Three companies-Aggressive, Moderate, and Conservative---have different working capital management policies as implied by their names. For example, Aggressive employs only minimal current assets, and it finances almost entirely with current liabilities plus equity. This restricted approach has a dual effect. It keeps total assets low, which tends to increase return on assets, but because of stock-outs and credit rejections , total sales are reduced , and because inventory is ordered more frequently and in smaller quantities, variable costs are increased. Condensed balance sheets for the three companies follow.
- Aggressive Moderate Conservative
- Current Assets $225,000 $300,000 $450,000
- Fixed Assets 300,000 $300,000 300,000
- Total Assets $525,000 $600,000 $750,000
- Current liabilities (cost=12%) $300,000 $150,000 $750,000
- Long-term debt (cost=10%) 0 150,000 300,000
- Total Debt 300,000 $300,000 $375,000
- Equity 225,000 300,000 375,000
- Total Liabilities and equity 525,000 $600,000 $750,000
- Current Ratio 0.75 2.0 6.0
The cost of goods sold functions for the three firms are as follows:
Cost of Goods Sold = Fixed Costs + Variable Costs
Aggressive: Cost of goods sold = $300,000 + 0.70 (Sales)
Moderate: Cost of goods sold = $405,000 + 0.65 (Sales)
Conservative: Cost of goods sold = $577,500 + 0.60 (Sales)
Because of working capital differences, sales for the three firms under different economic conditions are expected to vary as follows:
Aggressive Moderate Conservative
Strong economy $1,800,000 $1,875,000 $1,950,000
Average economy 1,350,000 1,500,000 1,725,000
Weak economy 1,050,000 1,200,000 1,575,000
Question:
Compare the returns on equity for the companies and find which company is best in the strong, average, and weak?What considerations for the management of working capital are indicated by this problem?