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Barnes has long believed that SKI’s working capital situation should be
studied—the company may have the optimal amounts of cash, securities,
receivables, and inventories; but it may also have too much or too little of
A. Barnes plans to use the ratios in Table IC 16.1 as the starting point
for discussions with SKI’s operating executives. He wants everyone
to think about the pros and cons of changing each type of current
asset and the way changes would interact to affect profits and EVA.
Based on the data in Table IC 16.1, does SKI seem to be following a
relaxed, moderate, or restricted current assets investment policy?
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Table IC 16.1. Selected Ratios: SKI and Industry Average
SKI Industry
Current 1.75 2.25
Debt/assets 58.76% 50.00%
Turnover of cash and securities 16.67 22.22
Days sales outstanding (365-day basis) 45.63 32.00
Inventory turnover 4.82 7.00
Fixed assets turnover 11.35 12.00
Total assets turnover 2.08 3.00
Profit margin 2.07% 3.50%
Return on equity (ROE) 10.45% 21.00%
Answer: [Show S16-1 through S16-4 here.] A company with a relaxed
current assets investment policy would carry relatively large
B. How can we distinguish between a relaxed but rational current
assets investment policy and a situation where a firm has a large
amount of current assets due to inefficiency? Does SKI’s current
assets investment policy seem appropriate? Explain.
Answer: [Show S16-5 here.] SKI may choose to hold large amounts of
inventory to avoid the costs of “running short,” and to cater to
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C. SKI tries to match the maturity of its assets and liabilities. Describe
how SKI could adopt a more aggressive or a more conservative
financing policy.
Answer: [Show S16-6 through S16-8 here.] With an aggressive financing
policy, some of SKI’s permanent assets would be financed with
short-term debt. Of course, there are different degrees of
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D. Assume that SKI’s payables deferral period is 30 days. Now
calculate the firm’s cash conversion cycle estimating the inventory
conversion period as 365/Inventory turnover.
Answer: [Show S16-9 and S16–10 here.] A firm’s cash conversion cycle is
calculated as:
.
conversion
Cash
deferral
Payables
collection
sReceivable
conversion
Inventory
=−+
E. What might SKI do to reduce its cash and securities without
harming operations?
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Answer: [Show S16-11 here.] To the extent that “cash and securities”
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In an attempt to better understand SKI’s cash position, Barnes developed a cash budget.
Table IC 16.2. SKI’s Cash Budget for January and February
Nov Dec Jan Feb Mar Apr
I. Collections and Purchases Worksheet
(1) Sales (gross) $71,218 $68,212.00 $65,213.00 $52,475.00 $42,909 $30,524
Collections
Purchases
(6) (0.85)(forecasted sales
2 months from now) $44,603.75 $36,472.65 $25,945.40
III. Cash Surplus or Loan Requirement
(15) Cash at beginning of month
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F. In his preliminary cash budget, Barnes has assumed that all sales
are collected and, thus, that SKI has no bad debts. Is this realistic?
If not, how would bad debts be dealt with in a cash budgeting
sense? (Hint: Bad debts affect collections but not purchases.)
Answer: [Show S16-12 through S16–15 here.] It is not realistic to assume
zero bad debts. When credit is granted, bad debts should be
G. Barnes’s cash budget for the entire year, although not given here, is
based heavily on his forecast for monthly sales. Sales are expected to
be extremely low between May and September but then increase
dramatically in the fall and winter. November is typically the firm’s
best month, when SKI ships equipment to retailers for the holiday
season. Interestingly, Barnes’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 in Table IC 16.1, does it appear that SKI’s target cash balance is
appropriate? In addition to possibly lowering the target cash balance,
what actions might SKI take to better improve its cash management
policies and how might that affect its EVA?
Answer: [Show S16-16 and S16-17 here.] The company’s turnover of cash
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H. Is there any reason to think that SKI may be holding too much
inventory? If so, how would that affect EVA and ROE?
Answer: [Show S16–18 and S16-19 here.] As pointed out in Part a, SKI’s
inventory turnover (4.82) is considerably lower than the average
I. 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.
Answer: [Show S16-20 here.] Reducing inventory purchases will increase the
company’s cash holdings in the short run, thus reducing the amount
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J. Barnes knows that SKI sells on the same credit terms as other firms
in the industry. Use the ratios presented in Table IC 16.1 to explain
whether SKI’s customers pay more or less promptly than those of
its competitors. If there are differences, does that suggest that SKI
should restrict or relax its credit policy? What four variables make
up a firm’s credit policy, and in what direction should each be
changed by SKI?
Answer: [Show S16-21 and S16-22 here.] SKI’s DSO is 45.63 days as
compared with 32 days for the average firm in its industry. This
suggests that SKI’s customers are paying less promptly than those
dollar cost of the discounts. The effect on bad debt expense is
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indeterminate. If the firm restricted its credit policy it is unclear
what the firm would do with its cash discount policy. The firm
could decrease the discount period and keep discounts unchanged.
In order to qualify for credit in the first place, customers must
meet the firm’s credit standards. These dictate the minimum
Finally, collection policy refers to the procedures that the firm
follows to collect past-due accounts. These can range from a simple
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K. Does SKI face any risks if it restricts its credit policy? Explain.
Answer: [Show S16-23 here.] A restrictive credit policy may discourage
L. If the company reduces its DSO without seriously affecting sales,
what effect will 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?
Answer: [Show S16-24 here.] If customers pay their bills sooner, this will
increase the company’s cash position in the short run, which would
M. Assume that SKI buys 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.
Also, assume that it purchases $3 million of components per year, net
of discounts. How much free trade credit can the company get, how
much costly trade credit can it get, and what is the percentage cost of
the costly credit? Should SKI take discounts? Why or why not?
Answer: [Show S16-25 through S16–30 here.] If SKI’s net purchases are
$3,000,000 annually, then with a 1% discount, its gross purchases
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Therefore:
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N. Suppose SKI decided to raise an additional $100,000 as a 1-year
loan from its bank, for which it was quoted a rate of 8%. What is
the effective annual cost rate assuming simple interest and add-on
interest on a 12-month installment loan?
Answer: [Show S16-31 through S16–34 here.] For a simple interest loan, the
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