SKI Equipment Company - Assignment Example

SKI Equipment Company Denise E. Williams like this) Your a. SKI seems to be following a relaxed working capital policy. Ski has large amounts of inventories and sales are stimulated by the use of a credit policy that provides liberal financing to customers and a correspondingly high level of receivables (Brigham et al., 1999). Its Current assets ratio of 1.75 is well below the industry average 2.25. SKI’s inventory turnover of 4.82 indicates that it turns over its inventory every 75 (365/4.82) days which is rather high. The industry average is 52 days (365/7). Additionally, the company’s Days’ sales outstanding is 45.63 which is way above the industry average. b. We can distinguish between a relaxed but rational working capital policy and a situation where a firm has a large amount of current assets simply because it is inefficient. A relaxed and rational policy is one in which the company’s credit policy stimulates sales with due regard to its customers ability to pay. Additionally, inventory levels held would take into account the lead times between the order and receipt of inventory. This would prevent lost sales due to inventory shortages. When a firm is inefficient as SKI is, it keeps more than the enough inventory in stock (overtrading) without due regard to lead times between order and delivery and stimulates sales through reckless credit policies from which it does not benefit. SKI’s working capital policy does not seem appropriate. c. SKI tries to match the maturity of its assets and liabilities. “This strategy recognizes that temporary current assets will be converted into cash in the near term, hence the company finances those assets with short-term capital” (Brigham et al., 1999). SKI’s Debt/assets ratio of 58.76 % does not suggest that amounts in receivables are collected on time to pay any debts borrowed for the purpose of financing inventory purchases. An aggressive financial policy would involve SKI financing all its fixed assets with long-term capital and part of its permanent current assets with short-term, non-spontaneous credit (Brigham et al.,). In a conservative financing policy approach, permanent capital is being used to finance all permanent asset requirements and also to meet some of the seasonal needs and a small amount of short-term, non-spontaneous credit to meet its peak requirements (Brigham et al., 1999). I would recommend that SKI takes the conservative approach. d. Assuming that SKI’s payables deferral period is 30 days, the firm’s cash conversion cycle is calculated as follows: = Inventory conversion period + Days sales outstanding – Payables deferral period = 365/4.82 + 45 – 30 = 76 + 45 – 30 = 91 days which is way too high. e. In order to reduce its cash and securities without harming operations SKI could hold marketable securities which can be sold on short notice. “Marketable securities serve both as a substitute for cash and as a temporary investment for funds that will be needed in the near future.” These are considered safe (Brigham et al., 1999). f. In his preliminary cash budget, Barnes has estimated that all sales are collected and thus SKI has no bad debts. This is unrealistic. SKI needs to look at the aged debtors listing to determine what percentage of its debts are likely to go bad based on the past trends. This would reduce the projected amount of cash receipts expected. g. Based on the ratios given in the first Table, it does not appear that SKI’s target cash balance is appropriate. If turnover of cash and securities is 16.67 times and turnover is estimated to be about $661,000 for the year at best, then the cash and securities should be on average $39,000 per month. The average for January and February (two of the best months) is $$16,084 as seen in the cash budget. In addition to lowering its cash balance SKI should seek to reduce the Days sales outstanding and reduce the levels of inventory. This would help to reduce the cost of capital and therefore increase EVA. h. SKI is holding too much inventory compared to the industry average. The industry average inventory turnover is 7 times while SKI’s is 4.82 times per year. This will impact on EVA and ROE by way of the cost of capital if debt is used to finance inventory. i. If the company reduces its inventory without adversely affecting sales, the effect on the company’s cash position would be positive as less funds would be tied up in inventory. This would impact the cash budget and balance sheet in both the short and long run as SKI would have about one month less payable or inventory to pay for. j. It is obvious from the ratios presented in the first Table that SKI’s customers pay less promptly than those of its competitors. For example, the Days’ sales outstanding for the industry is 32 days on average while SKI’s is 45 days. It therefore means that SKI needs to tighten its credit policy. The four variables that make up a firm’s credit policy are: credit period, credit standards, collection policy, and discounts. Ski needs to shorten the credit period to an average of 30 days, review the financial strengths of its credit customers to determine whether the limits need to be reduced, send letters to slow paying customers after 3 days has passed, and consider decreasing the period allowed for the application of discounts to 7 days. k. If SKI tightens its credit policy it could result in a fall in sales. Right now it appears as if the credit policy has been relaxed to allow for increases in sales. The company would need to assess the situation carefully before it acts to determine what implications any such move would have on the business. l. If the company reduces its DSO without seriously affecting sales, the cash budget would not show any significant improvements immediately, based on the timing of receipts and payments. The balance sheet would not show much improvement in the current ratio as both inventory and payables would decline. However, in the long run the cash balance will improve. In the long run this could impact EVA positively as its debts on which it has to pay interest would be significantly reduced thus reducing the cost of capital. m. If SKI buys on terms of 1/10 net 30 days but can get away with paying on the 40th day, if it chooses not to take discounts, then, assuming that it purchases $3 million of components per year, net of discounts, the company can get $3,030,303 (3,000,000/.99) of free trade credit. Based on the total assets turnover of 2.08 and the debt/assets ratio and the budgeted turnover of not more than $661,102, SKI could get approximately $130,000 in costly credit in order to remain within a Debt/asset ratio of 100%. The percentage cost of the costly credit would be somewhere between 15 and 21%. If we use 21% which is the industry average ROE then the cost would be $27,300 (21% of $130,000). This is less than the approximately $30,000 that SKI can get from extending the creditor days to 40. It is therefore beneficial to SKI to pay on the 40th day. n. If SKI decided to raise an additional $100,000 as a 1-year loan from its bank, for which it was quoted a rate of 8%, then the effective annual cost assuming simple interest and add-on interest on a 12-month installment loan is: Total interest charge = $100,000/(0.08) = $8,000. Therefore, the amount to be paid is $100,000 + $8,000 = $108,000. The monthly payment is $108,000/12 = $9000. APR (i) = the annual percentage rate; n = number of periods; I = interest charges; P = Principal Annual Percentage Rate (i) = 2 x n x I/P(N+1) = 2 x 12 x 0.08/1300000 = 14.77% References Brigham, E. F., Ehrhardt, M.C., & Gapenski, L.C. (1999) Financial Management: Theory and Practice, The Dryden Press, FL. Read More