Introduction:

Action standard was established in 1920. It is a nationally known producer of top quality
lawnmowers, garden tractors, tillers and implements. It has been growing steadily since its
establishment. In 2015, it decided to embark on a rapid program to take advantage of the
growing market for all purpose tractor/ lawnmowers/snow blower machines. This expansion
called for increase in assets of approximately 50 percent in both 2016 and 2017. Dianne
Covington, financial vice president of Action Standard manufacturing company while reviewing
the financial projection for 2017 together with balance sheet for 2015 and 2016 and ratios (see
table 1 and 2) saw significant trends developing. By the end of 2016, the liquidity position was
below the prescribed level and the projected level for 2017 was unacceptable. The debt ratio is
also not good ( worrisome) but since the ratio was let to climb to the level shown in 2017 at the
last directors meeting, it was anticipated. However, the directors tentatively agree to consider a
cut in the dividend until the debt ratios can be reduced to the approximately the level of the
industry average but the level of the industry average but final action has not been taken. She had
not expected the declining profit margin on of efficiency, resulting from the plant modernization
and expansion program. While studying the figures she realized that the abandonment of its
policy of taking discounts all purchases had contributed to the increase in costs and resulted in
decline in the profit margin on sales and rate of return. The firm purchase the material on terms
of 2\5 net 20. Covington is convinced that important changes must be done and this is reinforced
by a letter that she receives form the insurance company that holds Action Standard long term
debt. The insurance company voices concern in the declining liquidity position and points out the
agreement under which the loan was made requires the company to maintain a current ratio of at
least 2 to 1. This letter also states that Action Standard is expected to correct its liquidity position
in the near future. Covington is sure that if she devises a plan where by the liquidity ratios will
be corrected with in a reasonable period of time, the insurance company will give time to correct
the deficiency. Covington thinks of various alternatives. Her first question or the alternatives is
whether the company should down its expansion program. However, this seems to be difficult to
implement. The company has already contracted for the fixed assets expansion which makes its
impossible to reduce the $25 million figure anticipated for 2017. The company could slow down
its rate of growth in sales by turning down orders there by reducing the estimated figure for 2017
for working capital. The turning down of offers will lead the company in not being able to make
profitable sales and could harm future operation if crucial retail outlets are lost. Hence,
Covington feels that this alternative is highly undesirable. The anticipated level of accounts of
payable presents two problems. Firstly, the $19.47 million projected for 2017 which is based on
the assumption that the account payable will not be paid until the 30 days until their past due
date. Even though such delay in payments is common in the industry, Covington feels that this
trend could hurt the company’s reputation. Action Standard has been able to negotiate favorable
prices in its supply contracts. If it becomes a slow paying account, as the current projections
prepared by her staff would have it, these intangible benefits could be lost. The second problem

1
 with the accounts payable projection, is that the firm would continue to lose the trade discounts
as it did during 2016.

In 2016 the Action Standard attempted to borrow the additional funds from the Mid Con National
Bank( with whom the firm deal since its establishment), to reduce the accounts payable by
increasing the notes payables to the bank. However the company is not being able to provide the
loan to the company because of the capital and the surplus of $90 million and the bank cannot
lend more than 10 percent of this amount. Due to this reason it make plan to establish the
relationship with the larger bank in Cincinnati. The Mid Co bank’s president suggest additional
bank loan at 8 percent along with discount basis and the compensating balance of 12 percent.
Similarly she has the another alternatives to obtain the loan from the major finance company
with the interest rate of 11 percent if the account receivables are pledged for the loan or 10
percent plus 5 percent on the discount basis, if the credit is obtained by factoring the receivables
on a non recourse basis. As another alternative for her, is the use of the commercial paper. She
has noted in the recent issues of ‘The wall of the Street journal’ the commercial paper rates is
approximately 9 percent. For the past dealers had contacted Covington two or more three months
but from last six month she has not received any solicitation form these dealers.

