Dan Barnes, financial manager of Ski Equipment Inc. (SKI), is excited, but apprehensive. The company's founder recently sold his 51 percent controlling block of stock to Kent Koren, who is a big fan of EVA (Economic Value Added). EVA is found by taking the net after-tax operating profit and then subtracting the dollar cost of all the capital the firm uses:
EVA = NOPAT - Capital costs
= EBIT (1 - T) - WACC(Capital employed).
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 stockholders' 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 can generate its current level of sales with less 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 SKI's 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 SKI's designs of skis, boots, 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 company employs too much capital, and he wants SKI's managers to correct the problem or else.
Barnes has long felt that SKI's working capital situation should be studied--the 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 Barnes' 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. Koren's 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.
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 On Sales 2.07% 3.50%
Payables Deferral Period 30.00 33.00
a) Barnes plans to use the preceding ratios as the starting point for discussions with SKI's operating executives. He wants everyone to think about the pros and cons of changing each type of current asset and how changes would inter-act to affect profits and EVA. Base on the data, does SKI seem to be following a relaxed, moderate, or restricted working capital policy?
b) 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 SKI's working capital policy seem appropriate?
c) Calculate the firm's cash conversion cycle. Assume a 365-day year.
d) What might SKI do to reduce its cash without harming operations? In an attempt to better understand SKI's cash position, Barnes developed a cash budget. Data for the first 2 months of the year are shown above. (Note that Barnes's 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.
a) A company with a relaxed working capital policy would carry relatively large amounts of current assets in relation to sales. It would be guarding against running out of stock or of running short of cash, or losing sales because of a restrictive credit policy. We can see that SKI has relatively low cash and inventory turnover ratios. For example, sales/inventories = 4.82 versus 7.0 for an average firm in its industry. Thus, SKI is carrying a lot of inventory per dollar of sales, which would meet the definition of a relaxed policy. Similarly, SKI's DSO is relatively high. Since DSO is ...