Karen Johnson, CFO for Raucous Roasters (RR), a specialty coffee manufacturer, is rethinking her companys working capital policy in light of a recent scare she faced when RRs corporate banker, citing a nationwide credit crunch, balked at renewing RRs 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 RRs 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 Johnsons 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 became 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 stock-outs 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 below RR Industry Current 1.75 2.25 Quick 0.92 1.16 TL/assets 58.76% 50.00% Turnover of cash 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 2.07% 3.50% Return on equity (ROE) 10.45% 21.00% Payables deferral period 30.00 33.00 a. Johnson plans to use the preceding ratios as the starting point for discussions with RRs operating team. Based on the data, does RR seem to be following a relaxed, moderate, or restricted current asset usage policy? See Ch21 Mini Case Show. 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 RRs working capital policy seem appropriate? See Ch21 Mini Case Show. c. Calculate the firms cash conversion cycle given annual sales are $660,000 and cost of goods sold are 90% of sales. Assume a 365-day year. First, determine the amount of inventory from the firm's inventory turnover ratio. Then, calculate the inventory conversion period from the data given in the problem. Annual sales $660,000 COGS/sales 90% COGS = 0.90 Sales COGS = 0.90 $660,000 COGS = $594,000 Inventory turnover = COGS / Inventory 10.80 = $594,000 / Inventory Inventory = $55,000 Inventory conversion period = Inventory / Daily COGS Inventory conversion period = $55,000 / $1,627.40 Inventory conversion period = 33.8 days Cash Conversion cycle (CCC) = Inventory conversion period + Average collection period Payables Deferral Period CCC = 33.8 + 45.6 30 CCC = 49.4 d. Is there any reason to think that RR may be holding too much inventory? See Ch21 Mini Case Show. 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? See Ch21 Mini Case Show. 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 RRs 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 firms credit policy, and in what direction should each be changed by RR? See Ch21 Mini Case Show. g. Does RR face any risks if it tightens its credit policy? See Ch21 Mini Case Show. h. If the company reduces its DSO without seriously affecting sales, what effect would this have on its free cash flows: (1) in the short run and (2) in the long run? See Ch21 Mini Case Show. 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? See Ch21 Mini Case Show. 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 percentage cost of the costly credit? Should RR take discounts? Terms: free credit period = 10 days. "Official" credit period = 30 days. Credit period taken = 40 Discount = 1% Annual net purchases = $200,000 Annual gross purchases = $202,020 Gross net purchase = $2,020 Company buys goods worth $200,000. Thats the cash price. They must pay $2,020 more over the year if they forego the discount. Think of the extra $2,020 as a financing cost similar to the interest on a loan. Net daily purchases = $548 Payables level if discount is taken: Payables = $548 10 Payables = $5,479 Payables level if dont take discount: Payables = $548 40 Payables = $21,918 Credit Breakdown Total trade credit = $21,918 Free trade credit = $5,479 Costly trade credit = $16,438 Nominal cost of costly trade credit: r(nom) = $2,020 / $16,438 r(nom) = 12.29% But the $2,020 in lost discounts is paid all during the year, not just at year-end, so the EAR is higher. r(nom) = Discount % 365 1 Discount % Days taken Discount period r(nom) = 1 365 99 30 r(nom) = 12.29% Effective Annual Rate Periodic rate = 1% / 99% Periodic rate = 1.01% Periods per year = 365 / ( 40 10 ) Periods per year = 12.2 EAR = (1 + Periodic rate)n 1.0 EAR = 13.01% k. Cash doesnt earn interest, so why would a company have a positive target cash balance? See Ch21 Mini Case Show. l. What might RR do to reduce its target cash balance without harming operations? See Ch21 Mini Case Show. 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. See Ch21 Mini Case Show. n. What are the advantages and disadvantages of using short-term debt as a source of financing? See Ch21 Mini Case Show. o. Would it be feasible for RR to finance with commercial paper? See Ch21 Mini Case Show. p. In an attempt to better understand RRs 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.) See Ch21 Mini Case Show. Cash Balance as presented in the Mini Case Nov Dec Jan Feb Mar Apr Sales Forecast ( 1 ) Sales (gross) $71,218 $68,212 $65,213 $52,475 $42,909 $30,524 Collections ( 2) During month of sale (month's sales) x (0.98) x 0.2 12,781.75 10,285.10 ( 3 ) During first month after sale (previous month's sales) x 0.7 47,748.40 45,649.10 ( 4 ) During second month after sale (sales 2 months ago) x 0.1 7,121.80 6,821.20 ( 5 ) Total collections (Lines 2 + 3 + 4) $67,651.95 $62,755.40 Purchases ( 6 ) During month $44,603.75 $36,472.65 $25,945.40 (forecast sales in 2 months)x 0.85 Payments ( 7 ) Payments (1-month lag) 44,603.75 36,472.65 ( 8 ) Wages and salaries 6,690.56 5,470.90 ( 9 ) Rent 2,500.00 2,500.00 ( 10 ) Taxes ( 11 ) Total payments $53,794.31 $44,443.55 Net Cash Flows ( 12 ) Cash on hand at start of forecast $3,000.00 ( 13 ) NCF: Total Collection Payments (Line 5 Line 11) $13,857.64 $18,311.85 ( 14 ) Cum. NCF: Prior mos. + this mos. NCF $16,857.64 $35,169.49 Cash Surplus (or Loan Requirement) ( 15 ) Target cash balance 1,500.00 1,500.00 ( 16 ) Cumulative surplus cash or loan needed (Line 16 Line 17) $15,357.64 $33,669.49