Historically, RR has done little to examine working capital, mainly because of poor communication among business functions. In the past, the
wide examination of cash, marketable securities, inventory, and accounts receivable levels.
shown after the ratios is used later in this mini case.)
Inventory turnover 10.80 20.00
Fixed assets turnover 7.75 13.22
Total assets turnover 2.60 3.00
Profit margin on sales 2.07% 3.50%
Return on equity (ROE) 10.45% 21.00%
Payables deferral period 30.00 33.00
1
2
3
4
5
6
7
14
15
16
17
18
19
20
21
22
29
30
31
32
37
38
39
40
41
42
43
44
45
A B C D E F G H I J
12/10/2012
EVA = NOPAT – Capital costs
= EBIT(1 – T) – WACC (Total capital employed).
RR Industry
Current 1.75 2.25
Quick 0.92 1.16
TL/assets 58.76% 50.00%
Turnover of cash 16.67 22.22
Days sales outstanding (365-day basis) 45.63 32.00
Karen Johnson, CFO for Raucous Roasters (RR), a specialty coffee manufacturer, is rethinking her company’s working capital policy in light of a
recent scare she faced when RR’s corporate banker, citing a nationwide credit crunch, balked at renewing RR’s line of credit. Had the line of credit
not been renewed, RR would not have been able to make payroll, potentially forcing the company out of business. Although the line of credit was
Chapter 16. Mini Case for Supply Chains and Working Capital Management
If EVA is positive then the firm’s management is creating value. On the other hand, if EVA is negative, then the firm is not covering its cost of
capital and stockholders’ value is being eroded. If RR could generate its current level of sales with fewer assets, it would need less capital. This
would, other things held constant, lower capital costs and increase its EVA.
Johnson also knows that decisions about working capital cannot be made in a vacuum. For example, if inventories could be lowered without
adversely affecting operations, then less capital would be required, the dollar cost of capital would decline, and EVA would increase. However,
1 of 6
goal of determining whether the line of credit can be eliminated entirely. In addition to (possibly) freeing RR from the need for a line of credit,
Synchronize inflows and outflows.
Use float.
Negotiate a line of credit (also reduces need for a “safety stock”). Of course, if RR wants to eliminate the line of credit, it should focus on the
techniques above.
53
54
55
56
57
58
59
60
61
62
63
68
69
70
71
72
88
89
90
91
92
93
97
98
99
100
101
A B C D E F G H I J
=
Inventory / Daily COGS
=$55,000 /$1,627.40
=33.8 days
Cash
Conversion
cycle (CCC)
=
Inventory
conversio
n period
+
Average
collection
period
–
Payables
Deferral
Period
Use lockboxes.
Insist on wire transfers or automatic debit from customers.
c. Calculate the firm’s cash conversion cycle given annual sales are $660,000 and cost of goods sold are 90% of sales. Assume a 365-day year.
Need to determine the amount of inventory from the firm’s inventory turnover ratio. Then, one can calculate the inventory conversion period from
the data given in the problem.
b. How can one distinguish between a relaxed but rational working capital policy and a situation in which a firm simply has excessive current
assets because it is inefficient? Does RR’s working capital policy seem appropriate?
a. Johnson plans to use the preceding ratios as the starting point for discussions with RR’s operating team. She wants everyone to think about the
pros and cons of changing each type of current asset and how changes would interact to affect profits and EVA. Based on the data, does RR seem
to be following a relaxed, moderate, or restricted working capital policy?
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 RR has large amounts of working capital relative to its level of sales. Thus, RR is following a relaxed policy.
d. What might RR do to reduce its cash and securities without harming operations?
Inventory conversion period
Inventory conversion period
Inventory conversion period
2 of 6
industry. This suggests that the company probably has excessive working capital.
( 9 ) Rent 2,500.00 2,500.00
( 10 ) Taxes
( 11 ) Total payments $53,794.31 $44,443.55
( 12 ) Cash on hand at start of forecast $3,000.00
( 14 ) Cum. NCF: Prior mos. + this mos. NCF $16,857.64 $35,169.49
of sales.
108
109
110
111
112
113
114
115
116
117
126
127
128
129
130
131
132
133
142
143
144
145
146
147
148
152
153
154
155
156
157
A B C D E F G H I J
Cash Balance as presented in the Mini Case
Nov Dec Jan Feb Mar Apr
Sales Forecast
( 1 ) Sales (gross) $71,218 $68,212 $65,213 $52,475 $42,909 $30,524
Purchases
( 6 ) During month $44,603.75 $36,472.65 $25,945.40
(forecast sales in 2 months)x 0.85
Payments
( 7 ) Payments (1-month lag) 44,603.75 36,472.65
( 8 ) Wages and salaries 6,690.56 5,470.90
Cash Surplus (or Loan Requirement)
( 15 ) Target cash balance 1,500.00 1,500.00
( 16 ) Cumulative surplus cash or loan needed
(Line 16 – Line 17) $15,357.64 $33,669.49
No! In almost all situations there are bad debts.
In an attempt to better understand RR’s cash position, Johnson developed a cash budget. Data for the first 2 months of the year are shown above.
(Note that Johnson’s preliminary cash budget does not account for interest income or interest expense.) She has the figures for the other months,
but they are not shown.
e. Should depreciation expense be explicitly included in the cash budget? Why or why not?
f. In her preliminary cash budget, Johnson has assumed that all sales are collected and thus that RR has no bad debts. Is this realistic? If not, how
would bad debts be dealt with in a cash budgeting sense? (Hint: Bad debts will affect collections but not purchases.)