Action standard Manufacturing has the four alternatives:

 Banking financing ( Interest =8 % and compensating balance =12%)

 Commercial paper ( Interest rate = 9%)
 Factoring financing ( Interest rate = 10% and discount=5%)
 Secured loan ( Interest rate =11%)

Lastly the Covington sees the possibility of obtaining the credit secured by Action Standard’s
inventories they are almost able to rise $23 by the end of 2017 and if lower the interest rate, the
loan would be secured by inventories. Covington would be willing to use them as collateral.
There is no possibility of selling additional long term debt. The agreement with the insurance
company calls for Action Standard to receive an additional $ 5 million during 2017, but it
specifies that the company can obtain no other new long term debt financing and also board of
directors has decreed that there will be no new common stock issued during 2017.

Table 1: Action Standard manufacturing Co. (In '000$)

2015 2016 Estimated 2017
Cash and securities 1,540 1,980 5,425
Account receivable 7,502 9,933 15,675
Inventories:
Raw material 768 1,342 1,692
Work in progress 6,542 11,144 20,092

2
 Finished goods 413 714 1,152
Total inventories 7,722 13,200 22,935
Total current assets 16,764 25,113 44,035
Net fixed assets 14,036 21,087 25,265
Total assets 30,800 46,200 69,300

Account payable 3,025 7,480 19,470

Notes payable (Bank 10%) 3,421 4,478 5,710
Total current liabilities 6,446 11,958 24,640
Long-term debt 5,941 11,336 16,500
Common equity 18,413 22,906 28,160
Total claims 30,800 46,200 69,300
Sales 77,000 99,295 137,885
Note: Accounts payable are reported net of discounts even if not taken

Table 2: Significant Industry Ratios

2,015 2,016 Estimated 2017 Average Industry (2016)
Current ratio, times 2.60 2.10 1.79 2.20
Quick ratio, times 1.40 1.00 0.86 1.20
Debt ratio (%) 40.2 50.4 59.4 43
Profit margin on sales (%) 6 5.3 5.3 6.0
Rate of return on assets (%) 15.0 11.4 10.6 11.0
Rate of return on net worth (%) 25.0 23.0 26.0 23.0

Some of the issues to be noted while analyzing (table 1 and 2) the financial statements for the year
2015, 2016 and estimated figures for 2017 are:
1. Increasing levels of inventory and accounts payable.
2. Increasing levels of long term debt and corresponding increase in debt ratio.
3. Deteriorating current ratio and quick ratio.
4. Deteriorating profit margin on sales and falling return on assets.
5. Increasing estimated return on equity as compared to the industry average.

3
 Issues

Issue 1: Does the commercial paper market now present a feasible alternative to Action
Standard? Explain your reasoning.

This case include four alternatives to manages the required founds of $23 Million. Through the
given alternatives the cost of funds are as follows:
Alternative 1: Bank Loan
Banks loans are a business loans with an original, or financial maturity of more than one years,
repayable according to a specified schedule.
Interest Discount Rate = 8%
Compensating Balance =12%
Required Fund = $ 23 Million
We have,

Interest Anount
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐹𝑢𝑛𝑑 = Required fund−Interest Amount –Compensating Balance

$ 25 million X 0.08
= $ 25 million −$ 25 million X 0.08 − $ 25 million X 0.12

$ 2 million
= $ 25 million −$ 2 million − $ 3 million

$ 2 million
= $ 20 million

= 0.1 or 10 %

Alternative 2: Secured Loan (i.e. Account Receivable)

A secured loan occurs when the borrower pledges specific assets, called collateral, to back loan.
The security agreement spells out the terms of the loan, the assets pledge as collateral, and
provisions affecting the safeguarding of the collateral.

Here,

Interest Rate = 11%

Required Funds = $ 25 Million
We know,

4
 Interest Amount
Cost of fund = Required Founds

$ 25 million X 0.11
= $25 million

$ 2.75 million
= $25 millio

= 0.11 or 11%

Alternative 3: Factoring

The factor will charge commission or fee for bearing risk and servicing the receivables or for
performing the functions of the credit department. The commission will be more or less, it
depends on quality and size of receivables.

