Mini Case

Dan Barnes, financial manager of Ski Equipment Inc. (SKI), is excited but apprehensive. The companys 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:

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. Koren rewards 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 SKIs senior executives to tell them of his plans for the company. First, he presented some EVA data that convinced everyone that SKI had not been creating value in recent years. He then stated, in no uncertain terms, that this situation must change. He noted that SKIs 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 SKIs managers to correct the problem or else.

Barnes has long felt that SKIs working capital situation should be studiedthe 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 Barness 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 securities balances. Korens 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 collecting the ratios shown below.

	SKI	Industry
Current	1.75	2.25
Quick	0.83	1.20
Debt/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	4.82	7.00
Fixed assets turnover	11.35	12.00
Total assets turnover	2.08	3.00
Profit margin	2.07%	3.50%
Return on equity (ROE)	10.45%	21.00%
Payables deferral period	30.00	33.00

Barnes plans to use the preceding ratios as the starting point for discussions with SKIs operating executives. He wants everyone to think about the pros and cons of changing each type of current asset and how changes would interact to affect profits and EVA. Based on the data, does SKI seem to be following a relaxed, moderate, or restricted working capital policy?

How can one distinguish between a relaxed but rational working capital policy and a situation in which a firm simply has a lot of current assets because it is inefficient? Does SKIs working capital policy seem appropriate?

Calculate the firms cash conversion cycle.

What might SKI do to reduce its cash without harming operations?

In an attempt to better understand SKIs cash position, Barnes has developed a cash budget. Data for the first 2 months of the year are shown above. (Note that Barness 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.

Should depreciation expense be explicitly included in the cash budget? Why or why not?

In his preliminary cash budget, Barnes has assumed that all sales are collected and, thus, that SKI 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.)

Barness cash budget for the entire year, although not given here, is based heavily on his forecast for monthly sales. Sales are expected to be extremely low between May and September but then increase dramatically in the fall and winter. November is typically the firms best month, when SKI ships equipment to retailers for the holiday season. Interestingly, Barness forecasted cash budget indicates that the companys cash holdings will exceed the targeted cash balance every month except for October and November, when shipments will be high but collections will not be coming in until later. Based on the ratios shown earlier, does it appear that SKIs target cash balance is appropriate? In addition to possibly lowering the target cash balance, what actions might SKI take to better improve its cash management policies, and how might that affect its EVA?

What reasons might SKI have for maintaining a relatively high amount of cash?

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

If the company reduces its inventory without adversely affecting sales, what effect should this have on the companys cash position

• (1)

in the short run and

• (2)

in the long run? Explain in terms of the cash budget and the balance sheet.

Is it likely that SKI could make significantly greater use of accruals?

Assume that SKI buys 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. Also, assume that it purchases $506,985 of equipment per year, net of discounts. How much free trade credit can the company get, how much costly trade credit can it get, and what is the percentage cost of the costly credit? Should SKI take discounts?

SKI tries to match the maturity of its assets and liabilities. Describe how SKI could adopt either a more aggressive or more conservative financing policy.

What are the advantages and disadvantages of using short-term debt as a source of financing?

Would it be feasible for SKI to finance with commercial paper?

Mov Dec Jan Feb Mar Apr I. Collections and Purchases Workshect (i) 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) 12,781.7510,285.10 (3) During first month after sale (0.7) (previous month's sales) (4) During second month after sale (0.1)(sales2 months ago) \begin{tabular}{|c|c|} \hline 47,748.0 & 45,642.10 \\ \hline 7,121.80 & 6,821.20 \\ \hline$67,651 L95 & $62,755.40 \\ \hline \end{tabular} (5) Total collections (Lines 2+3+4) Purchases (6) (0.85)( forecasted sales 2 months from now) \begin{tabular}{rrr} $44,603.75 & $36,472.65 & $25,945,40 \\ 44,603.75 & 36,472.65 \end{tabular} (7) Payments (1-month lag) II. Cash Increase or Decrease for Month (8) Collections (from Section I) \begin{tabular}{rr} $67,651.95 & $62,755.40 \\ 44,603.75 & 36,472.65 \\ 6,690.56 & 5,470.90 \\ 2,500.00 & 2,500.00 \\ \hline \end{tabular} (9) Payments for parchases (from Section I) (10) Wages and salaries (11) Rent (12) Taxes (13) Total payments \begin{tabular}{|c|c|} \hline$53,794.31 & $44,443,55 \\ \hline$13,857.64 & $18,311.85 \\ \hline \end{tabular} (14) Net cash increase (decrease) during month (Line 8 - Line 13) III. Cash Surplus or Loan Requirement (15) Cash at beginning of month if no borrowing is done $3,000.00$16,857.64 (16) Cumulative cash (cash at start + increase or decrease = Line 14+ Line 15) (17) Target cash balance (18) Cumulative surplas cash or loans outstanding to maintain \$1,500 target cash balance (Line 16 - Line 17) $15,357.64$33,662.49