CHAPTER 14 Working Capital Management Learning Objectives 1
!e"in !e"inee net net #ork #orkin ing g capit capital$ al$ %isc&s %isc&sss t'e t'e impo import rtanc ancee o" o" #ork #orking ing capit capital al man manage agemen ment$ t$ an% be able to comp&te a "irm(s net #orking capital
)
!e"in !e"inee t'e t'e oper operati ating ng an% an% cas' cas' c*cle c*cles$ s$ e+p e+plai lain n 'o# 'o# t'e* t'e* are are &se &se%$ %$ an% an% be able able to to comp&te t'eir val&es "or a "irm
,
!isc& !isc&ss ss t'e t'e rel relati ative ve a%v a%vant antage agess an% an% %isa% %isa%van vantag tages es o" o" p&rs& p&rs&ing ing -1. "le+i "le+ibl blee an% an% -). -). restrictive c&rrent asset investment strategies
4
E+pla E+plain in 'o# 'o# acc acco& o&nt ntss rec receiv eivab able le are are crea create% te% an% an% mana manage ge%$ %$ an% an% be able able to comp& comp&te te t'e cost o" tra%e cre%it
/
E+pla E+plain in t'e t'e tra tra%e0 %e0o" o""" bet bet#ee #een n car carr* r*ing ing costs costs an% an% reor reor%e %err cost costs$ s$ an% an% be able able to to comp&te t'e economic or%er &antit* "or a "irm(s inventor* or%ers
2
!e"in !e"inee cas cas' ' coll collec ectio tion n time$ time$ %isc&s %isc&sss 'o# 'o# a "ir "irm m can can mini minimi3 mi3ee t'is t'is time$ time$ an% an% be be abl ablee to comp&te t'e cas' collection costs an% bene"its o" a lockbo+
5%enti 5%enti"* "* t'r t'ree ee c&r c&rre rent nt asse assett "ina "inanci ncing ng stra strate tegie giess an% an% %isc& %isc&ss ss t'e t'e mai main n so&r so&rce cess o" s'ort0term "inancing
5
C'apter O&tline
141
Working Capital 6asics •
Working Working capital management involves two key issues.
What is the appropriate amount and mix of current assets for the firm to hold?
•
How should these current assets be financed?
Let us review some basic definitions related to working capital. cap ital.
C&rrent assets are cash and other assets that the firm expects to convert
into cash in a year or less.
C&rrent 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 company"s cash account! account receivables! inventory! and other current assets.
7et #orking capital -7WC. refers to the difference between current
assets and current liabilities. o
#W$ is important because it is a measure of li%uidity and represents the net short-term investment the firm keeps in the business.
Working capital management involves making decisions regarding the
use and sources of current assets
Working capital e""icienc* refers to the length of time between when a
working capital asset is ac%uired and when it is converted into cash.
Li&i%it* is the ability of a company to convert assets&real or financial
&into cash %uickly without suffering suffering a financial loss.
A.
Working Working Capital Capital Accounts Accounts and and Trade-Off Trade-Offss •
'he various working capital accounts are
Cas'8 'his account includes cash and marketable securities like
'reasury securities. o
'he higher the cash balance! the better the ability of the firm to meet its short-term financial obligations. o bligations.
b y customers who Receivables 'hese represent the amount owed by have taken advantage of the firm"s trade credit policy.
5nventor* )irms maintain inventory of raw materials and work in
process and finished goods.
Pa*ables 'he payables balance represents the amount owed to the
firm"s vendors and suppliers on materials purchased on credit. o
'he accrual accounts are liabilities incurred but not no t yet paid! such as accrued wages or taxes.
14) 14)
T'ee Ope T' Operat ratin ing g an% an% Cas' Cas' Con Conve versi rsion on C*cles C*cles
•
'he 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.
•
+ee ,xhibit ./ for a graphical representation of the cash conversion cycle.
When managing working capital accounts! accoun ts! financial managers want to do the following
0elay paying accounts payable as long as possible without suffering any penalties.
%uality product. 1aintain minimal finished goods inventories without losing sales. 3ffer customers the most attractive credit terms possible on trade credit to
maximi4e sales while minimi4ing the risk of nonpayment. $ollect cash payments on accounts receivable as fast as possible to close the loop.
