Karen Johnson, CFO for Raucous Roasters (RR), a specialty coffee manufacturer, is re-thinking 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 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.)

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 doesnt earn interest, so why would a company have a positive target cash balance?

l. 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?