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Solutions Manual

CHAPTER 17
ADDRESSING WORKING CAPITAL
POLICIES AND MANAGEMENT OF
SHORT-TERM ASSETS AND LIABILITIES
SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS
I. Questions
1. These are firms with relatively long inventory periods and/or relatively
long receivables periods. Thus, such firms tend to keep inventory on
hand, and they allow customers to purchase on credit and take a
relatively long time to pay.
2. These are firms that have a relatively long time between the time
purchased inventory is paid for and the time that inventory is sold and
payment received. Thus, these are firms that have relatively short
payables periods and/or relatively long receivable cycles.
3. Carrying costs will decrease because they are not holding goods in
inventory. Shortage costs will probably increase depending on how close
the suppliers are and how well they can estimate need. The operating
cycle will decrease because the inventory period is decreased.
4. Since the cash cycle equals the operating cycle minus the accounts
payable period, it is not possible for the cash cycle to be longer than the
operating cycle if the accounts payable period is positive. Moreover, it is
unlikely that the accounts payable period would ever be negative since
that implies the firm pays its bills before they are incurred.
II. Multiple Choice Questions
1.
2.
3.
4.
5.

C
C
B
C
D

6.
7.
8.
9.
10.

A
B
D
C
B

11.
12.
13.
14.

C
B
D
B

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III. Problems
Problem 1 (Cash Equation)
The total liabilities and equity of the company are the net book worth, or
market value of equity, plus current liabilities and long-term debt, so:
Total liabilities and equity = 10,380 + 1,450 + 7,500 = 19,330
This is also equal to the total assets of the company. Since total assets are the
sum of all assets, and cash is an asset, the cash account must be equal to total
assets minus all other assets, so:
Cash = 19,330 15,190 2,105 = 2,035
We have NWC other than cash, so the total NWC is:
NWC = 2,105 + 2,035 = 4,140
We can find total current assets by using the NWC equation. NWC is equal
to:
NWC = CA CL
4,140 = CA 1,450
CA = 5,590
Problem 2 (Changes in the Operating Cycle)
a.

Increase. If receivables go up, the time to collect the receivables would


increase, which increases the operating cycle.

b.

Increase. If credit repayment times are increased, customers will take


longer to pay their bills, which will lead to an increase in the operating
cycle.

c.

Decrease. If the inventory turnover increases, the inventory period


decreases.

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Addressing Working Capital Policies and Management

Chapter 17

d.

No change. The accounts payable period is part of the cash cycle, not
the operating cycle.

e.

Decrease. If the receivables turnover increases, the receivables period


decreases.

f.

No change. Payments to suppliers affects the accounts payable period,


which is part of the cash cycle, not the operating cycle.

Problem 3 (Changes in Cycles)


a.

Increase; Increase. If the terms of the cash discount are made less
favorable to customers, the accounts receivable period will lengthen.
This will increase both the cash cycle and the operating cycle.

b.

Increase; No change. This will shorten the accounts payable period,


which will increase the cash cycle. It will have no effect on the
operating cycle since the accounts payable period is not part of the
operating cycle.

c.

Decrease; Decrease. If more customers pay in cash, the accounts


receivable period will decrease. This will decrease both the cash cycle
and the operating cycle.

d.

Decrease; Decrease. Assume the accounts payable period does not


change. Fewer raw materials purchased will reduce the inventory
period, which will decrease both the cash cycle and the operating
cycle.

e.

Decrease; No change. If more raw materials are purchased on credit,


the accounts payable period will tend to increase, which would
decrease the cash cycle. We should say that this may not be the case.
The accounts payable period is a decision made by the companys
management. The company could increase the accounts payable
account and still make the payments in the same number of days. This
would leave the accounts payable period unchanged, which would
leave the cash cycle unchanged. The change in credit purchases made
on credit will not affect the inventory period or the accounts payable
period, so the operating cycle will not change.

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f.

Addressing Working Capital Policies and Management

Increase; Increase. If more goods are produced for inventory, the


inventory period will increase. This will increase both the cash cycle
and operating cycle.