•
1aintain minimal raw material inventories without causing manufacturing delays. 2se as little labor as possible to manufacture the product while producing a
With the financial manager"s goal being to maximi4e the value of the firm! each of the decisions above is intended to shorten the cash conversion cycle and improve the firm"s li%uidity.
•
'wo tools to measure the working capital management efficiency are the operating cycle and the cash conversion cycle . A. •
Operating Cycle
'he operating c*cle begins when the firm receives the raw materials it purchased and ends when the firm collects cash payments on its credit sales.
•
'wo measures&days" sales outstanding and days" sales in inventory&help determine the operating cycle.
!a*s( sales in inventor* -!95. shows how long the firm keeps its
inventory before selling it. o
5t is the ratio of the inventory balance to the daily cost of goods sold.
o
'he %uicker 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.
!a*s( sales o&tstan%ing -!9O. estimates how long it takes on average
for the firm to collect its outstanding accounts receivable balance. o
'his ratio is also called the average collection perio% -ACP. .
o
6n efficient firm with good working capital management should have a low average collection period compared to its industry.
•
'he operating cycle is calculated by summing the days" sales outstanding and the days" sales in inventory. Operating Cycle = DSO + DSI
B.
•
-141.
Cash Conversion Cycle
'he cas' conversion c*cle is related to the operating cycle! but it does not start until the firm actually pays for its inventory.
'he cash conversion cycle is the length of time between the cash outflow for materials and the cash inflow from sales.
•
'o measure the cash conversion cycle! we need another measure called the day"s payables outstanding.
•
!a*s( pa*able o&tstan%ing -!PO. shows how long a firm takes to pay off its
suppliers for the cost of inventory.
•
'he cash conversion cycle is then calculated by summing the days" sales outstanding and the days" sales in inventory and subtracting the days" payables outstanding.
'he formula is shown in ,%uation ./ CashConversionCycle = DSO + DSI
− DPO
14,
Working Capital 5nvestment 9trategies
•
)inancial managers use two types of strategies for current assets investments flexible and restrictive . A. •
Flexible Current Asset nvest!ent "trategy
'he flexible strategy has a high percent of current assets to sales! whereas a restrictive policy has a low percent of current assets to sales.
•
'he "le+ible strateg* calls for management to invest large amounts in cash! marketable securities! and inventory.
•
'he strategy also promotes a liberal trade credit policy for customers! which results in high levels of accounts receivable.
•
'he flexible strategy is perceived be a low risk and low return course of action for management to follow.
•
'he advantage of this policy is the large working capital balances the firm holds.
•
'he strategy"s downside is the high inventor*0carr*ing cost associated with owning a high level of inventory and providing liberal credit terms for its customers.
•
'he higher carrying costs result for two reasons
'he investment in the low return current assets deprives the higher returns that management could earn on longer term assets like plant and e%uipment.
Higher amounts of inventory results in higher warehousing and storage costs.
B.
#estrictive Current Asset nvest!ent "trategy
•
$urrent assets are kept to a minimum in the restrictive strateg*
•
'he firm barely invests in cash and inventory! and has tight terms of sale intended to curb credit sales and accounts receivable.
•
'he restrictive strategy is a high-risk! high-return alternative to the flexible strategy.
'he high risk comes in the form of s'ortage costs that can be either financial or operating.
Financial shortage costs arise mainly from the illi%uidity shortage of cash
and a lack of marketable securities to sell for cash. o
5f unpaid bills are due! the firm will be forced to use expensive external emergency borrowing.
o
5f funding cannot be secured! default occurs on some current liability and the firm runs the risk of being forced into bankruptcy by creditors.
Operating shortage costs result from lost production and sales.
o
5f the firm does not hold enough raw materials in inventory! time may be wasted by a halt in production.
o
5f the firm runs out of finished goods! sales may also be lost! and customer dissatisfaction may arise.
o
7estrictive sale policies such as allowing no credit sales will also result in lost sales.
o
3verall! operating shortage costs can be substantial! especially if the product markets are competitive.
C.
The Working Capital Trade-off
•
'he optimal current asset investment strategy will depend on the relative magnitudes of carrying costs versus shortage costs. 'his conflict is often referred to as the working capital trade-off .