3 of 6
( 2) During month of sale
( 3 ) During first month after sale
( 4 ) During second month after sale
( 5 ) Total collections (Lines 2 + 3 + 4) $67,651.95 $62,755.40
161
162
163
164
165
166
167
168
169
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 there, in part, to fund a planned fixed asset acquisition.
so EVA is further lowered.
Long run: Company is likely to then take steps to reduce its cash holdings.
Cash Discounts: Lowers price. Attracts new customers and reduces DSO.
Credit Period: How long to pay? 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.
Collection Policy: Tougher policy will reduce DSO, but may damage customer relationships.
212
YES! A tighter credit policy may discourage sales. Some customers may choose to go elsewhere if they are pressured to pay their bills sooner.
174
175
176
177
181
182
183
184
187
188
189
190
191
194
195
196
197
198
199
200
201
202
207
208
209
A B C D E F G H I J
If sales turn out to be considerably less than expected, RR could face a cash shortfall.
Short run: Cash will increase as inventory purchases decline.
h. What reasons might RR have for maintaining a relatively high amount of cash?
g. Johnson’s cash budget for the entire year, although not given here, is based heavily on her forecast for monthly sales. Sales are expected to be
extremely low between May and September but then to increase dramatically in the fall and winter. November is typically the firm’s best month,
when RR ships its holiday blend of coffee. Johnson’s forecasted cash budget indicates that the company’s cash holdings will exceed the targeted
cash balance every month except for October and November, when shipments will be high but collections will not be coming in until later. Based on
the ratios shown earlier, does it appear that RR’s target cash balance is appropriate? In addition to possibly lowering the target cash balance, what
actions might RR take to better improve its cash management policies, and how might that affect its EVA?
RR’s inventory turnover (12.00) is considerably lower than the industry average (20.00). The firm is carrying a lot of inventory per dollar of sales. By
i. Is there any reason to think that RR may be holding too much inventory? If so, how would that affect EVA and ROE?
l. Does RR face any risks if it tightens its credit policy?
k. Johnson knows that RR sells on the same credit terms as other firms in its industry. Use the ratios presented earlier to explain whether RR’s
customers pay more or less promptly than those of its competitors. If there are differences, does that suggest RR should tighten or loosen its credit
policy? What four variables make up a firm’s credit policy, and in what direction should each be changed by RR?
j. If the company reduces its inventory without adversely affecting sales, what effect should this have on the company’s cash position
(1) in the short run and (2) in the long run? Explain in terms of the cash budget and the balance sheet.
RR’s days’ sales outstanding (DSO) of 45.63 days is well above the industry average (32 days). RR’s customers are paying less promptly. So, RR
should consider tightening its credit policy to reduce its DSO.
4 of 6
Cash budget indicates the company probably is holding too much cash.
Annual net purchases = $200,000
Company buys goods worth $200,000. That’s the cash price.
They must pay $2,020 more over the year if they forego the discount.
Think of the extra $2,020 as a financing cost similar to the interest on a loan.
Credit Breakdown
213
214
215
216
217
221
222
223
224
225
229
230
231
232
233
234
235
236
247
248
249
250
251
252
253
254
255
256
A B C D E F G H I J
Short run: If customers pay sooner, this increases cash holdings.
Terms: free credit period = 10 days.
“Official” credit period = 30 days.
Net daily purchases = $548
Payables level if discount is taken:
Payables = $548 ×10
Payables = $5,479
Payables level if don’t take discount:
Payables = $548 ×40
Payables = $21,918
n. Is it likely that RR could make significantly greater use of accruals?
o. Assume that RR purchases $200,000 (net of discounts) of materials on terms of 1/10, net 30, but that it can get
away with paying on the 40th day if it chooses not to take discounts. How much free trade credit can the company get
from its equipment supplier, how much costly trade credit can it get, and what is the percentage cost of the costly
credit? Should RR take discounts?
m. If the company reduces its DSO without seriously affecting sales, what effect would this have on its cash position (1) in the short run and (2) in
the long run? Answer in terms of the cash budget and the balance sheet. What effect should this have on EVA in the long run?
In addition to improving the management of its current assets, RR is also reviewing the ways in which it finances its current assets. With this
concern in mind, Johnson is also trying to answer the following questions.
5 of 6
May have trouble rolling debt over.
Advantages of short-term debt.
Typically lower cost.
Can repay without penalty.
market at rates just above the T-bill rate. CP is bought by banks and other companies, then held as marketable securities for liquidity purposes.
263
264
265
266
267
268
288
289
290
291
292
293
294
295
296
297
298
304
305
306
307
308
A B C D E F G H I J
Nominal cost of costly trade credit:
r(nom) = $2,020 /$16,438
r(nom) = 12.29%
But the $2,020 in lost discounts is paid all during the year, not just at year-end, so the EAR is higher.
Aggressive: Uses short-term (temporary) capital to finance some permanent current operating assets.
Conservative: Uses long-term (permanent) capital to finance some temporary current operating assets.
Short-term debt is riskier than long-term debt for the borrower.
Short-term rates may rise.
Commercial paper (CP) are short term notes issued by large, strong companies. RR could not issue CP; the company is too small. CP trades in the
r. Would it be feasible for RR to finance with commercial paper?
p. RR tries to match the maturity of its assets and liabilities. Describe how RR could adopt either a more aggressive
or more conservative financing policy.
q. What are the advantages and disadvantages of using short-term debt as a source of financing?
6 of 6
r(nom) = 12.29%
Effective Annual Rate
Periodic rate = 1% /99%
Periodic rate = 1.01%
Periods per year = 365 /( 40 – 10 )
Periods per year = 12.2
EAR = 13.01%