CHAPTER 15 Managing Current AssetsWorking capital terminologySelected ratios for SKI Inc.How does SKI’s working capital policy compare with its industry?Is SKI inefficient or just conservative?Cash conversion cycleSlide 7Cash doesn’t earn a profit, so why hold it?What is the goal of cash management?Ways to minimize cash holdingsWhat is “float”, and how is it affected by the firm’s cash manager?Cash budget: The primary cash management toolSKI’s cash budget: For January and FebruarySKI’s cash budgetShould depreciation be explicitly included in the cash budget?What are some other potential cash inflows besides collections?How could bad debts be worked into the cash budget?Analyze SKI’s forecasted cash budgetWhy might SKI want to maintain a relatively high amount of cash?Types of inventory costsIs SKI holding too much inventory?If SKI reduces its inventory, without adversely affecting sales, what effect will this have on the cash position?Do SKI’s customers pay more or less promptly than those of its competitors?Elements of credit policyDoes 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?15-1CHAPTER 15Managing Current AssetsAlternative working capital policiesCash managementInventory managementAccounts receivable management15-2Working 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.15-3Selected ratios for SKI Inc. SKI Ind. Avg.Current 1.75x 2.25xDebt/Assets 58.76% 50.00%Turnover of cash & securities 16.67x 22.22xDSO (days) 45.63 32.00Inv. turnover 4.82x 7.00xF. A. turnover 11.35x 12.00xT. A. turnover 2.08x 3.00xProfit margin 2.07% 3.50%ROE 10.45% 21.00%15-4How does SKI’s working capital policy compare with its industry?SKI appears to have large amounts of working capital given its level of sales.Working capital policy is reflected in current 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. SKI is either very conservative or inefficient.15-5Is SKI inefficient or just 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.15-6Cash conversion cycleThe cash conversion model 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 = + – .InventoryconversionperiodReceivablescollectionperiodPayablesdeferralperiod15-7Cash conversion cycleCCC = + –CCC = + –CCC = + 46 – 30CCC = 76 + 46 – 30CCC = 92 days.InventoryconversionperiodReceivablescollectionperiodPayablesdeferralperiodDays per yearInv. turnoverPayablesdeferralperiodDays salesoutstanding3654.8215-8Cash doesn’t earn a profit, so why hold it?1. Transactions – must have some cash to operate.2. Precaution – “safety stock”. Reduced by line of credit and marketable securities.3. Compensating balances – for loans and/or services provided.4. Speculation – to take advantage of bargains and to take discounts. Reduced by credit lines and marketable securities.15-9What is the goal of cash management?To meet 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.15-10Ways to minimize cash holdingsUse a lockbox.Insist on wire transfers from customers.Synchronize inflows and outflows.Use a remote disbursement account.Increase forecast accuracy to reduce need for “safety stock” of cash.Hold marketable securities (also reduces need for “safety stock”).Negotiate a line of credit (also reduces need for “safety stock”).15-11What is “float”, and how is it affected by the firm’s cash manager?Float is the difference between cash as shown on the firm’s books and on its bank’s books.If SKI collects checks in 2 days but those to whom SKI writes checks don’t process them for 6 days, then SKI will have 4 days of net float.If a firm with 4 days of net float writes and receives $1 million of checks per day, it would be able to operate with $4 million less capital than if it had zero net float.15-12Cash budget:The primary cash management toolPurpose: Forecasts cash inflows, outflows, and ending cash balances. Used to plan loans needed or funds available to invest.Timing: Daily, weekly, or monthly, depending upon purpose of forecast. Monthly for annual planning, daily for actual cash management.15-13SKI’s cash budget:For January and February Net Cash Inflows Jan FebCollections $67,651.95 $62,755.40Purchases 44,603.75 36,472.65Wages 6,690.56 5,470.90Rent 2,500.00 2,500.00Total payments$53,794.31 $44,443.55Net CF $13,857.64 $18,311.8515-14SKI’s cash budget Net Cash Inflows Jan FebCash at start if no borrowing $ 3,000.00 $16,857.64Net CF 13,857.64 18,311.85Cumulative cash 16,857.64 35,169.49Less: target cash 1,500.00 1,500.00Surplus $15,357.64 $33,669.4915-15Should depreciation be explicitly included in the cash budget?No. Depreciation is a noncash charge. Only cash payments and receipts appear on cash budget.However, depreciation does affect taxes, which appear in the cash budget.15-16What are some other potential cash inflows besides collections?Proceeds from the sale of fixed assets.Proceeds from stock and bond sales.Interest earned.Court settlements.15-17How 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.15-18Analyze SKI’s forecasted cash