TO: Bob Knight, CFO

DATE: April 14, 2015

SUBJECT: Working Capital Policy

Overview
Office Mates, Inc. is a manufacturer of metal filing cabinets for home and office use. They have
sold their cabinets through regular channels for its office furniture; and under the name “Office
Friends” through large mass merchandisers for home use. With the demand for paper storage
cabinets dwindling, Office Mates has decided to start manufacturing computer CDs and diskette
storage systems. While the firm has been keeping up to date in manufacturing and marketing,
the financial management has always come last. Office Mates has decided to bring in Bob
Knight after their former financial manager retired. Knight worked for several years at a
competing company as the Chief Financial Officer.

After familiarizing himself with Office Mates, Knight has concluded there needs to be a
development of a rational working capital policy. Before instating said policy Knight wants to
examine three alternatives to the policy: an aggressive policy, which requires minimizing the
amount of cash and inventories and using only short-term debt; a conservative policy, which
requires a large amount of cash and inventories, and using only long-term debt; or a moderate
policy, which falls between the two extremes. The company’s $5 million in net fixed assets is
sufficient to cover the range of sales which will be discussed.

Analysis
With a change in the working capital policy there will also be a residual change in the company’s
costs. We have determined, regardless of which policy is chosen fixed costs will be 50 percent of
sales. Annual fixed costs on the other hand will vary between: $4,000,000 under the aggressive
policy, $4,500,000 under the moderate policy, and $5,000,000 under the conservative policy.

Each working capital policy will also have an effect on the company’s ability to respond to
changes in the economy. Table 1 in the Appendix shows the projected sales under each policy
and different states of the economy. Under the conservative policy sales have the highest
projection. This would also mean an increase in accounts receivable because of the use of long-
term debts. In the aggressive policy we see it has the lowest projected sales. This is partially
due to lost sales from the very low level of inventory on hand.

Brian King also suggested as part of the aggressive policy the company could also minimize
accounts receivable, and under the conservative policy it could be maximized. A change like
this would ultimately undermine the concept of the conservative policy. It is not very
conservative to relax lending policies, enabling weaker customers to borrow on credit.
Recommendation
Based upon the things discussed in the analysis of the situation it is my recommendation that
Office Mates, Inc. select the moderate policy. The moderate working capital policy will allow
Office Mates to take on both short- and long-term debt. They will also be able to meet the large
order quantities from their mass merchandisers for the “Office Friends” home line. While the
conservative policy has the largest overall projected sales, it also has the lowest projected net
income in an average economy. This is due to the higher level of fixed costs. In an average
economy the aggressive policy has the largest projected net income. However, I argue that
reducing inventory levels too low can be detrimental. If one of their mass merchandisers, like
Wal-Mart, places a large order, Office Mates would not have the necessary inventory on hand to
meet the demand. This would result in lost sales, either because a large customer went to a
competitor who could handle larger orders; or several small customers were lost because Office
Mates choose to meet the demand of their large customer first. Either way I see a significant
amount sales could be lost with very low inventory levels.
Appendix
Table 1) Estimated sales based upon each working capital policy and state of the economy

Aggressive Moderate Conservative

Sales:
Weak $9,000 $11,000 $13,000
Average $12,000 $13,000 $14,000
Strong $13,000 $14,500 $16,000

Table 2) Projected Income Statement for each working capital policy during an average economy
Average Economy: Working Capital Policy
Aggressive Moderate Conservative
Sales $12,000 $13,000 $14,000
Cost of goods sold 10,000 11,000 12,000
------- ------- -------
EBIT $2,000 $2,000 $2,000
Interest on debt 450 575 715
------- ------- -------
EBT $1,550 $1,425 $1,285
Taxes 620 570 514
------- ------- -------
Net income $930 $855 $771
======= ======= =======
Basic Earning Power
(EBIT/Assets) 22.2% 20.0% 18.2%
Return on equity 20.7% 17.1% 14.0%