22 - CHAPTER 22 Working Capital Management  Alternative working capital policies  Cash, inventory, and A/R management  Accounts payable management  Short-term financing policies  Bank debt and commercial paper 22 - Basic Definitions  Gross working capital: Total current assets  Net working capital: Current assets - Current liabilities  Net operating working capital (NOWC): Operating CA – Operating CL = (Cash + Inv + A/R) – (Accruals + A/P) (More…) 22 -  Working capital management: Includes both establishing working capital policy and then the day-to-day control of cash, inventories, receivables, accruals, and accounts payable  Working capital policy: The level of each current asset How current assets are financed 22 - Selected Ratios for SKI SKI Industry Current Quick Debt/Assets Turnover of cash DSO (365-day basis) Inv turnover F A turnover T A turnover Profit margin ROE Payables deferral 1.75x 0.83x 58.76% 16.67x 45.63 4.82x 11.35x 2.08x 2.07% 10.45% 30.00 2.25x 1.20x 50.00% 22.22x 32.00 7.00x 12.00x 3.00x 3.50% 21.00% 33.00 22 - How does SKI’s working capital policy compare with the industry?  Working capital policy is reflected in a firm’s current ratio, quick ratio, turnover of cash and securities, inventory turnover, and DSO  These ratios indicate SKI has large amounts of working capital relative to its level of sales Thus, SKI is following a relaxed policy 22 - Is SKI inefficient or just conservative?  A relaxed policy may be appropriate if it reduces risk more than profitability  However, SKI is much less profitable than the average firm in the industry This suggests that the company probably has excessive working capital 22 - Cash Conversion Cycle The cash conversion cycle focuses on the time between payments made for materials and labor and payments received from sales: Cash Inventory Receivables Payables conversion = conversion + collection - deferral cycle period period period 22 - Cash Conversion Cycle (Cont.) Payables CCC = Days per year + Days sales – deferral Inv turnover outstanding period CCC = 365 + 45.6 – 30 4.82 CCC = 75.7 + 45.6 – 30 CCC = 91.3 days 22 - Cash Management: Cash doesn’t earn interest, so why hold it?  Transactions: Must have some cash to pay current bills  Precaution: “Safety stock.” But lessened by credit line and marketable securities  Compensating balances: For loans and/or services provided  Speculation: To take advantage of bargains, to take discounts, and so on Reduced by credit line, marketable securities 22 - 10 What’s the goal of cash management?  To have sufficient cash on hand to meet the needs listed on the previous slide  However, since cash is a non-earning asset, to have not one dollar more 22 - 30 If SKI succeeds in reducing DSO without 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 in more productive assets, or pay it out to shareholders Both of these actions would increase EVA 22 - 31 Is there a cost to accruals? Do firms have much control over amount of accruals?  Accruals are free in that no explicit interest is charged  Firms have little control over the level of accruals Levels are influenced more by industry custom, economic factors, and tax laws 22 - 32 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 22 - 33 SKI buys $506,985 net, on terms of 1/10, net 30, and pays on Day 40 How much free and costly trade credit, and what’s the cost of costly trade credit? Net daily purchases = $506,985/365 = $1,389 Annual gross purch = $506,985/(1-0.01) =$512,106 22 - 34 Gross/Net Breakdown  Company buys goods worth $506,985 That’s the cash price  They must pay $5,121 more if they don’t take discounts  Think of the extra $5,121 as a financing cost similar to the interest on a loan  Want to compare that cost with the cost of a bank loan 22 - 35 Payables level if take discount: Payables = $1,389(10) = $13,890 Payables level if don’t take discount: Payables = $1,389(40) = $55,560 Credit Breakdown: Total trade credit Free trade credit Costly trade credit = $55,560 = 13,890 = $41,670 22 - 36 Nominal Cost of Costly Trade Credit Firm loses 0.01($512,106) = $5,121 of discounts to obtain $41,670 in extra trade credit, so $5,121 rNom = $41,670 = 0.1229 = 12.29% But the $5,121 is paid all during the year, not at year-end, so EAR rate is higher 22 - 37 Nominal Cost Formula, 1/10, net 40 rNom Discount % 365 days = × − Discount % Days Discount − taken period 365 = × = 0.0101× 12.1667 99 30 = 0.1229 = 12.29% Pays 1.01% 12.167 times per year 22 - 38 Effective Annual Rate, 1/10, net 40 Periodic rate = 0.01/0.99 = 1.01% Periods/year = 365/(40 – 10) = 12.1667 EAR = (1 + Periodic rate)n – 1.0 = (1.0101)12.1667 – 1.0 = 13.01% 22 - 39 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 22 - 40 Moderate Financing Policy $ Temp NOWC } Perm NOWC S-T Loans L-T Fin: Stock & Bonds, Fixed Assets Years Lower dashed line, more aggressive 22 - 41 Conservative Financing Policy $ Marketable Securities Zero S-T debt Perm NOWC L-T Fin: Stock & Bonds Fixed Assets Years 22 - 42 What are the advantages of short-term debt vs long-term debt?  Low cost yield curve usually slopes upward  Can get funds relatively quickly  Can repay without penalty 22 - 43 What are the disadvantages of shortterm debt vs long-term debt?  Higher risk The required repayment comes quicker, and the company may have trouble rolling over loans 22 - 44 Commercial Paper (CP)  Short term notes issued by large, strong companies SKI couldn’t issue CP it’s too small  CP trades in the market at rates just above T-bill rate  CP is bought with surplus cash by banks and other companies, then held as a marketable security for liquidity purposes .. .22 - Basic Definitions  Gross working capital: Total current assets  Net working capital: Current assets - Current liabilities  Net operating working capital (NOWC): Operating... (More…) 22 -  Working capital management: Includes both establishing working capital policy and then the day-to-day control of cash, inventories, receivables, accruals, and accounts payable  Working. .. 10.45% 30.00 2.25x 1.20x 50.00% 22. 22x 32.00 7.00x 12.00x 3.00x 3.50% 21.00% 33.00 22 - How does SKI’s working capital policy compare with the industry?  Working capital policy is reflected in