Karen Johnson, CFO for Raucous Roasters (RR), a specialty coffee manufacturer, is rethinking her company's working capital policy in light of a recent scare she faced when RR'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 make payroll, potentially forcing the company out of business. Although the line of credit was ultimately 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 the line of credit can be eliminated entirely. In addition to (possibly) freeing RR from the need for a line of credit, Johnson is well aware that reducing working capital will improve free cash flow. Historically, RR has done little to examine working capital, mainly because of poor communication among business functions. In the past, the production manager resisted Johnson's efforts to question his holdings of raw materials, 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 the cash and securities balances. However, with the recent credit scare, this resistance has become unacceptable and Johnson has undertaken a company-wide examination of cash, marketable 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, then less capital would be required, and free cash flow would increase. However, lower raw materials inventories might lead to production slowdowns and higher costs, and lower finished goods inventories might lead to stockouts and loss of 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. Johnson has begun her investigation by collecting the ratios shown here. (The partial cash budget shown after the ratios is used later in this mini case.) RR Industry Current 1.75 2.25 Quick 0.92 1.16 Total liabilities/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 10.80 20.00 Fixed assets turnover 7.75 13.22 Total assets turnover 2.60 3.00 Profit margin on sales Return on equity (ROE) Payables deferral period 2.07% 3.50% 10.45% 21.00% 30.00 33.00 + Cash Budget (Thousands of Dollars) Nov Dec Jan Feb Mar Apr Sales Forecast (1) Sales (gross) $71,218.00 $68,212.00 $65,213.00 $52,475.00 $42,909.00 $30,524.00 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) 12,781.75 10,285.10 47,748.40 45,649.10 (4) During second month after sale: (0.1)(sales 2 months ago) 7,121.80 6,821.20 (5) Total collections (Lines 2+3+4) Purchases $67,651.95 $62,755.40 (6) (0.85)(forecasted sales 2 months from now) Payments (7) Payments (1-month lag) (8) Wages and salaries (9) Rent (10) Taxes $44,603.75 $36,472.65 $25,945.40 44,603.75 36,472.65 6,690.56 5,470.90 2,500.00 2,500.00 (11) Total payments NCFs (12) Cash on hand at start of forecast (13) NCF: Collections - Payments Line 5-Line 11 (14) Cum NCF: Prior + this mos. NCF $53,794.31 $44,443.55 $3,000.00 $13,857.64 $18,311.85 $16,857.64 $35169.49 Cash Surplus (or Loan Requirement) (15) Target cash balance 1,500.00 1,500.00 (16) Surplus cash or loan needed $15,357.64 $33,669.49 a. Johnson plans to use the preceding ratios as the starting point for discussions with RR's operating team. Based on the data, does RR seem to be following a relaxed, moderate, or restricted current asset usage policy? b. 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? c. Calculate the firm's cash conversion cycle given that annual sales are $660,000 and cost of goods sold represents 90% of sales. Assume a 365-day year. d. Is there any reason to think that RR may be holding too much inventory? e. If RR reduces its inventory without adversely affecting sales, what effect should this have on free cash flow: (1) in the short run and (2) in the long run? f. 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? g. Does RR face any risks if it tightens its credit policy? h. If the company reduces its DSO without seriously affecting sales, what effect would this have on free cash flow: (1) in the short run and (2) in the long run? i. What is the impact of higher levels of accruals, such as accrued wages or accrued taxes? Is it likely that RR could make changes to accruals? j. Assume that RR purchases $200,000 (net of discounts) of materials 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. How much free trade credit can the company get from its equipment supplier, how much costly trade credit can it get, and what is the nominal annual interest rate of the costly credit? Should RR take discounts? k. Cash doesn't earn interest, so why would a company have a positive target cash 1. What might RR do to reduce its target cash balance without harming operations? m. RR tries to match the maturity of its assets and liabilities. Describe how RR could adopt either a more aggressive or a more conservative financing policy. n. What are the advantages and disadvantages of using short-term debt as a source of financing? o. Would it be feasible for RR to finance with commercial paper? p. In an attempt to better understand RR's cash position, Johnson developed a cash budget for the first 2 months of the year. She has the figures for the other months, but they are not shown. After looking at the cash budget, answer the following questions. 1. What does the cash budget show regarding the target cash level? 2. Should depreciation expense be explicitly included in the cash budget? Why or why not? 3. What are some other potential cash inflows besides collections? 4. How can interest earned or paid on short-term securities or loans be incorporated in the cash budget? 5. 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.)