Interest Rate = 10%

Discount = 5%
Required Fund = $ 25 Million
We have,
Cost of commission of factoring = $ 25 million X 0.05
= $ 1.25 million
After cost of commission credit amount = $ 25million - $ 1.25 million
= $ 23.75 million
Now,
Interest amount = $ 23.75 million X 0.10
= $ 2.375 million
Therefore,
Commission+Interest Amount
Cost of Fund =
Total Required Founds

$1.25 million+$ 2.375 million

= = 0.145 or 14.50%
$25 million

Alternative 4: Commercial Paper

Commercial paper is a money-market security issued (sold) by large corporations to obtain funds
to meet short-term debt obligations (for example, payroll), and is backed only by an issuing bank
or company promise to pay the face amount on the maturity date specified on the note.

5
Cost of fund = 9%
Summary Table:

Alternatives Cost of fund

Bank Loan 10 %

Secured Loan (i.e. Account Receivable) 11 %

Factoring 14.50 %

Commercial Paper 9%

Based on the cost of funding, commercial paper would be feasible out of other alternatives as it
bears least cost with 9% cost of fund (representing cheaper bank loan) and it avoid the
inconvenience and expenses . As Action Standard Manufacturing Company is nationally known
company so it is easier to get the access of the commercial paper. But the following reason
avoids the commercial paper as the best alternatives:

 Action Standard Company is facing poor liquidity position, it has declined in terms of credit
rating of the firm.
 Due to decline of credit ratings of the firm, investors would not prefer commercial paper of the
company. So it is not feasible for Action Standard to issue commercial paper at this condition.
 This company has not received any solicitation (proposal) from the dealers from past 6 months,
which it was getting every 2 or 3 months for issuance of commercial paper. It means that the
dealers are also not interested in Action Standard Company due to its poor financial position.
 There will be high risk to issue commercial paper while having the above situation. . So,
commercial paper is not feasible alternative for Action Standard Company.

Issue: - 2: Discuss the feasibility of Action Standard's using its inventory as collateral for a
loan. If this form of financing is undertaken, what type of security arrangements would

6
 probably be used? Do you think that Action Standard's inventories would make very good
security for a loan?

Inventories are regarded as reasonably liquid assets. They are acceptable as security to the lender
for short term loan. It is the important source of assets for the Action Standard. The decision
regarding how much loan to provide against inventory will depend upon the quality of inventory,
market price stability, and ease in selling these inventories. Similarly, the perishability of
inventory also determines how much loan to lend. Firms hold three types of inventories: raw
materials, work-in-process and finished goods. The inventories of Action Standard are
lawnmowers, garden tractors, snow blow machines, which are specialized equipment. As stated
in the case, Action Standard Company is facing liquidity problem, willing to use the inventories
as collateral but the case also mentioned WIP is higher as compared to finished goods and raw
material. However, only raw materials and finished goods represent reasonable liquid assets
which are appropriate as collateral for short-term loan. Which can be shown in the following
table:-

Table: showing the inventories in 3 different years

Inventories 2015 2016 Estimated 2017

Raw material $768,000 $1342,000 $1692,000
Work in progress $6542,000 $11,144,000 $20,092,000
Finished goods $413,000 $714,000 $1,152,000

Work-in-progress is the least valuable because there's not much demand for unfinished goods.
There are not many potential buyers for a half-built machine tool or lawnmower. Higher work-
in-progress refers that there are lesser finished items in hand. So, the inventory condition of
Action Standard is not feasible to use it as collateral for a loan as only smaller percentage of loan
would be provided.

