Dan Barnes, financial manager of Ski Equipment Inc. (SKI), is excited but apprehensive. The company's founder recently sold his 51% controlling block of shares 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(l - T) - W ACC(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 shareholders' value is being eroded. Korenrewards 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 some EV A data that convinced everyone that SKI had not been creating value in recent years. He then stated, in no uncer- tain terms, that this situation must change. He noted that SKI's designs of skis, boots, and clothing are acclaimed throughout the industry, but that 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 Barnes'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 secur- ities 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

Current Quick Debt/assets Turnover of cash and securities Days' sales outstanding (365-day basis) Inventory turnover Fixed assets turnover Total assets turnover Profit margin Return on equity (ROE) Payables deferral period SKI 1.75 0.83 58.76% 16.67 45.63 4.82 11.35 2.08 2.07% 10.45% 30.00 Industry 2.25 1.20 50.00% 22.22 32.00 7.00 12.00 3.00 3.50% 21.00% 33.00 Nov Dec Jan Feb Mar Apr I. Collections and Purchases Worksheet (1) Sales (gross) $71,218 $68,212 $65,213 $52,475 $42,909 $30,524 12,781.75 10,285.10 Collections (2) During month of sale (0.2)(0.98)(month's sales) (3) During first month after sale (0.7)(previous month's sales) (4) During second month after sale (0.1)(sales 2 months ago) (5) Total collections (Lines 2 + 3 + 4) 47,748.40 45,649.10 7,121.80 6,821.20 $67,651.95 $62,755.40 $44,603.75 $36,472.65 44,603.75 $25,945.40 36,472.65 $67,651.95 $62,755.40 44,603.75 6,690.56 2,500.00 36,472.65 5,470.90 2,500.00 $53,794.31 $44,443.55 Purchases (6) (0.85)(forecasted sales 2 months from now) (7) Payments (1-month lag) II. Cash Gain or Loss for Month (8) Collections (from Section 1) (9) Payments for purchases (from Section 1) (10) Wages and salaries (11) Rent (12) Taxes (13) Total payments (14) Net cash gain (loss) during month (Line 8 - Line 13) III. Cash Surplus or Loan Requirement (15) Cash at beginning of month if no borrowing is done (16) Cumulative cash (cash at start + gain or - loss = Line 14 + Line 15) (17) Target cash balance (18) Cumulative surplus cash or loans outstanding to maintain $1,500 target cash balance (Line 16-Line 17) $13,857.64 $18,311.85 $ 3,000.00 $16,857.64 16,857.64 1,500.00 35,169.49 1,500.00 $15,357.64 $33,669.49 In an attempt to better understand SKI's cash position, Barnes has developed a cash budget. Data for the first 2 months of the year are shown above. (Note that Barnes's preliminary cash budget does not account for interest income or interest expense.) He has the figures for the other months, but they are not shown. i. Is there any reason to think that SKI may be holding too much inventory? If so, how would that affect EVA and ROE? 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