Professional Documents
Culture Documents
Define net working capital, discuss the importance of working capital management,
and be able to compute a firms net working capital.
2.
Define the operating and cash cycles, explain how they are used, and be able to
compute their values for a firm.
3.
Discuss the relative advantages and disadvantages of pursuing (1) flexible and (2)
restrictive current asset investment strategies.
4.
Explain how accounts receivable are created and managed, and be able to compute
the cost of trade credit.
5.
Explain the trade-off between carrying costs and reorder costs, and be able to
compute the economic order quantity for a firms inventory orders.
6.
Define cash collection time, discuss how a firm can minimize this time, and be able
to compute the cash collection costs and benefits of a lockbox.
7.
Identify three current asset financing strategies and discuss the main sources of
short-term financing.
I.
Chapter Outline
14.1
What is the appropriate amount and mix of current assets for the firm to
hold?
Current assets are cash and other assets that the firm expects to convert
into cash in a year or less.
Current liabilities (or short-term liabilities) are obligations that the firm
expects to pay off in a year or less.
Working capital, also called gross working capital, is the funds invested
in a companys cash account, account receivables, inventory, and other
current assets.
A.
The higher the cash balance, the better the ability of the
firm to meet its short-term financial obligations.
14.2
The cash conversion cycle begins when the firm invests cash to purchase the raw
materials that would be used to produce the goods that the firm manufactures and ends
not with the finished goods being sold to customers and the cash collected on the sales;
but when you take into account the time taken by the firm to pay for its purchases.
See Exhibit 14.2 for a graphical representation of the cash conversion cycle.
When managing working capital accounts, financial managers want to do the following:
quality product.
Maintain minimal finished goods inventories without losing sales.
Offer customers the most attractive credit terms possible on trade credit to
With the financial managers goal being to maximize the value of the firm, each of the
decisions above is intended to shorten the cash conversion cycle and improve the firms
liquidity.
Two tools to measure the working capital management efficiency are the operating cycle
and the cash conversion cycle.
A.
Operating Cycle
The operating cycle begins when the firm receives the raw materials it purchased
and ends when the firm collects cash payments on its credit sales.
Days sales in inventory (DSI) shows how long the firm keeps its
inventory before selling it.
o
The quicker a firm can move out its raw materials as finished
goods, the shorter the duration when the firm holds it inventory,
and the more efficient it is in managing its inventory.
The operating cycle is calculated by summing the days sales outstanding and the
days sales in inventory.
(14.1)
B.
The cash conversion cycle is related to the operating cycle, but it does not start
until the firm actually pays for its inventory.
The cash conversion cycle is the length of time between the cash outflow
for materials and the cash inflow from sales.
To measure the cash conversion cycle, we need another measure called the days
payables outstanding.
Days payable outstanding (DPO) shows how long a firm takes to pay off its
suppliers for the cost of inventory.
The cash conversion cycle is then calculated by summing the days sales
outstanding and the days sales in inventory and subtracting the days payables
outstanding.
14.3
Financial managers use two types of strategies for current assets investments: flexible and
restrictive.
A.
The flexible strategy has a high percent of current assets to sales, whereas a
restrictive policy has a low percent of current assets to sales.
The flexible strategy calls for management to invest large amounts in cash,
marketable securities, and inventory.
The strategy also promotes a liberal trade credit policy for customers, which
results in high levels of accounts receivable.
The flexible strategy is perceived be a low risk and low return course of action for
management to follow.
The advantage of this policy is the large working capital balances the firm holds.
The investment in the low return current assets deprives the higher returns
that management could earn on longer term assets like plant and
equipment.
B.
The firm barely invests in cash and inventory, and has tight terms of sale intended
to curb credit sales and accounts receivable.
The high risk comes in the form of shortage costs that can be either
financial or operating.
Financial shortage costs arise mainly from the illiquidity shortage of cash
and a lack of marketable securities to sell for cash.
o
If unpaid bills are due, the firm will be forced to use expensive
external emergency borrowing.
If the firm does not hold enough raw materials in inventory, time
may be wasted by a halt in production.
If the firm runs out of finished goods, sales may also be lost, and
customer dissatisfaction may arise.
C.
The optimal current asset investment strategy will depend on the relative
magnitudes of carrying costs versus shortage costs. This conflict is often referred
to as the working capital trade-off.
If carrying costs are larger than shortage costs, then the firm will
maximize value by adopting a more restrictive strategy.
On the other hand, if shortage costs dominate carrying costs, the firm will
need to move toward a more flexible policy.
Overall, management will try to find the level of current assets that
minimizes the sum of the carrying costs and shortage costs.
14.4
Accounts Receivables
A.
Terms of Sale
Whenever a firm sells a product, the seller spells out the terms and conditions of
the sale in a document called the terms of sale.
The agreement specifies when the cash payment is due and the amount of any
discount if early payment is made.
Trade credit, which is short-term financing, is typically made with a discount for
early payment rather an explicit interest charge.
An offer of 3/10, net 40 means that the selling firm offers a 3 percent
discount if the buyer pays the full amount of the purchase in cash within
10 days of the invoice date.
o
Otherwise, the buyer has 40 days to pay the balance in full from
the date of delivery.
To calculate the cost, we need to determine the interest rate the buyer is paying
and convert it to an equivalent annual rate.
The formula for calculating the EAR for a problem like this is shown below, in
Equation 14.4,
Discount
1+
Discounted price
Effective annual rate =
365/dayscredit
Trade credit is a loan from the supplier and it can be a very costly form of credit.
B.
The aging schedule shows the breakdown of the firms accounts receivable by
their date of salehow long has the account not been paid in days.
Its purpose is to identify and then track delinquent accounts and to see that they
are paid.
Aging schedules are also an important financial tool for analyzing the quality of a
companys receivables.
14.5
Inventory Management
Manufacturing companies generally carry three types of inventory: raw materials, work
in process, and finished goods.
A.
The optimal order size strikes the balance between these two costs.
B.
In this system the exact day-by-day, or even hour-by-hour, raw material needs
are delivered by the suppliers, who deliver the goods just in time for them to
be used on the production line.
A big advantage of this system is that there are essentially no raw inventory
costs and no chance of obsolescence or loss to theft.
On the other hand, if the supplier fails to make the needed deliveries, then
production shuts down.