If inventory financing is undertaken, following types of security arrangements would probably be

used:-

 Trust receipt loan(TR):

7
Trust Receipt (TR) is a type of short-term import loan to provide the buyer with financing to settle
goods imported under Letter of Credit where title of goods is held by the bank. Under a TR
arrangement, the Bank retains title to the goods but allows the buyer to take possession of the
goods on trust for resale before paying the Bank on TR due date. TR financing is applicable to
goods imported under documentary credit.

Action Standard can enjoy the following benefits under TR:

 Do not need to effect payment immediately when documents are presented under
documentary credit, documentary collection or open account.
 Enjoy credit terms pre-approved by the Bank, with principal and interest only payable on
maturity.
 Its working capital or cash flow is not tied up and can be deployed for other business
purposes.
Even though these securities do have several benefits, there are a few potential disadvantages. One
of the biggest disadvantages is that these securities cost a lot of money to issue. When issued, the
company that issues them has to pay a higher interest rate than they would for other types of
debt. The reason behind this is that this type of debt is subordinated behind other types of debt.
Since investors are taking a bigger risk of losing their capital because of this, they are going to
require a higher interest rate.

 Chattel mortgage

If inventories are identifiable by serial number or by some other means, then inventory loans may
be provided under chattel mortgages. Under this arrangement, Action Standard will hold title to
the goods, but the lender exercises a lien on inventory. It means inventory cannot be sold without
the consent of the lender. The chattel mortgages are suited for Action Standard's inventories
because it does not involve rapid turnover and hence its inventories are not difficult to be
identified.

 Terminal warehouse receipt loans

Action Standard can secure a terminal warehouse receipt loan by storing inventory with a public,
or terminal, warehousing company. The warehouse company will issue a warehouse receipt,
which evidences title to specified goods that are located in the warehouse. Under such an
arrangement, the warehouse can release the collateral to the borrower only when authorized to do
so by the lender. Consequently, the lender is able to maintain strict control over the collateral and
will release collateral only when the borrower pays a portion of the loan. For protection, the
lender usually requires the borrower to take out an insurance policy with a loss payable clause in
favor of the lender. Action Standard can secure a nonnegotiable warehouse receipt which is
issued in favor of the lender who is given title to the goods and has sole authority to release
them. The release of goods can be authorized only in writing.

8
 Field Warehouse Receipt Loans
Field warehousing, will permit loans to be made against inventory that is located on Action
Standard's premises. Under this arrangement, a field warehousing company sets off a designated
storage area on the borrower's premises for the inventory pledged as collateral. The field
warehousing company has sole access to this area and is supposed to maintain strict control over
it.
The terminal and warehouse receipt loans are available options for Action Standard to secure loans
but these forms will be more expensive for the company as it will have to insure the inventories
and hence have to incur additional insurance costs. Action Standard can pledge its inventory as
truest receipt loan or chattel mortgage for less cost.
Action Standard's inventories consist of lawn mowers, garden tractors, tillers and implements and
these inventories do not have high marketability as compared to food grains. The inventories are
such that they are specialized equipments and will be difficult to sell. The lender will have to
incur additional expenses in its selling with the inventories being of reasonably large size and
face difficulty in selling due to their low marketability. The lender may provide small percentage
of loans against the inventories or may refuse to lend. So, Action Standard's inventories will not
make a good security for the loan.

Issue 3: Determine the approximate rate of interest on foregone discounts. What are the
advantages and disadvantages of allowing accounts payable to build up, as the financial
staff has suggested? Discuss specifically the firm's declining liquidity position and its use of
"spontaneous" financing through trade credit. Would it be a wise policy to build up
accounts payable?

The approximate rate of return on foregone discounts is:

Terms of sales=2/5, net 20

𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭 % 𝟑𝟔𝟓
𝐀𝐧𝐧𝐮𝐚𝐥 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐂𝐨𝐬𝐭 = ×
𝟏𝟎𝟎 − 𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭% 𝐂𝐫𝐞𝐝𝐢𝐭 𝐏𝐞𝐫𝐢𝐨𝐝 − 𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭 𝐏𝐞𝐫𝐢𝐨𝐝

2 365
= ×
100 − 2 20 − 5

= 49.66%

Therefore, the approximate rate of return on foregone discount is 49.66%.

