Under "Mistake 1: Managing to the Income Statement," starting in about the fifth paragraph of that section, the Note talks about a metals refining firm that decided to bother its clients with calls reminding them to pay their bills on time, something they had never done in the past and something their sales people said "will drive customers to the competition." The Note states that it did cause sales to decline for the firm.

Which answer below best states the relevant working capital facts and analysis of how that change created a positive financial benefit?

CASE NOTE: The Jones Electrical case has facts about ways to create an overall positive financial benefit for the company through different management of working capital accounts. Look for a similar opportunity in that case as the one found in the metals refining firm of the Note.

Mistake 1: Managing to the Income Statement The first favor you can do your company in a downturn is throw any profitability performance measures you may be using out the window. Suppose you are a purchasing manager and your performance is judged largely by your contribution to reported profits. Chances are, a supplier will at some point propose that you buy more supplies than you need in return for a discount. If you accept the offer, you will have to lock up cash in holding the extra inventory. But since inventory costs do not appear on the income statement, you will have no incentive to turn your suppliers offer down, even if you take the trouble to calculate those costs and find that they are greater than the gains from the lower prices. In fact, if you do turn the discount down, your compensation, which is linked to the income statement, is likely to suffer, even though your decision may be good for the company. Whether theyre in manufacturing or in services, companies that hold managers accountable for balance sheets and not just profits are less likely to fall into that trap. Managers will have every incentive to explicitly measure and compare all costs and gains in order to determine the best course of action. The same argument applies to all the components of working capital. Take receivables. Lets assume that you are contemplating reducing your terms of payment from 30 days to 20 days. You assess the likely impact on customers and estimate that you will have to reduce prices by 1% to compensate for the tighter terms and you will sell 2% fewer units, which will lead to a drop in after-tax operating profit of $1 million this year. On the other hand, if the company generates $2 million in sales per day, shortening receivables by 10 days would free up $20 million in capital. Assuming an opportunity cost of capital of 10% (that is, you could make alternative investments that would generate a 10% return), you should be willing to sacrifice up to $2 million in profit per year to get your hands on this capital. The decision, then, is quite clear: If you estimate that profits will fall in future years in excess of that $2 million, you probably should not reduce your payment terms. But if you estimate that the profit loss will be less than the return on your $20 million, you definitely should. A metals refining firm that had extraordinarily high levels of receivables in its Japanese business illustrates precisely this calculus. Following the companys acquisition by a private equity firm, managers started requiring salespeople to call customers a week before their payments were due to remind them. The salespeople were predictably horrified. This is going to drive customers to the competition for sure, they protested. The incoming senior vice president countered their objections by asking a simple question: How would your customers feel if we deliberately delayed shipping their products until after the agreed-upon date? Would they hesitate to call us? Of course not! the salespeople responded. So then why should customers that consistently pay late be surprised when we call to remind them that their payments are coming due? With this perspective, the sales force enthusiastically started calling customers to encourage ontime payment. As a result, receivables fell from 185 days to 45 days, putting the equivalent of $115 million in recovered capital back into the bank account and reducing capital costs by $8 million a year. Sales did decline, but the resulting loss in margin was only about $3 million. The reduction in receivables clearly outweighed the loss in sales from demanding faster payment. This is the sort of trade-off that we urge all companies to consider.

	a. The benefit was $112 million of new profit. The reduction in receivables was $115 million, and clearly outweighed the loss in sales from demanding faster payment, which was $3 million.
	b. The benefit was $115 million of new profit. Reducing the days of receivables from 185 days to 45 days put the equivalent of $115 million in recovered capital back into the bank account of the company.
	c. The benefit was $5 million a year of new profit, each year after that. The 45 days of receivables created $115 million less of the "accounts receivable" than did 185 days of receivables. That extra $115 million asset had been funded with money that cost $8 million a year, and the sales declined by only $3 million a year.

QUESTION: Under "Mistake 3: Overemphasizing Quality in Production," starting in about the fourth paragraph of that section, the Note talks about an Italian food manufacturer that stopped "aging" some of its products in its inventory for 12 - 24 months to increase product quality. Management originally insisted the "aged" products were profitable and should be kept.

Which answer below best states the relevant working capital facts and analysis of how that change created a positive financial benefit?

CASE NOTE: Again, the Jones Electrical case has facts about ways to create an overall positive financial benefit for the company through different management of working capital accounts, like this company tried.

