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CHAPTER 15 Working Capital Management. Alternative working capital policies Cash management Inventory and A/R management Trade credit Bank loans. Working capital terminology. Gross working capital – total current assets.

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chapter 15 working capital management

CHAPTER 15Working Capital Management

Alternative working capital policies

Cash management

Inventory and A/R management

Trade credit

Bank loans

working capital terminology
Working capital terminology
  • 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.
how does ski s working capital policy compare with its industry
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 relatively inefficient.
is ski inefficient or conservative
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.
working capital financing policies
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.
moderate financing policy


Temp. C.A.



Perm C.A.

L-T Fin:



Spon. C.L.

Fixed Assets


Lower dashed line would be more aggressive.

Moderate financing policy
conservative financing policy




Zero S-T


L-T Fin:



Spon. C.L.

Perm C.A.

Fixed Assets


Conservative financing policy
cash conversion cycle










CCC = + – .

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.
cash doesn t earn a profit so why should the firm hold it
Cash doesn’t earn a profit, so why should the firm hold it?
  • 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.
the goal of cash management
The goal of cash management
  • 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.
minimizing cash holdings
Minimizing cash holdings
  • 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
    • Increase forecast accuracy
    • Hold marketable securities
    • Negotiate a line of credit
cash budget
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.
ski s cash budget for january and february
SKI’s cash budget:For January and February

Net Cash Inflows

Jan Feb

Collections $67,651.95$62,755.40

Purchases 44,603.75 36,472.65

Wages 6,690.56 5,470.90

Rent 2,500.002,500.00

Total payments $53,794.31$44,443.55

Net CF $13,857.64 $18,311.85

ski s cash budget con t
SKI’s cash budget (con’t)

Net Cash Inflows

Jan Feb

Cash at start if

no borrowing $ 3,000.00 $16,857.64

Net CF 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

inventory costs
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.
is ski holding too much inventory
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 Economic Value Added (EVA) is also lowered.
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.
do ski s customers pay more or less promptly than those of its competitors
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.
elements of credit policy
Elements of credit policy
  • Credit Period – How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales.
  • Cash Discounts – Lowers price. Attracts new customers and reduces DSO.
  • Credit Standards – Tighter standards tend to reduce sales, but reduce bad debt expense. Fewer bad debts reduce DSO.
  • Collection Policy – How tough? Tougher policy will reduce DSO but may damage customer relationships.
does ski face any risk if it tightens its credit policy
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.
if ski reduces its dso without adversely affecting sales how would this affect its cash position
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.
short term credit
Short-term credit
  • Debt scheduled for repayment within 1 year.
  • Major sources of short-term credit
    • Accounts payable (trade credit)
    • Bank loans
    • Commercial loans
    • Accruals
  • From the firm’s perspective, S-T credit is riskier than L-T debt.
    • Always a required payment around the corner.
    • May have trouble rolling over loans.
what is trade credit
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.
terms of trade credit
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

breaking down trade credit
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

nominal cost of trade credit
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.
nominal cost of trade credit formula
Nominal cost of trade credit formula

1/10 net 30

NOTE: PAID IN 40 DAYS – Not exactly on the 30th day

effective cost of trade credit
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%

bank loans
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
simple annual interest
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

add on interest
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).
add on interest monthly pmt
Add-on interest, monthly pmt

From the calculator output below, we have:

rNOM = 12 (0.012043)

= 0.1445 = 14.45%

EAR = (1.012043)12 – 1 = 15.45%