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? A company with a relaxed working capital policy would carry relatively large amounts of current assets in relation to their 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. Working capital policy is reflected in a firm’s current ratio, quick ratio, turnover of cash and securities, inventory turnover and days sales outstanding or DSO. The ratios that are related to SKI, has large amount of working capital relative to its level of sales. An example would be the sales/inventories = 6.00 versus 8.00 for an average firm in its industry. This means that SKI is carrying a lot of inventory per dollar of sales. This ratio is the definition of a relaxed policy. Also, SKI's DSO is relatively high. Since DSO is calculated as receivables/sales per day, a high DSO indicates a lot of receivables per dollar of sales. SKI seems to have a relaxed working capital policy, and a lot of current assets.
How can we distinguish between a relaxed but rational working capital policy and a situation where a firm simply has a lot of current assets because it is inefficient? Does SKI’s working capital policy seem appropriate? SKI may choose to hold large amounts of inventory so they never run short on their inventory This way they are able to cater to customers who expect to receive their equipment in a short period of time. SKI may also choose to hold high amounts of receivables to maintain good relationships with its customers. However, if SKI is holding large stocks of inventory and receivables to better serve customers, it should be able to offset the costs of carrying that working capital with high prices or higher sales, and its ROE should be no lower than that of firms with other working capital policies. It is clear from the chart that showed SKI and the Industry Averages, SKI is not as profitable as the average firm in its industry. So a relaxed policy may be appropriate if it reduce risk more than profitability. However because SKI does not seem as profitable than the average, it suggest that the company probably has excessive working capital and that it should take steps to reduce its working capital.
Calculate the firm’s cash conversion cycle given that annual sales are $660,000 and cost of goods sold represents 90% of sales. Assume a 365-day year. Inventory Conversion Per. +Receivable Collection Per. – Payable deferral Per. = Cash Conversion cycle SKI’s Inventory Turnover : 6.00
Inventory Conversion Period: 365/(Inventory Turnover) = 365/6.00 = 60.83 ≈ 61 days Days Sale Outstanding: 45.63 days ≈ 46 days
SKI’s receivable collection period is equal to its DSO
SKI’s Cash Conversion Cycle:
76 days + 46 days -30 days =92 days
SKI needs to pay $580,000 after 92 days
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. To the extent that cash and securities consist of low-yielding securities, they could be sold off the cash and generated could be used to reduce debt. This way they could buy back stocks, or to invest in operating assets, it would help to reduce cash. Also, if SKI was about to synchronize inflows and outflows of the company, it would help.
Should depreciation expense be explicitly included in the cash budget? Why or why...
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