If the system works for a firm, it cuts down their investment in working capital
dramatically.
14.6
Two reasons exist for holding a cash balance. First, it facilitates transactions
with suppliers, customers and employees.
The second reason is simply that most banks require firms to hold minimum cash
balances, or compensating balances, in exchange for the services they provide.
B.
Cash Collection
Collection time, or float, is the time between when a customer makes a payment
and when the cash becomes available to the firm.
Finally, there is a delay between the time of the deposit and the time when
the cash is available for withdrawal.
Payments in cash at the point of sale reduce the collection time to zero.
o
Either approach will reduce the collection time to an extent, but there is a cost
associated with it.
14.7
Exhibit 14.7 shows the three basic strategies that a firm can follow to finance its
working capital and fixed assets.
Each of the three panels show: (1) the total long-term financing needed,
which consists of long-term debt and equity, and (2) the seasonal needs for
working capital that fluctuates with the level of sales.
All working capital is funded with short-term borrowing, and, as the level of
sales varies seasonally, short-term borrowing fluctuates between some
minimum and maximum level.
This strategy relies on long-term debt to finance both capital assets and
working capital.
This strategy reduces the risk of funding current assets because there is no
need to worry about refinancing assets since all funding is long term.
Figure C in Exhibit 14.7 shows the short-term funding strategy whereby all
working capital and a portion of fixed assets are funded with short-term debt.
While this lowers the cost under some interest rate scenarios, it forces the
firm to continually refinance the funding of the long-term assets in a changing
interest rate environment.
B.
Many financial managers try to match the maturities of assets and liabilities when
funding the firm.
That is, short-term assets are funded with short-term financing, and longterm assets are funded with long-term financing.
Most financial managers like to fund some of their currents assets with long-term
debt as shown in Figure A of Exhibit 14.7, so-called permanent working capital.
C.
Accounts payable (trade credit), bank loans, and commercial paper are common
sources of short-term financing.
Between 1990 and 2003, accounts payable constituted 37 percent of total current
liabilities for all publicly traded manufacturing firms.
The buyer needs to figure out whether it makes financial sense to pay early
and take advantage of the discount or to wait and pay in full when the account
is due.
Between 1990 and 2003, short-term bank loans accounted for 19 percent of total
current liabilities for all publicly traded manufacturing firms.
An informal line of credit is a verbal agreement between the firm and the
bank, allowing the firm to borrow up to an agreed-upon upper limit.
In exchange for providing the line of credit, a bank may require that the
firm holds a compensating balance with them.
The firm pays a yearly fee, in addition to the interest expense on the
amount they borrow.
If the firm backs the loan with an asset, the loan is defined as secured;
otherwise, the loan is unsecured.
Secured loans allow the borrower to borrow at a lower interest rate, all
else being equal.
Commercial paper is not secured, which means that the issuer is not
pledging any assets to the lender in the event of default.
The firm that sold the receivables has no further legal obligation to the
factor.
II.
This chapter focuses on short-term financial decisions that involve cash inflows and outflows
that will occur within a year or less. Examples include the purchase of raw materials, payment
for the purchases of raw materials, sale of finished inventory, and the collection of cash for sales
made on credit. This chapter focuses on these types of decisions, which are called working
capital management.
The chapter begins by reviewing some basic definitions and concepts that are necessary
to further our study of working capital management. Next, the authors examine the individual
working capital accounts and then learn how to construct and analyze the operating and cash
conversion cycles. Then they examine how the different working capital accounts are managed:
the cash account, accounts receivables, and inventory. Finally, the different financing options that
financial managers consider, and the risks involved, are discussed.
Instructors may choose to cover this chapter at any point in the semester. The material is
sufficiently independent of previous material to allow that. It is important to recognize that many
undergraduates are more likely to deal with working capital management issues on their first job
than with issues like capital budgeting decisions or capital structure decisions.
None of the quantitative material is likely to be overwhelming, and as in previous
chapters, the end-of-chapter problems emphasize repetition to allow instructors to work some
problems in class and assign others for the students to work on their own.
Define net working capital, discuss the importance of working capital management, and
be able compute a firms net working capital.
Net working capital is the difference between current assets and current liabilities. Working
capital management refers to the decisions made regarding the use of current assets and how
they are financed. The goal of working capital management is to ensure that the firm can
continue its day-to-day operations and pay its short-term debt obligations. The computation
of net working capital for Dell Computer is illustrated in Section 14.1
Discuss the operating and cash cycles, explain how are they used, and be able to
compute their values for a firm
The operating cycle can be defined as the period starting with the receipt of raw materials
and ending with the receipt of cash for finished goods made from those raw materials. It can
be broken into two components: (1) days sales in inventory, which shows how long a firm
keeps its inventory before selling it, and (2) days sales outstanding, which indicates how
long it takes on average for the firm to collect its outstanding accounts receivable. Related to
the operating cycle is the cash conversion cycle, which is the length of time between the cash
outflow for materials and the cash inflow from sales. An additional measure, that of days
payables outstanding, is required to calculate the cash conversion cycle. Both cycles are
simple tools to help the financial manager measure working capital efficiency and control
liquidity. The computations are illustrated in Section 14.2.
1.
Discuss the relative advantages and disadvantages of pursuing (1) flexible and (2)
restrictive current asset investment strategies.
A flexible strategy involves maintaining relatively high levels of cash, marketable securities,
and inventory, while a restrictive strategy keeps the levels of current assets relatively low. In
general, a flexible strategy is thought to be low risk and low return; its downsides include
low returns on current assets, potentially high inventory-carrying costs, and the cost of the
money necessary to provide liberal credit terms. The restrictive strategy involves higher risk
and return, with higher potential financial and operating shortage costs as its major
drawbacks.
Explain how accounts receivable are created and managed, and be able to compute the
cost of trade credit.
Accounts receivable are promises of future payment from customers that buy goods or
services on credit. The details are defined in the terms of sale, which include the due date, the
interest rate charge, and any discounts for early payment. The terms of sale are affected by
the practice in the industry and the creditworthiness of the customer. To manage accounts
receivable, the financial manager should keep close track of both days sales outstanding and
the aging schedule.
Explain the terms inventory-carrying costs and reorder costs, and be able to compute the
economic order quantity for a firms inventory orders.
