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 12.80 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 35.00 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 80% of sales. Assume a 365-day year.