The advantages of allowing accounts payable to build up are:

 It will be readily available source of fund for Action Standard Manufacturing Company.

9
 It acts as the continuous source of credit.
 There is no need to arrange financing formally and negotiate much.
 It has shorter lead time as being a source of short term fund.
 There is no need of pledging collateral.

The disadvantage of following account payable to build up are:

 The cost of cash discount foregone.
 The possible deterioration of credit rating. This may hurt the company’s reputaution for being an
excellent customer which may hamper its ability to negotiate favorable prices and terms and
condition in its supply contracts.

2015 2016 Estimated Average

2017 Industry
(2016)
Current Ratio, times 2.60 2.10 1.79 2.20
Quick Ratio, times 1.40 1.00 0.86 1.20
Debt Ratio (%) 40.2 50.4 59.4 43.0
Profit Margin on Sales (%) 6.0 5.3 5.3 6.0
Rate of return on assets (%) 15.0 11.4 10.6 11.0
Rate of return on net worth (%) 25.0 23.0 26.0 23.0

As seen in the table, the liquidity position of the company is in decreasing trend which is shown by
current and Quick ratios. The reason behind this is that the percent of increase in current assets is
less than percent increase in the current liability of the company which can be seen on the table 1
of this case. As the company is expanding there is increase in production of the company which
requires the higher amount of purchase of raw material and this has resulted in building up of
accounts payable. Similarly, the stretching of accounts payable has worsened the liquidity
position of the company
The insurance company that holds Action Standard long term debt already voiced its concern
over the declining liquidity position and has pointed out the agreement under which the loan was
made requires the company to maintain a current ratio of at least 2:1. Building up od accounts
payable will further deteriorate the liquidity position to less than prescribed by its lender.
Similarly, the cost of foregone discounts is quite high and stretching of accounts payable also
hampers its credit ratings. So, it would not be the wise policy to build accounts payable.
10
Issue 4: Discuss the pros and cons of Action Standard's using account receivable financing at
the present time. What would be the impacts of accounts receivable financing on
current ratio and quick ratio? Determine the new level of these ratios. If the company
elects to use receivable financing, would it be better off factoring or pledging its accounts
receivable?( Assume 95% loan on receivables). Also prepare the balance sheet that would
look like if the company undertakes receivables financing.

Action Standard Manufacturing Company can obtain accounts receivable financing in two ways
i.e. through assignment of accounts receivables or factoring.

The major advantages of using accounts receivable financing at the present time are:

 Ease of cash flow problem: The Company can receive instant cash which will help ease the
cash flow problem. The cash can be used to improve the financial performance of the company.
This type of arrangement will improve cash flow and shorten the cash cycle. The business will
be able to receive immediate cash from the factor and without carrying out the collections
process.

 Quick access to financing: Accounts receivables are one of the most liquid forms of assets.
They act as attractive collateral to commercial banks and finance companies as securing a loan
against this form of financing involves less bureaucracy. In case of factoring, the business can
receive cash immediately from the factor instead of waiting to receive the from the customers
accounts receivables. This is important for Action Standard as it needs cash to pursue finance
growth.
.
 Focus on income generating activities: Selling receivables can free the owners up to work on
income generating activities. Instead of tracking down missing payments, owners can
concentrate on other business operations.

 Protection from bad debts: Since the factoring alternative is on a non-recourse basis, the factor
will assume the risk of bad debts. Hence, if a customer account cannot be collected, the factor
must absorb the loss. This will protect the company against the bad debt losses.

 High size of receivables: Action Standard sells top quality lawnmowers, garden tractors, tillers
and implements which cost high amount. The accounts receivable for the year 2016 and 2017 are
$ 9,933,000 and 15,675,000 which are huge amounts. Hence, the size of accounts receivable is
big. This is a benefit for the company as it can secure higher percentage of loan against the size
of its receivables.