The trade-off between carrying costs and reorder costs exists because as the size of a firms
orders for materials increases, the number of orders and total reorder costs decline. At the
same time, larger order size increases the average inventory size, and, therefore, average
inventory-carrying costs. The economic order quantity (EOQ) is a tool for mathematically
finding the combination of the two costs that minimizes the firms total inventory cost.
Learning by Doing Application 14.3 offers practice in computing a firms EOQ.
2. Define cash collection time, discuss how a firm can minimize this time, and be able to
compute the economic costs or benefits of a lockbox.
Cash collection time is the time between when a customer makes a payment and when the
cash becomes available to the firm. It has three components: (1) delivery or mailing time, (2)
processing delay, and (3) delay between deposit time and availability. Possible methods a
firm can use to minimize this time include lockboxes, concentration accounts, and electronic
funds transfers. Work through Learn by Doing Application 14.4 to decide whether a lockbox
is worth keeping.
3. Identify three current asset financing strategies and discuss the main sources of shortterm financing.
There are three main current asset financing strategies: (1) the matching maturity strategy,
which matches the maturities of assets with the maturities of liabilities; (2) the long-term
funding strategy, which finances both working capital and long-term assets with long-term
debt; and (3) the aggressive funding strategy, which uses short-term debt for both working
capital and long-term assets. Sources of short-term financing include accounts payable, shortterm bank loans, lines of credit, and commercial paper.
Description
Operating cycle
Cash conversion cycle
Formula
Operating cycle = DSO + DSI
Cash conversion cycle =DSO + DSI DPO
Cash conversion cycle = Operating cycle
14.3
Cash conversion cycle
14.4
Effective annual rate (EAR)
14.5
DPO
Discount
1+
Discounted price
EAR =
EOQ =
365/dayscredit
V.
Section 14.1
1
Net working capital is calculated as the difference between the current assets and current
liabilities. It is important for a firm to keep a positive net working capital balance, as
these funds are used to cover the day-to-day expenses and short-term liabilities as they
come due.
2.
What are some of the trade-offs required in the management of working capital accounts?
When managing working capital accounts, a financial manager is looking to delay paying
accounts payable as long as possible without suffering any penalties, maintain minimal
finished goods inventories without losing sales, and collect cash payments on accounts
receivable as fast as possible to close the loop, among other things.
Section 14.2
1.
What is the operating cycle, and how is it related to the cash conversion cycle?
The operating cycle starts with the receipt of raw materials and ends with the collection
of cash from customers for the sale of finished goods. The operating cycle can be
described in terms of two components: days sales in inventory and days sales
outstanding. The cash conversion cycle is the length of time between the actual cash
outflow for materials and the actual cash inflow from sales. To calculate it, we need all of
the information used to calculate the operating cycle plus one additional measure: days
payables outstanding.
Section 14.3
1.
What are the two general current asset investment strategies discussed in this section, and
how do they differ?
Typically, the two main current asset investment strategies are flexible and restrictive
strategies. The flexible strategy prompts management to keep large balances of cash,
marketable securities, and inventory. This strategy is perceived to be a relatively low-risk
and low-return course of action for management to follow. The restrictive strategy, on the
other hand, prompts management to keep the usage of current assets to a minimum and is
perceived to be high risk and high return.
2.
What are the types of costs associated with each of these strategies?
The flexible strategy is associated with a high level of carrying costs because of a firms
high levels of inventory and providing liberal credit for customers. The restrictive
strategy is associated with shortage costs, which can be either financial or operating in
nature.
Section 14.4
1.
If a company declares a 4/15, net 30 means of sale, it signifies that it will grant the
customer a 4 percent discount if the customer pays the full amount within 15 days of the
invoice date. Otherwise the customer has 30 days to pay the balance in full from the date
of the delivery.
2.
The aging schedule for a firm lists the accounts receivable broken down by the number of
days until they are due or past due. Firms use aging schedules to keep track of their
accounts receivables and to assess how effective they are collecting on these accounts.
Section 14.5
1.
The economic order quantity model is an inventory management tool that mathematically
determines the minimum total inventory cost, taking into account reorder costs and
inventory-carrying costs. The main objective of the model is to find the trade-off between
the two costs.
2.
Section 14.6
1
What is float?
The collection time, which is the time between when a customer makes a payment and
the time the cash becomes available is to the firm, is also referred to as float.
Lockboxes are post office boxes set up by the firm for its customers to deliver their
payments to these boxes instead of the firms business address. The post office then
collects these payments and delivers them to the bank. The main purpose of lockboxes is
to minimize collection time for firms through cutting down on postal time and through
processing the payments directly at the bank.
Section 14.7
1
List and briefly describe the three main short-term financing strategies.
The three main short-term financing strategies are (1) self-liquidating strategy, in which
the maturity of the liabilities is matched with that of assets; (2) conservative strategy,
which relies more heavily on long-term financing; and (3) restrictive strategy, which
relies primarily on short-term financing.
Short-term financing offers companies greater flexibility and usually a lower cost of
capital. On the other hand, short-term financing often comes with some illiquidity
problems as well as uncertainty due to increased exposure to interest rate fluctuations.
14.1
You are provided the following working capital information for the Blue Ridge
Company:
Account
Inventory
Accounts receivable
Accounts payable
Beginning Balance
$ 2,600
3,222
2,500
Net sales
Cost of goods sold
Ending Balance
$2,890
2,800
2,670
24,589
19,630
If all sales are on credit, what are the firms operating and cash conversion cycles?
Solution:
We calculate the operating and cash conversion cycles for Blue Ridge as follows:
Inventory = $2,890
Accounts receivable = $2,800
Accounts payable = $2,670
Net sales = $24,589
Cost of goods sold = $19,630
DSO =
DSI
Accounts receivable
$2,800
=
= 41.6 days
Credit sales 365
$24,589 365
Inventory
$2,890
53.7 days
COGS 365 $19,630 365
DPO =
Accounts payable
$2,670
=
= 49.6 days
COGS 365
$19,630 365
14.2
Merrifield Cosmetics calculates that its operating cycle for last year was 76 days. The
company had $230,000 in its accounts receivable account and had sales of $1.92 million.
What can you say about Merrifields inventory management?
