Black-Cross Working Capital and ROA

Early in 2013, Dick Blackford and Ann Cross, computer science graduate students, decided to go
into business together with a sophisticated business computer program that they had developed.
Although they had limited capital (only $91,000 between them), they formed a corporation,
Black-Cross Systems Inc., on May 1, 2013, and pledged their personal assets as collateral.
Interest in Black-Cross' product is strong and significant sales are anticipated. However, Blackford
and Cross, having invested all their capital in the enterprise, are sensitive to risk. Before
becoming fully operational, they are trying to establish what the company's working capital
strategy should be given that they are risk-adverse. In addition, they would like to show a return
on assets (ROA) for their first year of operations sufficient to attract new investors.
Black-Cross' Statement of Financial Position at the end of May 2013, the first month of opera-
tions, is shown below.

Black-Cross Systems Inc.

Statement of Financial Position
May 31, 2013
Assets
Current assets
Cash $ 20,000
Accounts receivable 100,000
Inventories 100,000
Fixed assets
Equipment (net book value) 180,000
Total assets $400,000

Liabilities and shareholders' equity

Current liabilities
Accounts payable $ 25,000
Salaries and commissions payable 13,000
Long-term liabilities
Mortgage and loans payable due in 5 years 250,000
Shareholders' equity
Capital stock 91,000
Retained earnings 21,000
Total liabilities and shareholders' equity $400,000

Sales for May 2013 were $140,000, resulting in net income for the month of $21,000 after a 30
percent provision for corporate income taxes.
Blackford and Cross are concerned about how to proceed after the first month. They believe they
can double their sales, but they will need additional inventory to avoid stockouts. Also, they will
need to buy equipment on installment credit. It is not likely that they will be able to obtain
external financing for several months. A financial consultant has told them that working capital is
linked to ROA, and they are now trying to formulate an appropriate working capital management
plan.
 Black-Cross Working Capital and ROA

Projected data for the next six months of operations are shown below. Each of the three
alternatives represents a different working capital strategy. All three alternatives will be financed
with a one-year, collateralized working capital loan.

Black-Cross Systems Inc.

Projected Data
June November 2013
Alternative 1 Alternative 2 Alternative 3
Sales $1,680,000 $1,505,000 $1,225,000
Earnings before tax $ 336,000 $ 301,000 $ 245,000
Current assets $1,070,000 $ 780,000 $ 490,000
Fixed assets 380,000 380,000 380,000
Total assets $1,450,000 $1,160,000 $ 870,000

Required:
A. 1. Give two ways in which working capital is associated with risk.
2. In what way is return on assets (ROA) linked with working capital?

B. Assuming the projections are accurate, calculate Black-Cross System Inc.'s annualized return
on assets (ROA) for the six months of operations under each alternative.

C. Given Black-Cross System Inc.'s risk temperament, which one of the three working capital
strategies would you recommend? Explain your answer.

D. Using the DuPont formula, the return on assets (ROA) can be expanded to the product of
two ratios. Define the two ratios, and discuss how management can use these ratios to
improve ROA.