)inancial managers need to balance shortage costs against carrying costs to find an optimal strategy.
5f carrying costs are larger than shortage costs! then the firm will maximi4e value by adopting a more restrictive strategy.
3n the other hand! if shortage costs dominate carrying costs! the firm will need to move toward a more flexible policy.
3verall! management will try to find the level of current assets that minimi4es the sum of the carrying costs and shortage costs.
144
Acco&nts Receivables A.
Ter!s of "ale
•
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.
•
'he agreement specifies when the cash payment is due and the amount of any discount if early payment is made.
•
'rade credit! which is short-term financing! is typically made with a discount for early payment rather an explicit interest charge.
6n offer of 89:;! net ;< means that the selling firm offers a 9 percent discount if the buyer pays the full amount of the purchase in cash within ; days of the invoice date. o
3therwise! the buyer has ; days to pay the balance in full from the date of delivery.
•
'o calculate the cost! we need to determine the interest rate the bu yer is paying and convert it to an e%uivalent annual rate.
•
'he formula for calculating the ,67 for a problem like this is shown below! in ,%uation .!
0iscount -@ 0iscountedprice÷ ,ffective annual rate = •
B.
9>?:dayscredit
−-
'rade credit is a loan from the supplier and it can be a very costly form of credit. Aging Accounts #eceivables
6 common tool that credit managers use is called an aging schedule . •
'he aging schedule shows the breakdown of the firm"s accounts receivable by their date of sale&how long has the account not been paid in days.
•
5ts purpose is to identify and then track delin%uent accounts and to see that they are paid.
•
6ging schedules are also an important financial tool for analy4ing the %uality of a company"s receivables.
'he aging schedule reveals patterns of delin%uency and shows where collection efforts should be concentrated.
14/
,xhibit .> shows aging schedules for three different firms.
5nventor* Management
5nventory management is largely a function of operations management! not financial management. 1anufacturing companies generally carry three types of inventory raw materials! work in process! and finished goods. A.
$cono!ic Order %uantity
'he economic order %uantity (,3A mathematically determines the minimum total inventory cost! taking into account reorder costs and inventory-carrying costs. •
'he optimal order si4e strikes the balance between these two costs.
•
,%uation . shows how to calculate ,3A.
B. •
&ust-in-Ti!e nventory 'anage!ent
5n this system the exact day-by-day! or even hour-by-hour! raw material needs are delivered by the suppliers! who deliver the goods 8Bust in time< for them to be used on the production line.
•
6 big advantage of this system is that there are essentially no raw inventory costs and no chance of obsolescence or loss to theft.
•
3n the other hand! if the supplier fails to make the needed deliveries! then production shuts down.
•
5f the system works for a firm! it cuts down their investment in working capital dramatically.
142
Cas' Management an% 6&%geting A. •
#easons for (olding Cash
'wo reasons exist for holding a cash balance. )irst! it facilitates transactions with suppliers! customers and employees.
•
'he second reason is simply that most banks re%uire firms to hold minimum cash balances! or compensating balances$ in exchange for the services they provide.
B.
Cash Collection
$ollection time! or "loat$ is the time between when a customer makes a payment and when the cash becomes available to the firm. $ollection time can be broken down into three components. )irst is delivery time! or mailing time. o
When a customer mails payment! it may take several days before that payment arrives.
+econd is processing delay. o
3nce the payment is received! it must be opened! examined! accounted for! and deposited at the firm"s bank.
)inally! there is a delay between the time of the deposit and the time when the cash is available for withdrawal. Cayments in cash at the point of sale reduce the collection time to 4ero. o
Cayment by check or credit card at the point of sale eliminates the mail time but not the processing time.
6 lockbox system allows geographically dispersed customers to send their payments to a post office box close to them. With a concentration account! a post office box is replaced b y a local branch! which receives the mailings! processes the payments! and makes the deposits. ,ither approach will reduce the collection time to an extent! but there is a cost associated with it. •
6nother increasingly popular means of reducing cash collection time is through the use of electronic funds transfers ! which reduces cash collection times in every phase.
)irst! mailing time is eliminated.
