Question.3218 - Background About a year ago soon after graduating with a college degree in finance, you joined a manufacturing company as an aide to the Vice President (Strategy). Your boss does not have any formal training in finance, but she has always been very receptive to new ideas that could improve the overall performance of the company. She is convinced that good financial strategy is a key component of the company’s overall growth strategy. During the past year, you have had the opportunity to accompany your boss to several high level policy meetings. You noticed that when it came to finance-related items in the agenda, most attention was focused on long-term fixed investment and the company debt policy. Even though working capital in the company was running at around 34% of sales and was trending up over the past few years, you noticed an absence of awareness, not to speak of urgency, about this matter. There were only occasional brief discussions in passing about how to improve the performance of the receivable department or the need to negotiate better terms with the suppliers. Since you were somewhat familiar with several well-known companies that had successfully introduced innovations in managing their working capital with remarkable results for the enterprise value, you felt that a new approach was needed for your company to achieve better control over working capital level, which you considered was way too high. You have since done some readings of the related literature and have done some brainstorming. Now you want to prepare a brief memo for your boss on this subject, highlighting the need for a new attitude toward working capital management. Working capital position is often interpreted as an indicator of how easily company can meet its short-term obligations. Creditors generally subscribe to this view of working capital. That is to say, working capital has traditionally been seen as a metric for evaluating a company’s operating liquidity, even though it is generally agreed that a company’s current assets may not often be easily liquidated in the short term. The idea of working capital as an indicator of liquidity is more meaningful in the context of a company facing liquidation than for a company as a going concern. In your memo, you should, among other things: I. Clarify the meaning(s) of the term working capital and explain what it means for the operation, profitability and growth of the company. You would like to use a simple cash conversion model to identify different components of operating cycle and show how these components can be influenced to better manage working capital. II. Point out that working capital is often viewed by companies simply as cost, and as a result, the company management tends to react to a “cash squeeze” by slashing working capital expenditure without carefully considering its implications for sales, profitability and growth. At the other end, there is also a tendency to invest too much in working capital to maximize short-term profit. Instead what you want to promote is an integrated and value-creating approach to working capital management in which all elements of tied-up capital across the balance sheet (fixed assets, inventories, receivables, payables, and cash) have to be considered as a whole. For example, it may be advantageous to acquire a new and more flexible machine (fixed asset) in order to reduce inventories. III. Highlight the significance of efficient management of working capital (shown as short-term investment) for the company’s long-term growth by showing working capital management as a lever for freeing up cash from inventory, accounts receivable, and accounts payable. By effectively managing various components of working capital, a company can reduce its dependence on outside funding for further investments and/or acquisitions. IV. Point out how inventory has received a lot attention in recent years. Excess inventory is one of the most overlooked sources of cash, some evidence suggesting that better inventory management can potentially account for almost half of the savings from a working capital optimization process. By streamlining processes within the company—as well as processes involving suppliers and customers— companies can optimize inventory throughout the value chain. A best-practice NWC optimization is not just a pure reduction of NWC. It requires the applications of enhanced forecast accuracy and demand planning, advanced delivery and logistics concepts and optimized production processes to reduce work-in-progress inventory. Against this background, it is time for you sit down to prepare your memo! First, you will need to think through and develop the structure of your memo. Additional reading materials posted in D2L should help you organize your thoughts. Additional web search is strongly recommended to identify real world evidence on best-practice working capital management as far as possible. You need to identify and retrieve more information to supplement what you already know. You should like to keep your memo short, and to the point. It should be limited to a maximum of 7 pages (single-spaced), including a one-page executive summary. The summary should be placed at the beginning of your submission. CASE B: Financial Ratios Data for Barry Computer and its industry average follow. a. Calculate the indicated ratios for Barry. b. Construct the Du Pont equation for both Barry and the industry. c. Outline Barry’s strengths and weaknesses as revealed by your analysis. d. What kind of financial strategy is being pursued by Barry- matching, aggressive or conservative? Your answers must be typed. Balance Sheet as of December 31, 2011 (in Thousands $) Cash 77,500 Accounts payable 129,000 Receivables 336,000 Notes payable 84,000 Inventories 241,500 Other current liabilities 117,000 Total Current Assets 655,000 Total current liabilities 330,000 Net fixed assets 292,500 Long-term debt 256,000 Common equity 361,000 Total assets 947,500 Total liabilities and equity 947,500 Income Statement for Year Ended December 31, 2011 ( In Thousands $) Sales 1,607,500 Cost of goods sold 1,392,500 SGA expenses 145,000 EBIT 70,000 Interest expense 24,500 EBT 45,500 Taxes (40%) 18,200 Earnings after taxes 27,300 Ratio Barry Industry Average Current assets/current liabilities __________ 2.0x Days’ sales outstanding a __________ 35 days Sales/inventory __________ 6.7x Sales/fixed assets __________ 12.1x Sales/total assets __________ 3.0x EAT/sales __________ 1.2% EAT/total assets __________ 3.6% EAT/common equity __________ 9.0% Total debt/total assets __________ 60.0% a = Calculation is based on a 365-day year.
Answer Below:
Management of working capital is an essential job of the finance manager. He has to ensure that the amount of working capital available with his concerns is neither too large nor too small for its requirements. A large amount of working capital would mean that the company has idle funds. Since funds have a cost, the company has to pay huge amount as interest on such funds. If the firm has inadequate working capital, such firm runs the risk of insolvency. Paucity of working capital may lead to a situation where the firm may not be able to meets its liabilities. Over capitalization implies that a company has too large funds for its requirements, resulting in a low rate of return a situation which implies a less than optimal use of its resources. A firm has, therefore, to be very careful in estimating its working capital requirements. Maintaining adequate working capital is not just important in the short term. Sufficient liquidity must be maintained in order to ensure the survival of the business in the long term as well. When business make investment decisions they must not only consider the financial outlay involved with acquiring the new machine or the new building etc, but must also take account of the additional current assets that are usually required with any expansion of activity. For e.g: ? Increased production leads to hold additional stocks of raw materials and work in progress. ? An increased sale usually means that the level of debtors will increase ? A general increase in the firm’s scale of operations tends to imply a need for greater levels of working capital. The finance manager is required to determine the optimum level of current assets so that the shareholders value is minimized. A firm needs fixed and current assets to support a particular level of output. As the firms output and sales increases, the need for current assets also increases. Generally, the current assets do not increase in direct proportion to output, current assets may increase at a decreasing rate with output. As the output increases, the firms start using its current assets more efficiently. The level of the current assets can be measured by creating a relationship between current assets and fixed assets. Dividing current assets by fixed assets gives current assets/fixed assets ratio. Assuming a constant level of fixed assets, higher current assets/fixed assets also indicates a conservative current assets policy and a lower current assets/fixed assets ratio means an aggressive policy. A conservative policy implies greater liquidity and lower risk whereas aggressive policy implies higher risk and poor liquidity. So, it is always better that current assets policy of firms fall between two extreme policies.More Articles From Finance
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