Chapter 17

Working Capital
Management
▪ Alternative Working Capital Policies
▪ Cash Management
▪ Inventory and A/R Management
▪ Trade Credit
▪ Bank Loans
17-1
Working Capital Terminology

▪ Working capital – 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.

17-2
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%
17-3
How does SKI’s working capital
policy compare with its industry?
▪ 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.

17-4
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
working capital.

17-5
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.

17-6
Moderate Financing Policy

$ Temp. C.A.
S-T
Loans

Perm C.A. L-T Fin:

Stock,
Bonds,
Spon. C.L.
Fixed Assets

Years
Lower dashed line would be more aggressive.
17-7
Conservative Financing Policy

Marketable
$ securities
Zero S-T
Debt

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

Fixed Assets
Years
17-8
Cash Conversion Cycle

▪ 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

17-9
Cash Conversion Cycle

Inventory Receivables Payables

CCC = conversion + collection − deferral
period period period
Payables
Days per year Days sales
CCC = + − deferral
Inventory turnover outstanding period
365
CCC = + 46 − 30
4.82
CCC = 76 + 46 − 30 = 92 days

17-10
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

17-11
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.

17-12
SKI’s Cash Budget for January and
February
Net Cash Inflows
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
Net cash flows $13,857.64 $18,311.85

17-13
SKI’s Cash Budget

Net Cash Inflows

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

17-14
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.

17-15
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.

17-16
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.

17-17
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.
17-18
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 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.

17-19
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.
▪ Long run: Company is likely to take steps to
reduce its cash holdings and increase its EVA.

17-20
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.

17-21
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 – 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.

17-22
Does SKI face any risk if it tightens
its credit policy?
▪ Yes, a tighter 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.

17-23
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.
▪ 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.

17-24
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.

17-25
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

17-26
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

17-27
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.

17-28
Nominal Cost of Trade Credit Formula

Discount % 365 days

rNOM = 
1 − Discount % Days taken − Disc. period
1 365
= 
99 40 − 10
= 0.1229
= 12.29%

17-29
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%

17-30
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

17-31
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.

17-32
Add-on Interest

▪ 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).
17-33
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 12 100 -9 0

N I/YR PV PMT FV

OUTPUT 1.2043

17-34