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1 Ch 20 Mini Case 3/14/2001
3 Chapter 20. Mini Case for Current Asset Management
5 Phil Kronk, financial manager of Personal Equipment Inc. (PEI), is excited, but apprehensive. The company's founder recently
6 sold his 51 percent controlling block of stock to Mike Lofaro, 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:
9 EVA = NOPAT - Capital costs
10 = EBIT(1 - T) - WACC (Operating capital).
12 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
13 capital, and stockholders' value is being eroded. Lofaro rewards managers handsomely if they create value, but those whose
14 operations produce negative EVAs are soon looking for work. Lofaro frequently points out that if a company can generate its
15 current level of sales with less assets, it would need less capital. That would, other things held constant, lower capital costs and
16 increase its EVA.
17 Shortly after he took control of PEI, Mike Lofaro met with PEI's senior executives to tell them of his plans for the company. First,
18 he presented some EVA data which convinced everyone that PEI had not been creating value in recent years. He then stated, in no
uncertain terms, that this situation must change. He noted that PEI's designs of PEI's, hats, gloves, and clothing are acclaimed
throughout the industry, but something is seriously amiss elsewhere in the company. Costs are too high, prices are too low, or the
20 company employs too much capital, and he wants PEI's managers to correct the problem or else.
22 Kronk has long felt that PEI's working capital situation should be studied--the company may have the optimal amounts of cash,
23 securities, receivables, and inventories, but it may also have too much or too little of these items. In the past, the production
manager resisted Phil's 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
25 want to talk about her cash and securities balances. Lofaro's speech made it clear that such resistance would no longer be tolerated.
28 Phil also knows that decisions about working capital cannot be made in a vacuum. For example, if inventories could be lowered
29 without adversely affecting operations, then less capital would be required, the dollar cost of capital would decline, and EVA would
30 increase. However, lower raw materials inventories might lead to production slowdowns and higher costs, while lower finished goods
31 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. Following are some ratios for PEI:
35 PEI Industry
36 Current 1.75 2.25
37 Quick 0.83 1.2
38 Debt/assets 58.76% 50.00%
39 Turnover of cash and securities 16.67 22.22
40 Days sales outstanding 45 32
41 Inventory turnover 4.82 7
42 Fixed assets turnover 11.35 12
43 Total assets turnover 2.08 3
44 Profit margin on sales 2.07% 3.50%
45 Return on equity (ROE) 10.45% 21.00%
46 Payables deferral period 30 33
49 a. Phil plans to use the preceding ratios as the starting point for discussions with PEI's 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 in the table, does PEI seem to be following a relaxed, moderate, or restricted working capital policy?
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a. Phil plans to use the preceding ratios as the starting point for discussionsF
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with PEI's operating executives. He wants everyone to
50 think about the pros and cons of changing each type of current asset and how changes would interact to affect profits and EVA.
51 Based on the data in the table, does PEI seem to be following a relaxed, moderate, or restricted working capital policy?
53 Working capital policy is reflected in a firm’s current ratio, quick ratio, turnover of cash and securities, inventory turnover, and
54 DSO. These ratios indicate PEI has large amounts of working capital relative to its level of sales. Thus, PEI is following a relaxed
55 (fat cat) policy.
57 b. How can one distinguish between a relaxed but rational working capital policy and a situation where a firm simply has a lot of
58 current assets because it is inefficient? Does PEI's working capital policy seem appropriate?
60 A relaxed policy may be appropriate if it reduces risk more than profitability. However, PEI is much less profitable than the
61 average firm in the industry. This suggests that the company probably has excessive working capital.
63 c. Calculate PEI’s cash conversion cycle, assuming all calculations use a 360-day year.
Cash Inventory Receivables Payables
= + -
Conversion conversion collection Deferral
65 cycle (CCC) period period Period
67 CCC = 75 + 45 - 30
68 CCC = 90
70 d. What might PEI do to reduce its cash and securities without harming operations?
