIs days sales outstanding (DSO) of 45.6 days
  is well above the industry average (32 days)
• Implication?
• Solution?

22
Credit Policy

• Elements
• Cash discounts
• Lowers price. Attracts new customers and reduces
  DSO.
• Credit period
• Shorter period reduces DSO and average A/R, but
  it may discourage sales.
• Credit standards
• Tighter standards reduce bad debt losses, but may
  reduce sales. Fewer bad debts reduces DSO

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Credit Policy

• Collection policy
• Tougher policy will reduce DSO, but may damage
  customer relationships
• Does SKI face any risk if it tightens its credit
  policy?
• If SKI succeeds in reducing DSO without adversely
  affecting sales, what effect would this have on
  its cash position?
• Short run?
• Long run? EVA Impact?

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Accruals

• Do they have a cost?
• Accruals are free in that no explicit interest is
  charged
• Do firms have control over the amount?
• Firms have little control over the level of
  accruals.
• Influenced more by industry custom, economic
  factors, and tax laws

25
Trade Credit

• Trade credit is credit furnished by a firms
  suppliers
• 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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Trade Credit

• SKI buys 506,985 of equipment net of discounts.
  Terms are 1/10, net 30, and pays on Day 40.
• Net purchases are 506,985
• Net means after the discount
• Gross purchases are 506,985/(1-.01) 506,985/.99
  512,106
• Gross means before the discount
• Difference is 5,121
• Buy goods worth 506,985. Cash price.
• Must pay 5,121 if they forego discount
• Financing cost
• Must compare cost to other forms of credit

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Gross/Net Breakdown

• How much free and costly trade credit are they
  getting? What is the cost of the costly trade
  credit?
• Net daily purchases 506,985/365 1,389
• Payables level if discount is taken 1,38910
  13,890
• Payables level if dont take discount 1,38940
  55,560
• Credit Breakdown
• Total trade credit 55,560
• Free trade credit 13,890
• Costly trade credit 41,670

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SKI Trade Credit

• Nominal Cost of Trade Credit
• Firm loses 0.01(512,106) 5,121 of discounts
  to obtain 41,670 in extra trade credit, sornom
  5,121/41,670 12.29
• But the 5,121 in lost discounts is paid all
  during the year, not just at year-end, so the EAR
  is higher

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Nominal Cost Formula(1/10 net 40)
Discount 1 - Discount
365
Days taken - Discount period
rNom x
Pays 1.01 12.167 times per year.
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Effective Annual Rate1/10 net 40

• Periodic rate 0.01/0.99 1.01.
• Periods/year 365/(40 - 10) 12.167
• EAR (1 Periodic rate)n - 1.0
  (1.0101)12.1667 - 1.0 13.01.

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Working Capital Financing Policies

• Maturity matching
• match maturity of assets and liabilities
• Match exactly?
• Aggressive
• use temporary capital to finance some permanent
  assets
• Conservative
• use permanent capital to finance some temporary
  assets

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ST vs. LT Debt

• Advantages of ST Debt
• Low cost-- yield curve usually slopes upward.
• Can get funds relatively quickly.
• Can repay without penalty
• Disadvantages of ST Debt
• Higher risk. The required repayment comes
  quicker, and the company may have trouble rolling
  over loans.

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Other Sources of Funding

• Bank loans
• Notes payable, line of credit, revolving credit
• Commercial paper
• Short term notes issued by large, strong companies