Question

Karen Johnson, CFO for Raucous Roasters (RR), a specialty coffee manufacturer, is rethinking her company’s working capital policy in light of a recent scare she faced when RR’s corporate banker, citing a nationwide credit crunch, balked at renewing RR’s line of credit. Had the line of credit not been renewed, RR would not have been able to make payroll, potentially forcing the company out of business. Although the line of credit was ultimately renewed, the scare has forced Johnson to examine carefully each component of RR’s working capital to make sure it is needed, with the goal of determining whether the line of credit can be eliminated entirely. In addition to (possibly) freeing RR from the need for a line of credit, Johnson is well-aware that reducing working capital can also add value to a company by improving its EVA (Economic Value Added). In her corporate finance course Johnson learned that EVA is calculated by taking net operating profit after taxes (NOPAT) and then subtracting the dollar cost of all the capital the firm uses:

                          EVA = EBIT(1 – T) – Capital costs

                                   = EBIT(1 – T) – WACC(Capital employed).

            If EVA is positive then the firm’s management is creating value. On the other hand, if EVA is negative, then the firm is not covering its cost of capital and stockholders’ value is being eroded. If RR could generate its current level of sales with fewer assets, it would need less capital. This would, other things held constant, lower capital costs and increase its EVA.

            Historically, RR has done little to examine working capital, mainly because of poor communication among business functions. In the past, the production manager resisted Johnson’s efforts to question his holdings of raw materials, 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 the cash and securities balances. However, with the recent credit scare, this resistance became unacceptable and Johnson has undertaken a company-wide examination of cash, marketable securities, inventory, and accounts receivable levels.

                  Johnson 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, and lower finished goods inventories might lead to stock-outs and loss of 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. Johnson has begun her investigation by collecting the ratios shown below. (The partial cash budget shown after the ratios is used later in this mini case.)

	RR	Industry
Current	1.75	2.25
Quick	0.92	1.16
Total liabilities/assets	58.76%	50.00%
Turnover of cash and securities	16.67	22.22
Days sales outstanding (365-day basis)	48.75	32.00
Inventory turnover	14.0	20.00
Fixed assets turnover	7.75	13.22
Total assets turnover	2.60	3.00
Profit margin on sales	2.07%	3.50%
Return on equity (ROE)	10.45%	21.00%
Payables deferral period	39.00	33.00

1. Johnson plans to use the preceding ratios as the starting point for discussions with RR’s operating team. She 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 RR seem to be following a relaxed, moderate, or restricted working capital policy?

2. How can one distinguish between a relaxed but rational working capital policy and a situation in which a firm simply has excessive current assets because it is inefficient? Does RR’s working capital policy seem appropriate?

3. Calculate the firm’s cash conversion cycle given annual sales are $900,000 and cost of goods represent 75% of sales. Assume a 365-day year.

Answer 1

Answer 1: Based on the data, RR seems to have a moderate working capital policy as Current Ratio is 1.75 which is decent. Also it's not a problem with the current assets but is with the current liabilties of the company might be due to more debt which results in greater current liabilities.

Answer 2: A relaxed but rational working capital policy is when company has adequate amount of cash in hand for its operations, account receivables are healthy, a decent amount of inventory is maitained and most importantly cash is allocated well to the marketable securities. A situation where firm has excessive cash in hand than required then it would fail to operate efficiently. RR's working capital seems apporporiate but credit policy of RR could be tighten a bit as they take more time to receive the money and take less time to pay the money which adversly affects the working capital.

Answer 3: Cash Conversion Cycle: Days of Inventory in hand+Days of Sales in Hand-Payable defferel period

Day os Inventory in hand= 365/Inventory Turnover= 365/14= 26.07 days

Days of Sales in Hand= 48.75 days

Payable defferel period= 39 days

Cash Conversion cycle= 26.07+48.75-39= 35.82 0r 36 days