Mistake 3: Overemphasizing Quality in Production On the production side, the chief source of working-capital mismanagement lies in the structure of incentivesessentially the same story we saw on the sales side. Production people are often evaluated on quality metrics, such as the number of defects in finished goods. This is understandable given concerns about warranty costs and the reputational harm that quality problems can cause. But although quality control reduces those costs, it tends to slow down the production cycle, locking up capital in work-in-process (WIP) inventory. At one European producer of drive systems for power generation, which has annual revenues of about 1 billion, production managers were given bonuses on the basis of their ability to reach or exceed agreed-upon reductions in product defects each year. Managers were also rewarded for incorporating an ever-increasing array of new features into products. The firm had a strong reputation for quality, which allowed it to secure some valuable long-term sales contracts, but over the years, its increasingly complex production processes led to a manufacturing cycle nearly three times as long as those of its competitors. When we asked whether customers appreciated this extra care, senior managers were quick to point out that their products were recognized as being of the highest quality. But, we asked, were they able to pass along the extra cost to customers? They admitted that customers often lacked the engineering sophistication to appreciate the incremental quality built into the products and were therefore unwilling to pay a higher price for them. Gradually the executives came around to the idea that they should stop trying to convince customers that the added quality was worth the difference in price and instead focus on reducing WIP inventory to keep costs down. After a determined effort to speed up production and scale back on non-valueadded quality, the firm was able to cut WIP inventory by 20 days. Although cycle times were still longer than industry averages, the inventory reduction freed up 20 million in cash. For an Italian food manufacturer we studied, a significant share of its product portfolio consisted of items that were aged between 12 and 24 months. These products commanded a price premium and represented almost a quarter of total sales, but they also generated below-average returns compared with the rest of the portfolio. The disappointing results were due to the high WIP inventory levels associated with maintaining product quality. Management insisted that the contribution to profit was highly significant, that these products were must-haves in the portfolio, and that they enhanced the prestige of the brand. Only after the economic environment worsened did management concede that the quality advantage conferred by their aging process was no longer defensible. Through a comprehensive redesign of the manufacturing process, including outsourcing arrangements, the company was able to free up tens of millions of euros in capital previously tied up in inventory. Although quality dipped, the change was imperceptible to customers, and thus the impact on margins was negligible. Because the company was able to maintain margins with much less capital, the return on invested capital dramatically improved. An important takeaway here is that although the customer may be willing to pay for high quality, companies should take careful notice of what that quality really costs. By sacrificing a small amount of quality to make a notable improvement in efficiency, a firm can maintain its reputation while freeing up large amounts of cash.

	a. The sole effect was a one-time increase in cash. This occurred when the inventory that had been built up for 24 months was sold and no longer kept by the company.
	b. Return on sales improved. Although quality dipped, the changes was imperceptible to customers, and thus the impact on margins was negligible.
	c. Return on invested capital improved. The invested capital was the tens of millions of euros (the currency in Italy) that was tied up in working capital represented by the "aging" products that had to be held in inventory for 12 - 24 months. Those "aged" products did not have as good a return on that invested capital as other products did on their invested capital.

QUESTION: Look at the example given under "Mistake 5: Applying Current and Quick Ratios" in the fourth paragraph of that section, of a French consumer goods company.

Which answer below best states the overall big picture of the mistake the company was making?

CASE NOTE: For the Jones Electrical case, you will need to summarize the overall picture of whether or not something that appears good,in ratios or other numbers, really is good from the perspective of working capital management. You will need to look at the effects good and bad working capital management can have in the long run for a company. Is Jones Electrical better off in the future? Look at their working capital issues, like the ones listed in these case analysis questions.

Mistake 5: Applying Current and Quick Ratios When bankers assess their customers creditworthiness, they often think in terms of current or quick ratiosindicators of how much cash or cash-equivalent a company can count on to meet its obligations. The current ratio is simply a companys short-term assets (cash, inventory, debtors) divided by its short-term liabilities (creditors, taxes, and deferred dividends). The quick ratio subtracts inventory from short-term assets and divides the result by short-term liabilities. Although current and quick ratios are popular with many bankers and some managers, they can be misleading. Worse, their use encourages companies to manage according to a death scenario. Bankers want to ensure that companies have enough liquid assets to repay their loans in the event of distress. The irony is that the more closely a company follows its bankers guidelines, the greater the likelihood that it will face a liquidity crisis and possible bankruptcy. Thats because a higher (which to bankers means better) current ratio value is achieved by having higher levels of receivables and inventories and a lower level of payablesall quite at odds with sound working-capital practices. Alternatively, suppose that the quick ratio is your main yardstick for determining working-capital levels, and you manage operations carefully to maximize that measure. To the extent that it discourages high inventory levels, this approach has some merit. Unfortunately, it also encourages you to build up your levels of receivables indiscriminately which, as we have already seen, is usually not a good idea. As long as credit is easy, this approach, though value destructive, will not cause a liquidity headache. But when a credit crunch takes hold, the company will quickly run out of cash. Experts in structured and leveraged finance therefore tend to ignore current and quick ratios, focusing instead on cash flow generation as a sound measure of short-term liquidity. Managing to the bankers ratios has gotten many company executives into trouble. Perhaps the best example comes from a French consumer goods company whose CEO announced in 2001 with considerable pride, Our working capital has increased from 1 million to over 4 million with our current ratio rising from 110% to 200% and the quick ratio rising from 35% to 100%. The company declared insolvency six months later.

	a. The higher current and quick ratios meant there was a large amount of capital tied up in receivables and inventory. The company's cost of invested capital could have been too high for the company to maintain those large amounts. That could be why they went bankrupt 6 months later.
	b. The higher quick ratio meant the company did keep higher inventory levels, but there were not enough receivables to repay their loans in the event of distress to the company. That could be why they went bankrupt 6 months later.
	c. The higher current ratio meant there were not enough receivables and inventory to repay their loans in the event of distress to the company. That could be why they went bankrupt 6 months later.