However, there are some disadvantages of accounts receivable financing as well:

11
 Sell at discount: Action Standard’s owners will have to sell their accounts receivables at a
discount under factoring which means that they get less money for them.

 Cost: Under a factoring agreement, the factor purchases accounts receivable at a discount.
Depending on the discount amount, a factoring agreement may imply a very high cost of capital.
This cost must be compared to the cost of other methods of financing available to the business.

 Factor’s influence: When Action Standard will work with a factor, they will be introducing an
outside influence into their business. Since the factor will be responsible for collecting accounts
receivable and may be responsible for amounts which cannot be collected, they may try to
influence sales practices. This can include attempts to influence sales policies and timing, as well
as the customers that a business with deal.

 Customer relations: When a factor comes into play, he/she as a third party will now deal
directly with customers to collect amounts owed, this can have a negative impact customer
perception of the business. This is especially true if the factor engages in aggressive or
unprofessional practices when collecting receivables.

 Sign of weakness: Receivable financing is seen by many creditors and customers as a sign of
weakness. Creditors may view receivables financing as harmful to next period’s cash and may
feel that the firm must be facing financial difficulties.

Impact of Account receivable financing on Current assets and Quick assets of Action Standard
Company.
There will be a great effect of account receivable financing in the account receivable. As the
account receivable decreased by the whole amount of financing which will affect the account
payable where account payable will also decreases but with the less proportion than the
receivable. This leads to change in current ratio as well as quick ratio.

Calculation of current and quick ratio after receivable financing:

Current account receivable for 2017 = $15,675

New current assets after financing = $69,300-$15,675

= $53625

Current account payable for 2017 = $19,470

12
New account payable = $19,470- 0.95* $15,675

= $ 4578.75

New current liabilities after financing= $ 5,170 +$4578.75

= $ 9748.75

𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝐴𝑠𝑠𝑒𝑡𝑠
Current ratio =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑒𝑠

$53625
=
$9748.75

= 5.500 times

𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝐴𝑠𝑠𝑒𝑡𝑠−𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
Quick Ratio =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑒𝑠

$53625−$22935
=
$9748.75

= 3.1480 times

Here, new current ratio is 5.500 which is higher than industry average i.e. higher than 2.20 and
quick ratio is 3.1480 which is lower than industry average i.e. higher than 1.20.

Here cost of pledging = 11%

Cost of factoring = 10% + 5% of 10 i.e. 10.5%

Here, the cost of factoring is less than the cost of pledging (11>10.5%). Company should go for
factoring.

13
Question 5

Assume that Action Standard does not go along with suggestions of building up accounts
payable to 50 days (reflected in the 2017 proforma balance sheet in Table 1) but opts
instead to start paying in 5 days and taking discounts.

a.What is revised amount of Action Standard's projected year end 2017 accounts payable?

Accounts Payable net of discounts for 50 days = $ 19,470,000

Action Standard Manufacturing Company starts to pay in 5 days and take discount,

Revised amount of accounts payable = $ 19,470,000 × 5

50

= $ 1,94,700

Therefore, if Action Standard does not go along with building up accounts payable to 50 days and
opts to pay in 5 days after taking discount than the revised amount of Action Standard’s
projected year end 2017 accounts payable will be $1,947,00.

b. Determine the amount of fund Action Standard would have to borrow in order to
take discounts. What would be the effective cost? Assume at this point that bank borrowing
at 8 percent discount interest and with a 12 percent compensating balance requirement is
used. Also assume that all assets accounts including cash and securities now on hand,
cannot be reduced. Base your answer on Action standard steady state borrowing
requirements, which means disregarding the one times funds requirement to account for
the fact accounts payable are currently carried at net, most of them will have to be paid off
at gross.