+econd! processing time is reduced or eliminated since no data entry is necessary. )inally! electronic funds transfers typically have little or no delay in funds availability.
14
:inancing Working Capital A.
"trategies for Financing Working Capital
•
,xhibit .D shows the three basic strategies that a firm can follow to finance its working capital and fixed assets.
,ach of the three panels show ( the total long-term financing needed! which consists of long-term debt and e%uity! and (/ the seasonal needs for working capital that fluctuates with the level of sales.
•
'he mat&rit* matc'ing strateg* is shown in )igure 6 of ,xhibit .D.
6ll 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.
6ll fixed assets are funded with long-term financing.
'he 8matching of maturities< is one of the most basic techni%ues used by financial managers to reduce risk when financing assets.
'he long0term "&n%ing strateg* is shown in )igure E in ,xhibit .D.
'his strategy relies on long-term debt to finance both capital assets and working capital.
'his strategy reduces the risk of funding current assets because there is no need to worry about refinancing assets since all funding is long term.
)igure $ in ,xhibit .D shows the s'ort0term "&n%ing strateg* 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.
Financing Working Capital in )ractice
•
1any financial managers try to match the maturities of assets and liabilities when funding the firm.
'hat is! short-term assets are funded with short-term financing! and longterm assets are funded with long-term financing.
•
1ost financial managers like to fund some of their currents assets with long-term debt as shown in )igure 6 of ,xhibit .D! so-called permanent #orking capital
•
5n recent years! a number of large! well-known firms of the highest credit standing have been funding some of their long-term fixed assets with short-term debt sold in the commercial paper market.
C.
"ources of "hort-Ter! Financing
•
6ccounts payable (trade credit! bank loans! and commercial paper are common sources of short-term financing.
•
Eetween FF; and /;;9! acco&nts pa*able constituted 9D percent of total current liabilities for all publicly traded manufacturing firms.
'he 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.
•
Eetween FF; and /;;9! s'ort0term bank loans accounted for F percent of total current liabilities for all publicly traded manufacturing firms.
6n in"ormal line o" cre%it is a verbal agreement between the firm and the bank! allowing the firm to borrow up to an agreed-upon upper limit.
5n exchange for providing the line of credit! a bank may re%uire that the firm holds a compensating balance with them.
6 "ormal line o" cre%it is also known as 8revolving credit!< whereby the bank has a legal obligation to lend to the firm an amount of money up to a preset limit.
o
'he firm pays a yearly fee! in addition to the interest expense on the amount they borrow.
5f the firm backs the loan with an asset! the loan is defined as secured* otherwise! the loan is unsecured.
+ecured loans allow the borrower to borrow at a lower interest rate! all else being e%ual.
•
Commercial paper is a promissory note issued by large financially secure firms!
which have high credit ratings.
$ommercial paper is not 8secured!< which means that the issuer is not pledging any assets to the lender in the event of default.
However! most commercial paper is backed by a credit line from a commercial bank.
'herefore! the default rate on commercial paper is very low! resulting in an interest rate that is usually lower than what a bank would charge on a direct loan.
•
)or medium-si4e and small businesses! acco&nts receivable "inancing is an important source of funds.
6 company can secure a bank loan by pledging the firm"s accounts receivable as security.
6 second way for a business to finance itself with accounts receivables is to sell the receivables to a factor at a discount.
'he firm that sold the receivables has no further legal obligation to the factor.
55
9&ggeste% an% Alternative Approac'es to t'e Material
'his chapter focuses on short-term financial decisions that involve cash inflows and outflows that will occur within a year or less. ,xamples 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. 'his chapter focuses on these types of decisions! which are called working capital management.
'he chapter begins by reviewing some basic definitions and concepts that are necessary to further our study of working capital management. #ext! the authors examine the individual working capital accounts and then learn how to construct and analy4e the operating and cash conversion cycles. 'hen they examine how the different working capital accounts are managed the cash account! accounts receivables! and inventory. )inally! the different financing options that financial managers consider! and the risks involved! are discussed. 5nstructors may choose to cover this chapter at any point in the semester. 'he material is sufficiently independent of previous material to allow that. 5t is important to recogni4e that man y undergraduates are more likely to deal with working capital management issues on their first Bob than with issues like capital budgeting decisions or capital structure decisions. #one of the %uantitative material is likely to be overwhelming! and as in previous chapters! the end-of-chapter problems emphasi4e repetition to allow instructors to work some problems in class and assign others for the students to work on their own.
