Karen Johnson, CFO for Raucous Roasters (RR), a specialty coffee manufacturer, isrethinking her company s working capital policy in light of a recent scare she faced whenRR 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 makepayroll, potentially forcing the company out of business. Although the line of credit wasultimately renewed, the scare has forced Johnson to examine carefully each component of RR s working capital to make sure it is needed, with the goal of determining whether theline of credit can be eliminated entirely. In addition to (possibly) freeing RR from the needfor a line of credit, Johnson is well aware that reducing working capital can also add valueto a company by improving its EVA (Economic Value Added). In her corporate financecourse Johnson learned that EVA is calculated by taking net operating profit after taxes(NOPAT) and then subtracting the dollar cost of all the capital the firm uses: EVA NOPAT Capital costs EBIT 1 T WACC Total capital employed

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 isbeing eroded. If RR could generate its current level of sales with fewer assets, it wouldneed less capital. This would, other things held constant, lower capital costs and increaseits EVA.Historically, RR has done little to examine working capital, mainly because of poorcommunication among business functions. In the past, the production manager resistedJohnson s efforts to question his holdings of raw materials, the marketing managerresisted questions about finished goods, the sales staff resisted questions about creditpolicy (which affects accounts receivable), and the treasurer did not want to talk about thecash and securities balances. However, with the recent credit scare, this resistance becameunacceptable and Johnson has undertaken a company-wide examination of cash, market-able securities, inventory, and accounts receivable levels.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, thenless capital would be required, the dollar cost of capital would decline, and EVA wouldincrease. However, lower raw materials inventories might lead to production slowdownsand higher costs, and lower finished goods inventories might lead to stock-outs and loss of sales. So, before inventories are changed, it will be necessary to study operating as well asfinancial effects. The situation is the same with regard to cash and receivables. Johnsonhas begun her investigation by collecting the ratios shown below. (The partial cash budgetshown after the ratios is used later in this mini case.)

a. Johnson plans to use the preceding ratios as the starting point for discussions withRR 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 profitsand EVA. Based on the data, does RR seem to be following a relaxed, moderate, orrestricted working capital policy?

b. How can one distinguish between a relaxed but rational working capital policy and asituation in which a firm simply has excessive current assets because it is inefficient?Does RR s working capital policy seem appropriate?

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