72 Use lockboxes.
73 Insist on wire transfers from customers.
74 Synchronize inflows and outflows.
75 Use a remote disbursement account.
76 Increase forecast accuracy to reduce the need for a cash “safety stock.”
77 Hold marketable securities instead of a cash “safety stock.”
78 Negotiate a line of credit (also reduces need for a “safety stock”).
80 e. What is "float," and how is it affected by the firm's cash manager (treasurer)?
82 Net float is the difference between cash as shown on the firm’s books and on its bank’s books. If it takes PEI 1 day to deposit
83 checks it receives and it takes its bank another day to clear those checks, PEI has 2 days of collections float. If it takes 6 days for
84 the checks that PEI writes to clear and be deducted from PEI’s account, PEI has 6 days of disbursement float. PEI’s net float is the
85 difference between the disbursement float and the collections float:
87 Net float = 6 days - 2 days = 4 days.
89 If PEI wrote and received $1 million of checks per day, it would be able to operate with $4 million less working capital than if it had
90 zero net float.
93 In an attempt to better understand PEI's cash position, Phil developed a cash budget. Data for the first two months of the year
94 are shown at the end of this mini case. (Note that Phil's preliminary cash budget does not account for interest income or interest
95 expense.) He has the figures for the other months, but they are not shown in this mini case.
97 Cash Balance as presented in the Mini Case
98 Nov Dec Jan Feb Mar Apr
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100 I. COLLECTIONS AND PURCHASES WORKSHEET
101 ( 1 ) Sales (gross) $71,218 $68,212 $65,213 $52,475 $42,909 $30,524
103 ( 2) During month of sale
104 (0.2)(0.98)(month's sales) 12,781.75 10,285.10
105 ( 3 ) During first month after sale
106 0.7(previous month's sales) 47,748.40 45,649.10
107 ( 4 ) During second month after sale
108 0.1(sales 2 months ago) 7,121.80 6,821.20
109 ( 5 ) Total collections (Lines 2 + 3 + 4) $67,651.95 $67,651.95
111 ( 6 ) 0.85(forecasted sales 2 months from now) $44,603.75 $36,472.65 $25,945.40
112 ( 7) Payments (1-month lag) 44,603.75 36,472.65
114 II. CASH GAIN OR LOSS FOR MONTH
115 ( 8 ) Collections (from Section I) $67,651.95 $62,755.40
116 ( 9 ) Payments for purchases (from Section I) 44,603.75 36,472.65
117 ( 10 ) Wages and salaries 6,690.56 5,470.90
118 ( 11) Rent 2,500.00 2,500.00
119 ( 12 ) Taxes
120 ( 13 ) Total payments $53,794.31 $44,443.55
121 ( 14 ) Net cash gain (loss) during month
122 (Line 8 - Line 13) $13,857.64 $18,311.85
124 III. CASH SURPLUS OR LOAN REQUIREMENT
125 ( 15 ) Cash at beginning of month if no borrowing is done $3,000.00 $16,857.64
126 ( 16 ) Cumulative cash (cash at start + gain or loss =
127 Line 14 + Line 15) 16,857.64 35,169.49
128 ( 17 ) Target cash balance 1,500.00 1,500.00
129 ( 18 ) Cumulative surplus cash or loans outstanding to
130 maintain $1,500 target cash balance
131 (Line 16 - Line 17) $15,357.64 $33,669.49
134 f. Should depreciation expense be explicitly included in the cash budget? Why or why not?
136 No. Depreciation is a noncash charge. Only cash payments and receipts appear on cash budget. However, depreciation does
137 affect taxes, which do appear in the cash budget.
140 g. In his preliminary cash budget, Phil has assumed that all sales are collected and, thus, that PEI has no bad debts. Is this realistic?
141 If not, how would bad debts be dealt with in a cash budgeting sense? (Hint: Bad debts will affect collections but not purchases.)
143 No! In almost all situations there are bad debts
145 Collections would be reduced by the amount of bad debt losses. For example, if the firm had 3% bad debt losses, collections would
146 total only 97% of sales.