555 9&mmar* o" Learning Objectives 1
!e"ine net #orking capital$ %isc&ss t'e importance o" #orking capital management$ an% be able comp&te a "irm(s net #orking capital
#et 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. 'he 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. 'he computation of net working capital for 0ell $omputer is illustrated in +ection .
)
!isc&ss t'e operating an% cas' c*cles$ e+plain 'o# are t'e* &se%$ an% be able to comp&te t'eir val&es "or a "irm
'he 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. 5t can be broken into two components ( days" sales in inventory! which shows how long a firm keeps its inventory before selling it! and (/ days" sales outstanding! which indicates how long it takes on average for the firm to collect its outstanding accounts receivable. 7elated 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. 6n additional measure! that of days" payables outstanding! is re%uired to calculate the cash conversion cycle. Eoth cycles are simple tools to help the financial manager measure working capital efficiency and control li%uidity. 'he computations are illustrated in +ection ./.
1
!isc&ss t'e relative a%vantages an% %isa%vantages o" p&rs&ing -1. "le+ible an% -). restrictive c&rrent asset investment strategies
6 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. 5n 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. 'he restrictive strategy involves higher risk and return! with higher potential financial and operating shortage costs as its maBor drawbacks.
,
E+plain 'o# acco&nts receivable are create% an% manage%$ an% be able to comp&te t'e cost o" tra%e cre%it
6ccounts receivable are promises of future payment from customers that buy goods or services on credit. 'he details are defined in the terms of sale! which include the due date! the interest rate charge! and any discounts for early pa yment. 'he terms of sale are affected by the practice in the industry and the creditworthiness of the customer. 'o manage accounts receivable! the financial manager should keep close track of both days" sales outstanding and the aging schedule.
4
E+plain t'e terms inventory-carrying costs an% reorder costs* an% be able to comp&te t'e economic or%er &antit* "or a "irm(s inventor* or%ers
'he trade-off between carrying costs and reorder costs exists because as the si4e of a firm"s orders for materials increases! the number of orders and total reorder costs decline. 6t the
same time! larger order si4e increases the average inventory si4e! and! therefore! average inventory-carrying costs. 'he economic order %uantity (,3A is a tool for mathematically finding the combination of the two costs that minimi4es the firm"s total inventory cost. Learning by 0oing 6pplication .9 offers practice in computing a firm"s ,3A.
) !e"ine cas' collection time * %isc&ss 'o# a "irm can minimi3e t'is time$ an% be able to comp&te t'e economic costs or bene"its o" a lockbo+
$ash collection time is the time between when a customer makes a payment and when the cash becomes available to the firm. 5t has three components ( delivery or mailing time! (/ processing delay! and (9 delay between deposit time and availability. Cossible methods a firm can use to minimi4e this time include lockboxes! concentration accounts! and electronic funds transfers. Work through Learn by 0oing 6pplication . to decide whether a lockbox is worth keeping.
, 5%enti"* t'ree c&rrent asset "inancing strategies an% %isc&ss t'e main so&rces o" s'ort0 term "inancing
'here are three main current asset financing strategies ( the matching maturity strategy! which matches the maturities of assets with the maturities of liabilities* (/ the long-term funding strategy! which finances both working capital and long-term assets with long-term debt* and (9 the aggressive funding strategy! which uses short-term debt for both working capital and long-term assets. +ources of short-term financing include accoun ts payable! shortterm bank loans! lines of credit! and commercial paper.
5;
9&mmar* o"
E&ation 141 14)
!escription
3perating cycle $ash conversion cycle
:orm&la
3perating cycle = 0+3 @ 0+5 $ash conversion cycle =0+3 @ 0+5 G 0C3 $ash conversion cycle = 3perating cycle G
14,
$ash conversion cycle 144
,ffective annual rate (,67
0C3
0iscount -@ 0iscountedprice÷ ,67 =
,conomic order %uantity
−-
/ H 7eorder costs H +ales per period
14/
(,3A
9>?:dayscredit
,3A =
$arrying costs
;
6e"ore =o& >o On ?&estions an% Ans#ers
9ection 141
How do you calculate net working capital! and why is it important?