Accounts Payable in the year end of 2017 = $ 19,470,000 (net of discounts)

Term of credit is 2/5, net 20

14
The amount of funds Action Standard would have to borrow in order to take discounts.

Funds to borrow= Total net amount - Revised amount

= $ 19,470,000 - $ 1,947,00

=$19,275,300 (net of discount)

Calculation of bank borrowing at 8% discount interest and with compensation balance 12%

Interest rate =8% (discounted interest rate)

Compensating balance=12%

𝐹𝑢𝑛𝑑 𝑛𝑒𝑒𝑑𝑒𝑑
Loan amount = 1− 𝑐𝑜𝑠𝑡

$19,275,300
= 1−(0.08+0.12)

= $ 24,094,125

Calculation of effective cost

3
Effective cost = (1 + 97)360/20 – 1 = 73.02% hjg jg jh jgbjhj

Situation projected by firm staff:

Not done

Then,
Free trade credit = $ 2,950,000

Costly trade credit = $14,750,000

Total account payable = $ 17,700,000

Situation if bank financing is used:

15
Free trade credit = $ 2,950,000

Add: notes payable bank = $18,437,500

Total bank financing = $21,387,500

Therefore, account payable will increase by $3,687,500 that is ($21,387,500-$ 17,700,000=$

3,687,500).

c. What are the net savings that Action Standard will realize from borrowing to take
the discounts? Note that accounts payables are recorded net of discount.( Hint find the
annual gross purchase as the initial step, followed by discount received, interst on
borrowing and so on).

Accounts Payable in the year 2007 = $ 19,470,000 (net of discounts)

Term of credit = 2/5, net 20

Calculating the net savings that Action Standard can realize from borrowing to take the discounts

$19,470,000
Annual Gross Account payable = = $19,867,346.94
0.98

19,867,346.94
Amount to be borrowed for taking discount = 1−0.08−0.12

= $ 24,834,183.67

Discount amount = 24,834,183.67 2% = $ 4,96,683.67

Interest borrowing amount = $ 24,834,183.67 12%

= $ 2980102.04

Net Savings from borrowing = Discount amount – Interest on borrowed amount

= ($2980102.04- $1,241,709.184)

= $ (2,483,418.37)

From the above calculation:

16
 We can say that when borrowing is made from the bank is order to get cash discount on the
purchases, there will be loss of 2,483,418.37 for the company. The interest on the borrowed
amount ( $ 24,834,183.67) is more than the discount ($ 2,980,102.04 ) that the company will
receive. So it is not profitable for the company to borrow in order to take discount on its
purchases.

6. What effect would Covington’s decision to take cash discounts have upon the current
ratio, Quick ratio, and profit margin? No further calculation are further required for this
question.

Cash discounts refers to providing opportunity to pay less to the company. Cash discount
encourages the prompt payment provided by the company while paying less and thus, cash can
be saved. As cash increases there will be increment in the current assets of the company hence,
current ratio and Quick ratio will be increased.

Covington’s decision to take cash discounts has a positive effect upon the current ratio, quick ratio
and profit margin. If the company takes cash discount, then it decreases the account payable. As
a result, company has to pay less to its supplier and thus saving is exercised. The company can
be benefitted by paying less and thus cash can be enchanced in the company.

We know,

Current asset ↔
↑ 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 = Current liabilitites ↓ ,

Quick asset ↔
↑ 𝑄𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 = Current liabilitites ↓

Net profit ↑
↑ Profit margin =
Net sales ↔

From the case, we came to know that, discount receipt increases the profit because it reduces the
cash outflow or operating profit of the company. When cash discount is taken, net profit of the

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 company increases, also it helps to increase the profit margin. Cash discount is taken, net profit
of the company increases, also it helps to increase the profit margin. Cash discount help to meet
account payable with fewer amounts of cash. Cash discount decreases the account payable and
decrease in account payable will increase in both current ratio and quick ratio. So, the cash
discount helps to maintain good position of current assets and current liabilities that maintain the
sound liquidation position of the company. The profit of a firm increases as cash discount
reduces the cash outflow or operating profit of the company and increases in profit increases
saving which helps to reduces the short term and long term debt that save the interest cost. The
decrease in interest cost leads to increases the income of the company.