Solution:
The following information describes Merrifields inventory management:
Operating cycle = 76 days
Accounts receivables = $230,000
Net sales = $1,920,000
DSO
Accounts receivable s
$230,000
43.7 days
Credit sales 365
$1,920,000 365
14.3
Below is a partial aging of accounts receivable for Bitar Roofing Services. Fill in the rest
of the information and determine its days sales outstanding. How does it compare to the
industry average of 40 days?
% of Total Account
Solution:
The missing information for Bitar Roofing is as follows:
Age of Accounts (in days)
0-10
11-30
31-45
46-60
Over 60
Total
% of Total Account
39.7%
22.7
19.4
13.7
4.5
100%
Effective DSO (0.397 10) (0.227 30) (0.194 45) (0.137 60) (0.045 365)
3.97 6.81 8.73 8.22 16.43
44.2 days
Bitar takes about 4 days more than the industry average of 40 to collect on its receivables.
The firm should focus collection efforts on all credit sales that take 60 days or more to
collect.
14.4
By obtaining a lockbox, Nizams Manufacturing was able to reduce its total cash
collection time by two days. The firm has annual sales of $570,000 and can earn 4.75
percent annual interest. Assuming that the lockbox costs $50 per year, calculate the
savings that can be attributed to the lockbox.
Solution:
$570,000
$1,561.64
365
Savings $1,561.64 0.0475 2 $50 $98.36
Average daily sales
The firm can save $98.36 each year by using the lockbox.
14.5
Rockville Corporation is looking to borrow $250,000 at a stated 8.5 percent APR from
its bank, which requires its customers to maintain a 10 percent compensating balance.
What is the effective interest rate on this loan for Rockville Corporation?
Solution:
Rockville Corporations loan information is as follows:
Amount to be borrowed = $250,000
Stated annual interest rate = 8.5%
Compensating balance = 10%
Amount deposited as compensating balance = $250,000 x 0.10 = $25,000
Effective borrowing amount equal to $250,000 $25,000 = $225,000
Interest expense = $250,000 x 0.085 = $21,250
Effective interest rate
Interest expense
$21,250
9.44%
Effective borrowing amount $225,000
By setting aside a compensating balance of 10 percent or $25,000 on the loan, the firm
increases its interest rate effectively to 9.44 percent.
What factors must a financial manager consider when making decisions about account
receivables?
When dealing with accounts receivables, important decisions for the financial manager
include the amount of credit offered to various customers and the term of the credit. The
financial manager should keep close track of both the aging schedule and the effective
DSO. If either or both show consistent deterioration, it may be time to reconsider the
firms credit policy or the characteristics of its customers. In addition, in some industries,
sales vary by season. A firm must be aware of seasonal patterns and make the necessary
adjustments before drawing any conclusions about its accounts receivable.
14.2
List some of the working capital management characteristics you would expect a
computer manufacturing company following just-in-time delivery system, such as Dell.
Firms like Dell are likely to do an exceptional job of managing their inventory and
collecting on their receivables. Dell employs a strategy similar to just-in-time
management where they maintain just sufficient inventory to meet the needs for a very
short time. This saves the firm a huge investment in inventory. Thus their days sales in
inventory (DSI) will be very low compared to other industries. Similar to Dell, firms will
have a short collection period, and their operating cycle will be much lower than firms in
other industries. If other computer manufacturing firms follow the Dell operating
philosophy, they will extend their days payables (DPO) to the point that tier cash
conversion cycle is negative. In other words, instead of having to invest in its working
capital, these firms will end up taking more time to pay their suppliers than the time taken
to produce, sell, and collect on the receivables.
14.3
What costs would a firm following a flexible current asset investment strategy worry
about, and why?
The strategys downside is the high carrying cost associated with owning a high level of
inventory and providing liberal credit terms for customers. By investing in current assets,
management foregoes the higher rate of return it could have earned by investing in longterm assets. Therefore, there is an opportunity cost involved when investing in current
assets. Second, large investments in some types of inventory can require significant
warehousing and storage costs, which can be expensive.
14.4
How are customers and suppliers affected by a firms working capital management
decisions?
Customers like firms to maintain large finished goods inventories because when they go
to make a purchase, the item they want will likely be in stock. In general, large inventory
helps stimulate sales and increase customer satisfaction, but they can be a costly item on
a firms balance sheet. Managements decisions on the firms receivables policy is driven
by the industry type. Companies selling perishable products, such as food companies,
might ask for payment in full in less than 10 days. On the other hand, if the firm is selling
durable goods, the terms of credit are likely to be more generous. The terms of sale are
also affected by the creditworthiness of the customer. If the firm is confident that it will
be paid, it is far more likely to extend credit than if there was some doubt about payment.
If the customer is a particularly large firm or if there is a likelihood of repeat business,
then extending credit may be part of the marketing effect to secure the order. Thus, when
the financial manager makes a decision to increase working capital, good things are likely
to happen to the firmsales should increase, relationships with vendors and suppliers
should improve, and work or manufacturing stoppages should be less likely.
14.5
A beverage bottling company in Vermont has days sales outstanding of 23.7 days. Is this
good? Explain.
In general, a lower DSO reflects the fact that the firm is managing its receivables very
well. However, it is not possible to decide whether a DSO of 23.7 days is good or bad
unless you have a basis for comparison. That basis of comparison could be a peer group,
historical data for the firm itself, or targets set by the management.
14.6
How do the following circumstances affect the cash conversion cycle: (a) favorable credit
terms allow the firm to pay its accounts payable more slowly, (b) inventory turnover
increases, and (c) accounts receivable turnover decreases?
(a)
Favorable credit terms from suppliers allow the firm to use the suppliers funds to
finance their working capital. It also reduces the firms cash conversion cycle.
(b)
An increase in the inventory turnover, that is, the DSI decreases, reduces both the
firms operating cycle and the cash conversion cycle.
(c)
As the accounts receivables turnover (DSO) decreases, the firm improves its
receivables management and reduces its operating cycle and hence, its cash
conversion cycle.
14.7
What are some industries in which the use of lockboxes would especially benefit
companies? Explain.
Lockboxes are a useful tool to speed up collection of receivables when the customer base
is dispersed across a large geographical area. Normally, this would mean customer
payments would have to be mailed in, consolidated, and then deposited at the firms
bank. The alternative of setting up a lockbox system allows the firm to redirect customer
payments to regional locations for quicker consolidation and cashing of payments. This is
typical in the retail industry where each store of a chain is located in a different city or
state.
