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 it purchases $506,908 of equipment 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?

Dan Barnes, financial manager of Ski Equipment Inc. (SKI), is excited but apprehensive. The company's founder recently sold his 51 % controlling block of crock to Kent Koren, who is a big fan of EVA (Economic Value Added). EVA is found by taking the after-tax operating profit and then subtracting the dollar cost of all the capital the firm uses:

EVA = NOPAT - Capital costs

= EBIT (1 - T) – WACC (Capital employed)

If EVA is positive, then the firm is creating value. On the other hand, if EVA is negative, the firm is not covering its cost of capital, and stockholders' value is being eroded. Koren rewards managers handsomely if they create value, but those whose operations produce negative EVAs are soon looking for work. Koren frequently points out that if a company could generate its current level of sales with fewer assets, it would need less capital. That would, other things held constant, lower capital costs and increase its EVA.

Shortly after he took control of SKI, Kent Koren met with SKI's senior executives to tell them of his plans for the company. First, he presented sonic EVA data that convinced everyone that SKI had not been creating value in recent years. He then stated, in no uncertain terms, that this situation must change. He noted that SKI's designs of skis, boots, and clothing are acclaimed throughout the industry, but something is seriously amiss elsewhere in the company. Costs are too high, prices are too low, or the company employs too much capital, and he wants SKI's managers to correct the problem or else.

Barnes has long felt 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 these items. In the past, the production manager resisted Barne's efforts to question his holdings of raw materials inventories, the marketing manager resisted questions about finished goods, the sales staff resisted questions about credit policy (which affects accounts receivable), and the treasurer did not want to talk about her cash and securities balances. Koren's speech made it clear that such resistance would no longer be tolerated.

Barnes 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, lower raw materials inventories might lead to production slowdowns and higher costs, while lower finished goods inventories might lead to the loss of profitable sales. So, before inventories are changed, it will be necessary to study operating as well as financial effects. The situation is the same with regard to cash and receivables. Barnes began collecting the ratios shown on the next page.

In an attempt to better understand SKI's cash position, Barnes developed a cash budget. Data for the first 2 months of the year are shown above. He has the figures for the other for the other months but they are notshown.

Transcribed Image Text:

SKI Industry Current Quick Debt/assets Turnover of cash and securities Days sales outstanding 1365-day basis) Inventory turnover Fixed assets turnover Total assets turnover Profit margin on sales Return on equity (ROE Payables deferral period 1.75 0.83 58.76% 16.67 45.63 4.82 11.35 2.08 2A7% 10.45% 0.00 2.25 1.20 50.00% 22.22 32.00 7.00 12.00 3.00 3.50% 21.00% 33.00 Nov Dec Feb Mar Apt L Collections and Purchases Worksheet ) Sales (gross 71,218.00 68212.00 $65,213,00 $52,475.00$42.909.00 $30,524.00 Collections During month of ale 3) During tirst month ater sale (4) During second month after sale 5) Total collections (Lines 2+3+4 (0,2)(0.98-(month's salesl 0.7 previous month's salesi o.1)sakes 2 months ago 12,78175 10,285.10 7,748.404L9.10 121.806821.20 96765195 562,75540 Purchases 6) (0.85forecasted sales 2 months from now 44,603.75 $36,47265 25,945,40 44,003.73 6,472 IL. Cash Gain or Loss for Month 1B) Collections from Section l 9) Payments for purchases $67 65195 $62,755.40 from Section D 44,603.75 36,472.65 6,690.56 5,470,90 10) Wages and salaries (11) Rent (12) Taxes 13) Total payments 14) Net cash gain loss) during month 53 7943 54444355 Line 8-Line 13 $13857 64 S1831185 IL. Cash Surplus or Loan Requirement (15) Cash at beginning of month if no borrowing is done $ 300002 $16857 (16 Cumulative cash (cash at start+ gain or loss Line 14 + Line 15 16,85764 35,169.49 17) Target cash balance 18) Cumulative surplus cash or laans outstanding to mainluin $1,500 target cash balance iLine 16-Line 17) 33669 4