Problem 4 (The Operating and Cash Cycles)


We first need the turnover ratios. Note that we use the average values for all
balance sheet items and that we base the inventory and payables turnover
measures on cost of goods sold:
Inventory turnover = 11,375/ [(1,273 + 1,401)/2] = 8.51 times
Receivables turnover = 14,750/ [(3,782 + 3,368)/2] = 4.13 times
Payables turnover = 11,375/ [(1,795 + 2,025)/2] = 5.96 times
We can now calculate the various periods:
Inventory period = 365 days/8.51 times = 42.89 days
Receivables period = 365 days/4.13 times = 88.38 days
Payables period = 365 days/5.96 times = 61.24 days
So the time it takes to acquire inventory and sell it is about 43 days.
Collection takes another 88 days, and the operating cycle is thus 43 + 88 =
131 days. The cash cycle is thus 131 days less the payables period: 131 61
= 70 days.
Problem 5 (Working Capital)
a. Working Capital = 400,000
Net Working Capital = 400,000 200,000 = 200,000
Current Ratio = 400,000/200,000 = 2 times
b. Five Stars return on equity is 12.5 percent (62,700/500,000).
Five Star Manufacturing Company
Income Statement
For the Year Ended December 31, 2011
Net sales
EBIT (20% of sales)
Less: Interest expense
Short-term debt (10%)
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800,000
160,000
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Addressing Working Capital Policies and Management

Chapter 17

Long-term debt (15%)


45,000
Earnings before taxes
95,000
Less: Income taxes (34%)
32,300
Net income
62,700
c. The net working capital and current ratios for each strategy are shown
below:

Current assets (CA)


Fixed assets
Total assets

Strategies
Current Assets as a Percent of Sales
30%
50%
70%
300,000 500,000 700,000
600,000
600,000
600,000
900,000 1,100,000 1,300,000

Current liabilities (CL)*


Long-term liabilities
Total liabilities
Stockholders equity (SE)
Total liabilities and equity

180,000 200,000 260,000


270,000
330,000
390,000
450,000 550,000 650,000
450,000
550,000
650,000
900,000 1,100,000 1,300,000

Net working capital (CA CL)


Current ratio (CA/CL)

120,000 300,000 440,000


1.7 times
2.5 times
2.7 times

*Assume that all current liabilities are in the form of short-term debt.
d. The firms liquidity position, as measured by the amount of net working
capital and current ratio, improves when current assets are a higher
percentage of sales.
e. The rate of return on equity for each strategy is shown below:

Net sales
EBIT (18% of sales)
Interest expense
Short-term debt (10%)
Long-term debt (15%)
Earnings before taxes (EBT)
Income taxes (34%)

Strategies
Current Assets as a Percent of Sales
30%
50%
70%
1,000,000 1,000,000 1,000,000
180,000
180,000
180,000
18,000
40,500
121,500
41,310
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20,000
49,500
110,500
37,570

26,000
58,500
95,500
32,470

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Addressing Working Capital Policies and Management

Net income

Return on equity (NI/SE)


f.

80,190

72,930

63,030

17.8%

13.0%

9.7%

Five Stars profitability decreases as liquidity increases. For example, the


firms liquidity (current ratio = 2.7 times) is the highest but profitability
(ROE = 9.7 percent) is the lowest when current assets are 70 percent of
sales.

g. The return on equity, net working capital and current ratio for each
strategy are shown below:

EBIT
Interest expenses
Short-term (10%)
Long-term (15%)
Earnings before taxes (EBT)
Income taxes (34%)
Net income
Return on equity (NI/SE)
Net working capital (CA CL)
Current ratio (CA/CL)

Financing- Mix Strategies


Restricted Compromise
Flexible
180,000
180,000
180,000
10,000
52,500
117,500
39,950
77,550

30,000
22,500
127,500
43,350
84,150

45,000
0
135,000
45,900
89,100

17.2%
200,000
3.0 times

18.7%
0
1.0 times

19.8%
(150,000)
0.7 times

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