14.8
Suppose you are a financial manager at a big firm and you expect the interest rates to
decline in the near future. What current asset investment strategy would you recommend
the company pursue?
At a large firm, management would have access to the commercial paper market, which
can provide cheaper funding than short-term bank financing. To borrow in the
commercial paper market, a firm has to be financially strong. If interest rates are expected
to decline, such firms can plan on raising working capital by issuing commercial paper.
Thus, all or a portion of the working capital needs can be funded through short-term
funds that can be rolled over as long as interest rates are declining.
14.9
Commercial paper is available only to firms that are financially strong for two reasons.
First, there is no secondary market for investors to liquidate prior to maturity.
Consequently, investors must hold it to maturity and have the confidence that the issuer
would pay them back at that time. Second, this type of debt is not secured by any real
assets of the issuing firm. Thus, firms that are the most creditworthy are able to raise
funds in this market at costs that are lower than bank loans.
its operating cycle. In other words, the amount of time to manage their inventory and the
time taken to collect its receivables is less than the time taken to pay its suppliers.
VIII.
BASIC
14.1
Cash conversion cycle: Wolfgangs Masonry estimates that it takes the company 27 days
on average to pay off its suppliers. It also knows that it has days sales in inventory of 64
days and days sales outstanding of 32 days. How does Wolfgangs cash conversion cycle
compare to that of an industry average of 75 days?
Solution:
DPO = 27 days
DSI = 64 days
DSO = 32 days
Industry average for cash conversion cycle = 75 days.
Wolfgangs cash conversion cycle =
14.2
Cash conversion cycle: Northern Manufacturing Company found that during the last
year, they took 47 days to pay off its suppliers, while they took 63 days to collect their
receivables. The companys days sales in inventory was 49 days. What is Northerns
cash conversion cycle?
Solution:
DPO = 47 days
DSI = 49 days
DSO = 63 days
Northerns cash conversion cycle =
14.3
Cash conversion cycle: Devon Automotive estimates that it takes the company about 62
days to collect cash from customers on finished goods from the day it receives raw
materials and about 65 days to pay its suppliers. What is the companys cash conversion
cycle? Interpret your answer.
Solution:
DPO = 65 days
Operating cycle = 62 days
Devons cash conversion cycle =
Cash conversion cycle = Operating cycle DPO
= 62 65
= -3 days
This firm has a negative cash conversion cycle. The amount of time to manage its
inventory and the time taken to collect its receivables is less than the time taken to pay its
suppliers.
14.4
Operating cycle: Lilly Bakery distributes its products to more than 75 restaurants and
delis. The companys collection period is 27 days, and it keeps its inventory for four days.
What is Lillys operating cycle?
Solution:
DSI = 4 days
DSO = 27 days
Lillys operating cycle =
14.5
Solution:
DSI = 29 days
DSO = 44 days
NetSpeeds operating cycle =
14.6
Cost of trade credit: Sybex Corp. sells its goods with terms of 2/10 EOM, net 30. What
is the implicit cost of the trade credit?
Solution:
Credit terms = 2/10 EOM, net 30
Discount
1
Discounted price
= (1 + 2/98)365/20 1
= (1.0204)18.2500 1
= 1.4459 1
= 0.4459, or 44.59 percent
14.7
Cost of trade credit: Juggs, Inc., sells its goods with terms of 4/10 EOM, net 60. What is
the implicit cost of the trade credit?
Solution:
Discount
1
Discounted price
= 1.3472 1
= 0.3472, or 34.72%
14.8
Lockbox: Rosenthal Design has daily sales of $59,000. The financial management team
determined that a lockbox would reduce the collection time by 1.6 days. Assuming the
company can earn 5.2 percent interest per year, what are the savings from the lockbox?
Solution:
All sales are assumed to be credit sales.
Annual interest rate = 5.2%
Collection time saved = 1.6 days
Average daily sales $59,000
Savings $59,000 0.052 1.6 $4,908.80
14.9
Lockbox: Pacific Traders has annual sales of $1,895,000. The firms financial manager
has determined that using a lockbox will reduce collection time by 2.3 days. If the firms
opportunity cost on savings is 5.25 percent, what are the savings from using the lockbox?
Solution:
Annual sales = $1,895,000
Annual interest rate = 5.25%
Collection time saved = 2.3 days
$1,895,000
$5,191.78
365
Savings $5,191.78 0.0525 2.3 $626.91
Average daily sales
14.10 Effective interest rate: The Kellog Bank requires borrowers to keep an 8 percent
compensating balance. Gorman Jewels borrows $340,000 at a 7 percent stated APR.
What is the effective interest rate on the loan?
Solution:
Amount to be borrowed = $340,000
Stated annual interest rate = 7.0%
Compensating balance = 8%
Amount deposited as compensating balance = $340,000 0.08 = $27,200
Effective borrowing amount = $340,000 $27,200 = $312,800
Interest expense = $340,000 0.07 = $23,800
Effective interest rate
Interest expense
$23,800
7.61%
Effective borrowing amount $312,800
By setting aside a compensating balance of 8 percent or $27,200 on the loan, the firm
increases its interest rate effectively to 7.61 percent.
14.11 Effective interest rate: Morgan Contractors borrowed $1.75 million at an APR of 10.2
percent. The loan called for a compensating balance of 12 percent. What is the effective
interest rate on the loan?
Solution:
Amount to be borrowed = $1,750,000
Stated annual interest rate = 10.2%
Compensating balance = 12%
Amount deposited as compensating balance = $1,750,000 0.102 = $210,000
Effective borrowing amount equal to $1,750,000 $210,000 = $1,540,000
Interest expense = $1,750,000 x 0.10.2 = $178,500
Effective interest rate
Interest expense
$178,500
11.6%
Effective borrowing amount $1,540,000
By setting aside a compensating balance of 12 percent or $210,000 on the loan, the firm
increases its interest rate effectively to 11.6 percent.
14.12 Formal line of credit: Winegartner Cosmetics is setting up a line of credit at its bank for
$5 million for up to two years. The loan rate is 5.875 percent and also calls for an annual
fee of 40 basis points on any unused balance for the year. If the firm borrows $2 million
on the day the loan agreement was signed, what is the firms effective rate?
