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:

a) As per the given information, RR appears to have a moderate working capital approach as present proportion is 1.75 which is decent.Also it is anything but an issue with the present assets yet is with the present liabilities of the organization may be because of more obligation which results in more prominent current liabilities.

b) A relaxed but rational working capital policy is when company maintain a minimum balance of cash in hand for its activities, account receivables are good, an average measure of stock is kept up and in particular money is assigned well to the marketable securities.A circumstance where firm has unnecessary money close by than required then it would neglect to work effectively. RR's working capital appears to proper yet credit strategy of RR could be fix a bit as they set aside greater opportunity to get the cash and set aside less opportunity to pay the cash which misfortune influences the working capital.

c) We have to Calculate the firm’s cash conversion cycle

We know that,

Cash conversion cycle = Days of inventory in hand + Days of sales in hand - Payable differ period

Where,

Days of inventory in hand = 365 / Inventory turn over

=365 / 14

Days of inventory in hand =26.07 days.

Days of sales in hand = 48.75 days

Payable differ period = 39 days

Therefore,

Cash conversion cycle = 26.07+48.75-39

Cash conversion cycle = 36 days(Approx)