Current Liabilities Management

2012 Pearson Prentice Hall. All rights reserved. 15-1

 Today

Week 6 6.2
Topic Accounts Payable Management
Study PPT sheets BB & CH 16.1
Exercises @ Cash Discount; Re-evaluating Payables
Class Policy
Exercises @ Suppliers Credit
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 Learning Goals

LG1 Review accounts payable, the key components of

credit terms, and the procedures for analyzing those
terms.

LG2 Understand the effects of stretching accounts payable

on their cost and the use of accruals.

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 Spontaneous Liabilities

Financing that arises from the normal course

of business; the two major short-term sources:
-accounts payable
- Cash Discounts
- Credit Terms
-accruals.

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 Accounts payable

Major source of unsecured short-term financing

No formal note is signed to show the purchasers liability to the seller.
Payment Period in case of Days Payable Outstanding: from date of
suppliers invoice until payment is made by purchasing company.
Float is more relevant for supplier, who needs to paid. Unless
purchaser will be impacted for tax reasons and/or deliveries of goods
upon full payment.

2012 Pearson Prentice Hall. All rights reserved. 15-5

 Spontaneous Liabilities: Accounts
Payable Management (cont.)
Accounts payable management is management by the firm
of the time that elapses between its purchase of raw
materials and its making payment to the supplier.
When the seller of goods charges no interest and offers no
discount to the buyer for early payment, the buyers goal is to
pay as slowly as possible without damaging its credit rating.
This allows for the maximum use of an interest-free loan from
the supplier and will not damage the firms credit rating
(because the account is paid within the stated credit terms).

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 Spontaneous Liabilities: Accounts
Payable Management (cont.)
The credit terms that a firm is offered by its suppliers enable it to
delay payments for its purchases.
Lawrence Industries:
-purchased $1,000 worth of merchandise on February 27
-from a supplier extending terms of 2/10 net 30 EOM.
-If the firm takes the cash discount, it must pay $980 [$1,000 (0.02
$1,000)] by March 10, thereby saving $20.

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 Spontaneous Liabilities: Accounts
Payable Management (cont.)
The cost of giving up a cash discount is the implied rate of
interest paid to delay payment of an account payable for an
additional number of days

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 Figure 16.1
Payment Options

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 Spontaneous Liabilities: Accounts
Payable Management (cont.)
To calculate the cost of giving up the cash discount, the true
purchase price must be viewed as the discounted cost of the
merchandise, which is $980 for Lawrence Industries.
Another way to say this is that Lawrence Industries supplier
charges $980 for the goods as long as the bill is paid in 10 days.
If Lawrence takes 20 additional days to pay (by paying on day 30
rather than on day 10), they have to pay the supplier an additional
$20 in interest.
Therefore, the interest rate on this transaction is 2.04%
($20 $980). Keep in mind that the 2.04% interest rate applies
to a 20-day loan.

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 Spontaneous Liabilities: Accounts
Payable Management (cont.)
To calculate an annualized interest rate, we multiply the interest rate
on this transaction times the number of 20-day periods during a year.
The following equation provides the general expression for calculating
the annual percentage cost of giving up a cash discount:

where
CD = stated cash discount in percentage terms
N = number of days that payment can be delayed by
giving up the cash

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 Spontaneous Liabilities: Accounts
Payable Management (cont.)
A simple way to approximate the cost of giving up a cash discount is
to use the stated cash discount percentage, CD, in place of the first
term of the previous equation:

Substituting the values for CD (2%) and N (20 days) results in an

Annualized: cost of giving up the cash discount of 37.24%
[(2% 98%) (365 20)]
Approximation: of 36.5% [2% (365 20)].
Exam Note: when in exam, youre expected to use the annualized one

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 Table 16.1 Cash Discounts and
Associated Costs for Mason Products

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 Spontaneous Liabilities: Accounts
Payable Management (cont.)
If the firm needs short-term funds, which it can borrow from its bank
at an interest rate of 13%, and if each of the suppliers is viewed
separately, which (if any) of the suppliers cash discounts will the firm
give up?
In dealing with supplier A: the firm takes the cash discount, because the
cost of giving it up is 36.5%, and then borrows the funds it requires from its
bank at 13% interest.
With supplier B: the firm would do better to give up the cash discount,
because the cost of this action is less than the cost of borrowing money from
the bank (8.1% versus 13%).
With either supplier C or supplier D: the firm should take the cash
discount, because in both cases the cost of giving up the discount is greater
than the 13% cost of borrowing from the bank.

2012 Pearson Prentice Hall. All rights reserved. 16-14

 Spontaneous Liabilities: Accounts
Payable Management (cont.)
Stretching accounts payable refers to paying bills as late as possible
without damaging the firms credit rating.
Lawrence Industries was extended credit terms of 2/10 net 30 EOM.
The cost of giving up the cash discount, assuming payment on the last
day of the credit period, was approximately 36.5% [2% (365 20)].
If the firm were able to stretch its account payable to 70 days without
damaging its credit rating, the cost of giving up the cash discount
would be only 12.2% [2% (365 60)].
Stretching accounts payable reduces the implicit cost of giving up
a cash discount.

2012 Pearson Prentice Hall. All rights reserved. 16-15

 Spontaneous Liabilities:
Accruals
Accruals are liabilities for services received for which payment has yet
to be made.
The most common items accrued by a firm are wages, interest &
taxes.
Because taxes are payments to the government, their accrual
cannot be manipulated by the firm.
However, the accrual of wages can be manipulated to some
extent.
This is accomplished by delaying payment of wages, thereby
receiving an interest-free loan from employees who are paid
sometime after they have performed the work.

2012 Pearson Prentice Hall. All rights reserved. 16-16

 Spontaneous Liabilities:
Accruals (cont.)
Tenney Company:
-Currently pays their employees at the end of work week
-Weekly payroll totals $400,000

What happens if TC extends the pay period, so employees will be paid

1 week later through an entire year?
-Interest rate of 10%
-Effectively employees lend the firm $400,000
Result: a one off of $40,0000 (0.10 $400,000).

2012 Pearson Prentice Hall. All rights reserved. 16-17

 Next Class

Week 7 7.1
Topic Short Term Financing
Study PPT sheets BB
Exercises @ In presentation
Class
Exercises @ Seasonal WC req
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