Solution:
Line of credit limit = $5,000,000
Loan rate = 5.875%
Annual fee on used balance = 0.4%
Amount borrowed = $2,000,000
Unused balance = $3,000,000
Annual fee = $3,000,000 x 0.004 = $12,000
6.48%
$2,000,000
The effective borrowing rate for the firm is 6.48% with the annual fee of 40 basis points.
INTERMEDIATE
14.13 Cash conversion cycle: Your boss asks you to compute the companys cash conversion
cycle. Looking at the financial statements, you see that the average inventory for the year
was $26,300, accounts receivable were $17,900, and accounts payable were at $15,100.
You also see that the company had sales of $154,000 and that cost of goods sold was
$122,000. Interpret your firms cash conversion cycle.
Solution:
All sales are assumed to be credit sales.
Accounts receivables = $17,900
Accounts payables = $15,100
Sales = $154,000
Inventory = $26,300
Cost of goods sold = $122,000
DSO =
Accounts receivable
$17,900
=
= 42.4 days
Credit sales 365
$154,000 365
DSI
Inventory
$26,300
78.7 days
COGS 365 $122,000 365
DPO =
Accounts payable
$15,100
=
= 45.2 days
COGS 365
$122,000 365
14.14 Cash conversion cycle: Blackwell Automotive, Inc., reported the following information
for the last fiscal year.
Assets
Cash and marketable sec.
Accounts receivable
Inventories
Other current assets
Total current assets
Net sales
Cost of goods sold
912,332
547,400
Solution:
Accounts receivables = $141,258
Accounts payables = $163,257
$163,257
21,115
$184,372
DSI
Accounts receivable
$141,258
=
= 56.5 days
Credit sales 365
$912,332 365
Inventory
$212,444
141.7 days
COGS 365 $547,400 365
DPO =
Accounts payable
$163,257
=
= 108.9 days
COGS 365
$547,400 365
Solution:
Net sales = $13,000,000
Credit sales = (0.75 $13,000,000) = $9,750,000
Accounts payable = $2,171,690
Inventory = $1,817,344
DSI =
Accounts payable
$2,171,690
=
= 93.8 days
COGS 365
$8,450,000 365
Inventory
$1,817,344
=
= 78.5 days
COGS 365 $8,450,000 365
DSO
Accounts receivables
AR
56.6 days
Credit sales 365
$9 , 750 , 000 365
14.16 Cash conversion cycle: Joanna Handicrafts, Inc., has net sales of $4.23 million with 50
percent of it being credit sales. Its cost of goods sold is $2.54 million. The firms cash
conversion cycle is 47.9 days. The firms operating cycle is 86.3 days. What is the firms
accounts payable?
Solution:
Net sales = $4,230,000
Credit sales = (0.5 x $4,230,000) = $2,115,000
Cash conversion cycle = 47.9 days
14.17 Operating cycle: Aviva Technologys operating cycle is 81 days. Its inventory level was
at $134,000 last year, and the company had a $1.1 million cost of goods sold. How long
does it take Aviva to collect on its receivables?
Solution:
Operating cycle = 81 days
Inventory = $134,000
Cost of goods sold = $1,100,000
DSI
Inventory
$134,000
44.5 days
COGS 365 $1,100,000 365
14.18 Operating cycle: Premier Corp. has sales of $812,344, and its cost of goods sold is 70
percent of sales. Assume all sales are credit sales. If the firms accounts receivable total
$113,902 and its operating cycle is 81.6 days, how much inventory does the firm have?
Solution:
Credit sales = $812,344
Operating cycle = 81.6 days
Cost of goods sold = (0.7 x $812,344) = $568,641
Accounts receivable = $113,902
DSO =
Accounts receivable
$113,902
=
= 51.2 days
Credit sales 365
$812,344 365
30.4 days
COGS 365 $568,641 365
Inventory $47,360.78
DSI
14.19 Economic order quantity: Longhorn Traders is one of the largest RV dealers in Austin
and sells about 2,800 recreational vehicles a year. The cost of placing an order with their
supplier is $800, and the inventory-carrying costs are $150 for each RV. The company
likes to maintain safety stock of 12 RVs. Most of their sales are either in spring or the fall
of each year. How many orders will the firm need to place this year?
Solution:
Annual sales = 2,800 units
Cost of placing an order = $800
Inventory-carrying cost per RV = $150
Safety stock = 12 RVs
EOQ
14.20 Effective interest rate: The Clarkson Designer Company is looking for a loan of
$750,000.The bank will provide the loan at an APR of 6.875. Since the loan calls for a
compensating balance, the effective interest rate on the loan increased to 9.25 percent.
What is the compensating balance on this loan?
Solution:
Amount to be borrowed = $750,000
Stated annual interest rate = 6.875%
Compensating balance = ?
Effective interest rate = 9.25%
Interest expense = $750,000 x 0.06875 = $51,562.50
Interest expense
Effective borrowing amount
$51,562.50
9.25%
Effective borrowing amount
$51,562.50
Effective borrowing amount
$557,432.43
0.0925
Effective interest rate
14.21 Effective interest rate: The Colonial Window Treatments Company is borrowing
$1,500,000. The loan requires a 10 percent compensating balance, and the effective
interest rate on the loan is 9.75 percent. What is the stated APR on this loan?
Solution:
Amount to be borrowed = $1,500,000
Stated annual interest rate = ?
Compensating balance = 10%
Effective interest rate = 9.75%
Compensating balance = (0.10 x $1,500,000) = $150,000
Effective borrowing amount = $1,500,000 $150,000 = $1,350,000
Interest expense
Effective borrowing amount
Interest expense
9.75%
Effective borrowing amount
Interest expense 0.0975 $1,350,000 $131,625
14.22 Formal line of credit: Gruppa, Inc., has just set up a formal line of credit of $10 million
with First Community Commercial Bank. The line of credit is good for up to five years.
The bank will be charging them an interest rate of 6.25 percent on the loan, and in
addition the firm will pay an annual fee of 60 basis points on the unused balance. The
firm borrowed $7.5 million on the first day the credit line became available. What is the
firms effective interest rate on this line of credit?
