Intermediate Finance

Front 1

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?

Back 1

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.

Front 2

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?

Back 2

A relaxed policy may be appropriate if it reduces risk more than profitability. However, RR is much less profitable than the average firm in the industry. This suggests that the company probably has excessive working capital.

Front 3

Working Capital, Mini Case Model d. What might RR do to reduce its cash and securities without harming operations?

Back 3

Working Capital, Mini Case Model Use lockboxes. Insist on wire transfers or automatic debit from customers. Synchronize inflows and outflows. Use float. Increase forecast accuracy to reduce the need for a cash “safety stock.” Hold marketable securities instead of a cash “safety stock.” 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.

Front 4

Working Capital, Mini Case Model e. Should depreciation expense be explicitly included in the cash budget? Why or why not?

Back 4

Working Capital, Mini Case Model No. Depreciation is a noncash charge. Only cash payments and receipts appear on the cash budget. However, depreciation does affect taxes, which do appear in the cash budget.

Front 5

Working Capital, Mini Case Model 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.)

Back 5

Working Capital, Mini Case Model No! In almost all situations there are bad debts.

Front 6

Working Capital, Mini Case Model 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?

Back 6

Working Capital, Mini Case Model Cash budget indicates the company probably is holding too much cash.

Working Capital, Mini Case Model RR could improve its EVA by either investing its excess cash in more productive assets or by paying it out to the firm’s shareholders.

Front 7

Working Capital, Mini Case Model h. What reasons might RR have for maintaining a relatively high amount of cash?

Back 7

Working Capital, Mini Case Model If sales turn out to be considerably less than expected, RR 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 there, in part, to fund a planned fixed asset acquisition.

Front 8

Working Capital, Mini Case Model i. Is there any reason to think that RR may be holding too much inventory? If so, how would that affect EVA and ROE?

Back 8

Working Capital, Mini Case Model 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 holding excessive inventory, the firm is increasing its operating costs which reduce its NOPAT. Moreover, the excess inventory must be financed, so EVA is further lowered.

Front 9

Working Capital, Mini Case Model 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.

Back 9

Working Capital, Mini Case Model Short run: Cash will increase as inventory purchases decline. Long run: Company is likely to then take steps to reduce its cash holdings.

Front 10

Working Capital, Mini Case Model 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?

Back 10

Working Capital, Mini Case Model 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. 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.

Front 11

Working Capital, Mini Case Model l. Does RR face any risks if it tightens its credit policy?

Back 11

Working Capital, Mini Case Model YES! A tighter credit policy may discourage sales. Some customers may choose to go elsewhere if they are pressured to pay their bills sooner.

Front 12

Working Capital, Mini Case Model 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?

Back 12

Working Capital, Mini Case Model 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.

Front 13

Working Capital, Mini Case Model n. Is it likely that RR could make significantly greater use of accruals?

Back 13

Working Capital, Mini Case Model Accruals are free in the sense that no explicit interest is charged. However, firms have little control over accrual levels, which are influenced more by industry custom, economic factors, and tax laws than by managerial actions.

Front 14

Working Capital, Mini Case Model 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.

Back 14

Working Capital, Mini Case Model 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.

Front 15

Working Capital, Mini Case Model q. What are the advantages and disadvantages of using short-term debt as a source of financing?

Back 15

Working Capital, Mini Case Model Short-term debt is riskier than long-term debt for the borrower. Short-term rates may rise. May have trouble rolling debt over. Advantages of short-term debt. Typically lower cost. Can get funds relatively quickly with low transactions costs. Can repay without penalty.

Front 16

Working Capital, Mini Case Model r. Would it be feasible for RR to finance with commercial paper?

Back 16

Working Capital, Mini Case Model 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 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.