7. Should Action Standard establish relations with and arrange a line of credit from security
Bank and trust Company? Give reasons.

Answer: The cost of various sources of financing alternatives of Action Standard is,
Discount % 365
Cost of not taking Discount = ×
100 − Discount% Credit Period − Discount Period
2 365
= ×
98 15
= 49.659%
The cost of pledging( bank financing) is given i.e. 12%.
Security Bank and Trust Company,

Effective cost =0.1/ (1 − 0.08 − 0.12)

= 12.5%
Factoring Cost = 0.10 + 5% of 0.10= 10.5%
Establishing the relations with and arranging a line of credit from security bank and trust company
is shown in the given table:

Cost item Cost %

Trade credit 49.659%
Cost of pledging 13%
Bank loan 12.5%

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 Factoring 10.5%

Decision not done

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Question 8:

What specific actions do you think Dianne Covington should recommend for Action
Standard during the coming year?

Action Standard is considering to improve its liquidity position, debt ratio and margins on
sales for the next year since in 2017 the company is going to have its ratios lower than that
of its industry average. Following are the specific actions that Dianne Covington should
undertake for Action Standard during the coming year:

Since, the Action Standard Manufacturing Company is the nationally known producer of top
quality lawnmowers, garden tractors, tillers, and implements and can improve its efficiency after
the plant modernization and expansion program in the coming years of the company’s
performance. Therefore, the specific actions that Dianne Covington should recommend for
Action Standard during the coming years are:

Establish relation with big Banks:

The company should establish the relation with big banks rather than borrowing loan with
Security Bank and Trust Company because Security Bank is a small bank and it cannot fulfill the
needs of big company’s like Action Standard Manufacturing Company as the borrowing amount
of capital is $25 million but Security Bank can provide bank loans at a 8% rate with a 12%
compensating balance. And Security bank can only fulfill $9 million. And the company should
choose such a Bank which help in bad days as well.

Expedite collection of Receivables:

Action Standard Manufacturing Company can also get $25 million through pledging
Its receivables and get quick access for financing and get the cash discount of 2%.By taking the
discount the company can maintain the intangible benefits like maintain its reputation, prompt
delivery of materials, supply of material during shortage periods. And also the company can
maintain good relation with Insurance Company’s by paying its dues on time as it holds Action
Standard long term Debt.

Eliminate Cash discount: The Company must eliminate cash discount because currently
Company is in need of capital for the fixed assets expansion and short term funds instead it can
distribute stock dividend in order to maintain its reputation.

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 Conclusion:

The company should slow down in the expansion in product line by large percentage because
with the expansion of product line, fixed assets are going to increase. If assets are not productive
for a longer period of time then it is useless for a company to invest in such assets. And with the
pledging of receivables, it can take cash discounts through which it can improve all its financial
ratios of 2017 and coming years because discount receipt increases the profit which reduces the
cash outflow or operating profit of the company. The company is in the midst of an expansion
program and she is faced with the decision of selecting the best form of short term financing
among the various alternatives to improve the liquidity ratio of the company so that she can
convince the Insurance Company, that holds Action Standard' long term debt, to give them time
to correct the deficiency. She has the alternatives of:

 slowing down the expansion program which is highly undesirable as the profit margin will go
down
 stretching accounts payable which will hurt the company's reputation of being an excellent
customer,
 increasing notes payable by obtaining bank loan,
 obtaining loan by either assigning accounts receivable from a major finance company or
factoring the receivables on a non recourse basis,
 using commercial paper,
 obtaining credit by pledging its inventories as collateral.
Covington has to choose from among these alternatives the best form of short term financing that
will help Action Standard to improve their financial performance and obtain loans at the lowest
cost

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