Solution:
Line of credit limit = $10,000,000
Loan rate = 6.25%
Annual fee on used balance = 0.6%
Amount borrowed = $7,500,000
Unused balance = $3,000,000
Annual fee = $2,500,000 x 0.006 = $15,000
Interest expense = $7,500,000 x 0.0625 = $468,750
Interest expense Annual fee
Borrowed amount
($468,750 $15,000)
6.45%
$7,500,000
14.23 Formal line of credit: Lansdowne Electronics has a formal line of credit of $1 million up
to three years with HND Bank. The interest rate on the loan is 5.3 percent, and under the
agreement, Lansdowne has to pay 50 basis points on the unused amount as the annual
fee. Suppose the firm borrows $675,000 the first day of the agreement. What is the fee
the company must pay? What is the effective interest rate?
Solution:
Line of credit limit = $1,000,000
Loan rate = 5.3%
Annual fee on used balance = 0.5%
Amount borrowed = $675,000
Unused balance = $325,000
Annual fee = $325,000 x 0.005 = $1,625
Interest expense = $675,000 x 0.053 = $35,775
Interest expense Annual fee
Borrowed amount
($35,775 $1,625)
5.54%
$675,000
14.24 Lockbox: Jennifer Electricals is evaluating whether a lockbox they are currently using is
worth keeping. Management estimates that the lockbox reduces the mail float by 1.8 days
and the processing by half a day. The remittances average $50,000 a day for Jennifer
Electricals, with the average check $500. The bank charges $0.34 per processed check.
Assume that there are 270 business days in a year and the firms opportunity cost of those
funds is 6 percent. What will the firms savings be from using the lockbox?
Solution:
Average daily sales = $50,000
No. of business days = 270
Opportunity cost of funds = 6%
Average check amount = $500
No. of checks processed per day = $50,000 / $500 = 100
Collection time saved = 1.8 days
Processing time saved = 0.5 days
Per-check processing fee = $0.34
The cost of a lockbox = 100 checks $0.34 per check 270 days = $9,180
Savings from mail float = 1.8 days $50,000 = $90,000
Savings from processing float = 0.5 days $50,000 = $25,000
Total savings = (Savings from mail float + Savings from processing float)
= $90,000 + $25,000 = $115,000
Savings from lockbox = $115,000 0.06= $6,900
Since the savings from the lockbox is less than the cost of the lockbox, it is not worth
keeping the lockbox for Jennifer Electricals.
14.25 Lockbox: Hazel Corp. has just signed up for a lockbox. Management expects the
lockbox to reduce the mail float by 2.1 days. Hazel Corp.s remittances average $37,000 a
day for Hazel, with the average check being $125. The bank charges $0.37 per processed
check. Assume that there are 270 business days in a year. What will the firms savings be
from using the lockbox if the opportunity cost of those funds is 12 percent?
Solution:
Average daily sales = $37,000
No. of business days = 270
Average check amount = $125
No. of checks processed per day = $37,000 / $125 = 296
Collection time saved = 2.1 days
Per check processing fee = $0.37
The cost of a lockbox = 296 checks $0.37 per check 270 days = $29,570.40
Savings from mail float = 2.1 days $37,000 = $77,700
Opportunity cost of funds = 12%
Savings from lockbox = $77,700 0.12= $9,324
Since the savings from the lockbox is less than the cost of the lockbox, it is not worth
keeping the lockbox for Hazel Corp.
14.26 Aging schedule: Ginseng Company collects 50 percent of its receivables in 10 days or
fewer, 31 percent in 11 to 30 days, 7 percent in 31 to 45 days, 7 percent in 46 to 60 days,
and 5 percent in more than 60 days. The company has $1,213,000 in accounts receivable.
Prepare an aging schedule for Ginseng Company.
Solution:
% of Total Account
50.0%
31.0
7.0
7.0
5.0
100.0%
14.27 Aging schedule: A partial aging of accounts receivable for Lincoln Cleaning Services is
given in the following table. What percent of receivables are in the 45-day range?
Determine the firms effective days sales outstanding. How does it compare to the
industry average of 35 days?
Age of Accounts
(in days)
10
30
45
60
75
Total
% of Total Account
53,980
31,245
$589,218
100.0%
% of Total Account
46.0%
24.6
14.9
9.2
5.3
Solution:
Accounts receivables = $589,218
Age of Accounts
(in days)
10
30
45
60
75
Total
$589,218
100.0%
Effective DSO = Age of the account category Percent of AR for the account category
= (10 x 0.46 + 30 x 0.246 + 45 x 0.149 + 60 x 0.092 + 75 x 0.053)
= 28.2 days
The firm is more efficient than other firms in the industry as its effective DSO is lower.
14.28 Aging schedule: Keswick Fencing Company collects 45 percent of its receivables in 10
days or fewer, 34 percent in 10 to 30 days, 12 percent in 31 to 45 days, 5 percent in 46 to
60 days, and 4 percent in more than 60 days. The company has $937,000 in its accounts
receivable account. Prepare an aging schedule for Keswick Fencing.
Solution:
Accounts receivables = $937,000
Age of Accounts
(in days)
0-10
11-30
31-45
46-60
Over 60
Total
% of Total Account
45.0%
34.0
12.0
5.0
4.0
100.0%
14.29 Factoring: Zenex, Inc., sells $250,000 of its accounts receivable to factors at 3 percent
discount. The firms average collection period is 90 days. What is the dollar cost of the
factoring service? What is the simple annual interest cost of the factors loan?
Solution:
Accounts receivables sold = $250,000
Factor discount = 3%
Average collection period = 90 days
Dollar cost of factoring per month = $250,000 x 0.03 = $7,500
Dollar cost over 90 days = $7,500 x 3 = $22,500
Simple monthly interest cost of factoring = 3/97 = 0.03093
Simple interest cost of factoring = 0.03093 x 12 = 37.1%
14.30 Factoring: A firm sells $100,000 of its accounts receivable to factors at 2 percent
discount. The firms average collection period is one month. What is the dollar cost of the
factoring service?