149 h. Phil's cash budget for the entire year, although not given here, is based heavily on his forecast for monthly sales. Sales are
150 expected to be extremely low between May and September but then increase dramatically in the fall and winter. November is
151 typically the firm's best month, when PEI ships equipment to retailers for the holiday season. Interestingly, Phil's forecasted cash
budget indicates that the company's 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 in the first table, does it
appear that PEI's target cash balance is appropriate? In addition to possibly lowering the target cash balance, what actions might
PEI take to better improve its cash management policies, and how might that affect its EVA?
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h. Phil's 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
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typically the firm's best month, when PEI ships Dequipment toE F G H I J
retailers for the holiday season. Interestingly, Phil's forecasted cash
152 budget indicates that the company's cash holdings will exceed the targeted cash balance every month except for October and
153 November, when shipments will be high but collections will not be coming in until later. Based on the ratios in the first table, does it
154 appear that PEI's target cash balance is appropriate? In addition to possibly lowering the target cash balance, what actions might
155 PEI take to better improve its cash management policies, and how might that affect its EVA?
157 Cash budget indicates the company probably is holding too much cash.
159 PEI could improve its EVA by either investing its excess cash in more productive assets or by paying it out to the firm’s shareholders.
162 i. What reasons might PEI have for maintaining a relatively high amount of cash?
164 If sales turn out to be considerably less than expected, PEI could face a cash shortfall.
165 A company may choose to hold large amounts of cash if it does not have much faith in its sales forecast, or if it is very conservative.
166 The cash may be there, in part, to fund a planned fixed asset acquisition.
168 j. What are the three categories of inventory costs? If the company takes steps to reduce its inventory, what effect would this have
169 on the various costs of holding inventory?
171 Carrying Costs: Storage and handling costs, insurance, property taxes, depreciation, and obsolescence.
173 Ordering Costs: Cost of placing orders, shipping, and handling costs.
175 Costs of Running Short: Loss of sales, loss of customer goodwill, and the disruption of production schedules.
177 k. Is there any reason to think that PEI may be holding too much inventory? If so, how would that affect EVA and ROE?
179 PEI’s inventory turnover (4.82) is considerably lower than the industry average (7.00). The firm is carrying a lot of inventory per
180 dollar of sales. By holding excessive inventory, the firm is increasing its operating costs which reduces its NOPAT. Moreover, the
181 excess inventory must be financed, so EVA is further lowered.
183 l. If the company reduces its inventory without adversely affecting sales, what effect should this have on the company's cash position
184 (1) in the short run and (2) in the long run? Explain in terms of the cash budget and the balance sheet.
186 Short run: Cash will increase as inventory purchases decline.
188 Long run: Company is likely to then take steps to reduce its cash holdings.
190 m. Phil knows that PEI sells on the same credit terms as other firms in its industry. Use the ratios presented in the first table to
191 explain whether PEI's customers pay more or less promptly than those of its competitors. If there are differences, does that suggest
192 that PEI should tighten or loosen its credit policy? What four variables make up a firm's credit policy, and in what direction should
193 each be changed by PEI?
195 PEI’s days’ sales outstanding (DSO) of 45 days is well above the industry average (32 days). PEI’s customers are paying less
196 promptly. So, PEI should consider tightening its credit policy to reduce its DSO.
199 Cash Discounts: Lowers price. Attracts new customers and reduces DSO.
200 Credit Period: How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales.
201 Credit Standards: Tighter standards reduce bad debt losses, but may reduce sales. Fewer bad debts reduces DSO.
202 Collection Policy: Tougher policy will reduce DSO, but may damage customer relationships.
204 n. Does PEI face any risks if it tightens its credit policy?
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206 YES! A tighter credit policy may discourage sales. Some customers may choose to go elsewhere if they are pressured to pay their
207 bills sooner.
209 o. If the company reduces its DSO without seriously affecting sales, what effect would this have on its cash position (1) in the short
210 run and (2) in the long run? Answer in terms of the cash budget and the balance sheet. What effect should this have on EVA in the
211 long run?
213 Short run: If customers pay sooner, this increases cash holdings.
215 Long run: Over time, the company would hopefully invest the cash in more productive assets, or pay it out to shareholders. Both of
216 these actions would increase EVA.
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