Solution:
Accounts receivables sold = $100,000
Factor discount = 2%
Average collection period = 30 days
Dollar cost of factoring per month = $100,000 x 0.02 = $2,000
ADVANCED
14.31 What impact would the following actions have on the operating and cash conversion
cycles? Would the cycles increase, decrease, or remain the unchanged?
b The company enters into an off season, and inventory builds up.
c
Solution:
Cash conversion
Situation
Operating cycle
cycle
Increase
Increase
Increase
No change
Decrease
Increase
Increase
Increase
Unchanged
purchased.
b. The company enters into an off season,
and inventory builds up.
c. Better terms of payment are negotiated
with suppliers.
d. The cash discounts offered to customers
are decreased.
e. All else remaining the same, an
improvement in manufacturing
technique decreases the cost of goods
sold.
14.32 What impact would the following actions have on the operating and cash conversion
cycles? Would the cycles increase, decrease, or remain the unchanged?
a
All else remaining the same, due to labor turnover and poor efficiency, the cost of
goods sold increases.
Solution:
Cash conversion
Situation
Operating cycle
cycle
Decrease
Decrease
Decrease
No change
Increase
Decrease
Decrease
Decrease
Unchanged
purchased.
b. The company encounters unseasonable
demand, and inventory declines rapidly.
c. Tighter terms of payment are demanded
by suppliers.
d. The cash discounts offered to customers
are increased.
e. All else remaining the same, due to
labor turnover and poor efficiency, the
cost of goods sold increases.
14.33
Assets
Cash and marketable sec.
Accounts receivable
Inventories
Total current assets
Net sales
Cost of goods sold
9,912,232
5,947,399
a.
b.
c.
d.
What is the firms operating cycle? How does it compare to the industry average
of 72 days?
e.
What is the firms cash conversion cycle? How does it compare to the industry
average of 42 days?
Solution:
DSO =
a.
DSI
b.
Inventory
$1,312,478
80.6 days
COGS 365 $5,947,399 365
DPO =
c.
Accounts receivable
$1,845,113
=
= 67.9 days
Credit sales 365
$9,912,332 365
Accounts Payable
$1,721,669
=
105.7 days
COGS 365
$5,947,399 365
67.9 80.6
148.5 days
$1,721,669
2,113,345
$3,835,014
The firm is very inefficient in managing its receivable and inventory as its
operating cycle exceeds the industry average of 72 days by about 77 days.
e.
The firms cash conversion cycle is on a par with the industry average of 42 days
thanks to its suppliers very generous credit policy.
14.34 Jackson Electricals is one of the largest dealers of generators in Phoenix and sells about
2,000 of them a year. The cost of placing an order with their supplier is $750,, and the
inventory-carrying costs are $170 for each generator. They like to maintain safety stock
of 15 at all times.
a.
b.
How many orders will the firm need to place this year?
c.
Solution:
Annual sales = 2,000 units
Cost of placing an order = $750
Inventory-carrying cost per generator = $170
Safety stock = 15 generators
EOQ
a.
c.
14.35 Tanzaniqe, Inc., sells $200,000 of its accounts receivable to factors at 5 percent discount.
The firms average collection period is 90 days.
a.
b.
c.
Solution:
Accounts receivables sold = $200,000
Factor discount = 5%
Average collection period = 90 days
a.
b.
c.
Quoted rate
EAR 1
1
m
12
(1 0.0526) 1
0.8506 85.06%
CFA Problems
14.36. A company increasing its credit terms for customers from 1/10, net 30 to 1/10, net
60 will likely experience
A. an increase in cash on hand.
B. an increase in the average collection period.
C. higher net income.
D. a higher level of uncollectible accounts.
Solution:
B is correct.
14.37. Suppose a company uses trade credit with the terms of 2/10, net 50. If the
company pays their account on the 50th day, the effective borrowing cost of skipping the
discount on day 10 is closest to
A. 14.6%
B. 14.9%
C. 15.0%
D. 20.2%
Solution:
D is correct.
Cost = 1+
0.02
0.98
365/ 40
1 20.24 percent
14.38. Which of the companies has the lowest accounts receivable turnover in the year
20X2?
A. Company A
B. Company B
C. Company C
D. Company D
Solution:
B is correct.
B is correct.
20X1: 73 days
20X2: 70.393
Note: If the number of days decreased from 20X1 to 20X2, the
receivable turnover increased.
14.40. Which of the companies reduced the average time it took to collect on accounts
receivable from 20X1 to 20X2?
A. Company A
B. Company B
C. Company C
D. Company D
Solution:
B is correct.
Company B increased its accounts receivable (A/R) turnover and reduced
its number of days of receivables between 20X1 and 20X2.
20X1
20X2
Company A/R
Number
AR
Number
turnover
of days of
turnover
of days of
receivables
receivables
A
5.000
73.000
5.000
73.000
B
2.500
146.000
2.667
136.875
C
3.125
116.800
3.000
121.667
D
5.000
73.000
3.000
121.667
14.1
If your firms DSO is 47.3 days and the days sales in inventory is 39.6 days, what is the
firms operating cycle?
Solution:
14.2
If Chalet Corp. has an operating cycle of 93.4 days and days payables outstanding of
48.2 days, what is the firms cash conversion cycle?
Solution:
14.3
Ranger Cleaning Company has borrowed $90,000 at a stated APR of 8.5 percent. The
loan calls for a compensating balance of 8 percent. What is the effective interest rate for
this company?
Solution:
Amount to be borrowed = $90,000
14.4
Interest expense
$7,650
9.24%
Effective borrowing amount $82,800
Rosemary Corp. has daily sales of $139,000. The financial manager determined that a
lockbox would reduce the collection time by 2.2 days. Assuming the company can earn
5.5 percent interest per year, what are the savings from the lockbox?
Solution:
Average daily sales = $139,000
Collection time saved = 2.2 days
Savings from mail float = 2.2 days $139,000 = $305,800
Savings if invested = $305,800 x (0.055) = $16,819
14.5
Choi Exports is setting up a line of credit at its bank for $7.5 million for up to three years.
The loan rate is 7.875 percent and also calls for an annual fee of 50 basis points on any
unused balance for the year. If the firm borrows $5 million on the day the loan agreement
was signed, what is the firms effective rate?
Solution:
Line of credit limit = $7,500,000
Loan rate = 7.875%
Annual fee on used balance = 0.5%
Amount borrowed = $5,000,000
Unused balance = $2,500,000
Annual fee = $2,500,000 x 0.005 = $12,500
Interest expense = $5,000,000 x 0.07875 = $393,750
Interest expense Annual fee
Borrowed amount
($590,625 $12,500)
8.04%
$7,500,000