#et working capital is calculated as the difference between the current assets and current liabilities. 5t is important for a firm to keep a positive net working cap ital balance! as these funds are used to cover the day-to-day expenses and short-term liabilities as they come due.
/.
What are some of the trade-offs re%uired 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 pa yments on accounts receivable as fast as possible to close the loop! among other things.
9ection 14) .
What is the operating cycle! and how is it related to the cash conversion cycle?
'he operating c*cle starts with the receipt of raw materials and ends with the collection of cash from customers for the sale of finished goods. 'he operating cycle can be described in terms of two components days" sales in inventory and days" sales outstanding. 'he cash conversion cycle is the length of time between the actual cash
outflow for materials and the actual cash inflow from sales. 'o calculate it! we need all of the information used to calculate the operating cycle plus one additional measure days" payables outstanding.
9ection 14, .
What are the two general current asset investment strategies discussed in this section! and how do they differ?
'ypically! the two main current asset investment strategies are flexible and restrictive strategies. 'he flexible strategy prompts management to keep large balances of c ash! marketable securities! and inventory. 'his strategy is perceived to be a relatively low-risk and low-return course of action for management to follow. 'he 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.
/.
What are the types of costs associated with each of these strategies?
'he flexible strategy is associated with a high level of carrying costs because of a firm"s high levels of inventory and providing liberal credit for customers. 'he restrictive strategy is associated with shortage costs! which can be either financial or operating in nature.
9ection 144
.
What does 8:! net 9;< mean?
5f a company declares a 8:! net 9;< means of sale! it signifies that it will grant the customer a percent discount if the customer pays the full amount within days of the invoice date. 3therwise the customer has 9; days to pay the balance in full from the date of the delivery.
/.
What is an aging schedule! and what is its purpose?
'he aging schedule for a firm lists the accounts receivable broken down by the number of days until they are due or past due. )irms use aging schedules to keep track of their accounts receivables and to assess how effective they are collecting on these accounts.
9ection 14/ .
What is the economic order %uantity model?
'he economic order %uantity model is an inventory management tool that mathematically determines the minimum total inventory cost! taking into account reorder costs and inventory-carrying costs. 'he main obBective of the model is to find the trade-off between the two costs.
/.
Why is an investment in inventory considered to be costly?
5nvestment in inventory is considered costly! because inventory must be stored! which results in rental and maintenance costs. )urthermore! inventory on hand is subBect to loss and theft! and faces the possibility of becoming obsolete. )inally! investment in inventory provides no return unlike an investment in financial or real assets would.
9ection 142
What is float?
'he 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.
/
,xplain how lockboxes are used.
Lockboxes are post office boxes set up by the firm for its customers to deliver their payments to these boxes instead of the firm"s business address. 'he post office then collects these payments and delivers them to the bank. 'he main purpose of lockboxes is to minimi4e collection time for firms through cutting down on p ostal time and through processing the payments directly at the bank.
9ection 14
List and briefly describe the three main short-term financing strategies.
'he three main short-term financing strategies are ( self-li%uidating strategy! in which the maturity of the liabilities is matched with that of assets* (/ conservative strategy! which relies more heavily on long-term financing* and (9 restrictive strategy! which relies primarily on short-term financing.
/
What are the advantages and disadvantages of short-term financing?
+hort-term financing offers companies greater flexibility and usually a lower cost of capital. 3n the other hand! short-term financing often comes with some illi%uidity problems as well as uncertainty due to increased exposure to interest rate fluctuations.
9
Iive examples of sources of short-term financing.
,xamples of short-term financing include accounts payable! short-term bank loans! informal lines of credit! formal lines of credit! or commercial paper. 'he two main current asset investment strategies are ( flexible strategy! which encourages management to keep large balances of current assets! and (/ restrictive strategy! which keeps the usage of current assets to a minimum.
;5 9el" 9t&%* Problems
141
Jou are provided the following working capital information for the Elue 7idge $ompany Acco&nt 5nventory 6ccounts receivable 6ccounts payable
6eginning 6alance K /!>;; 9!/// /!;;
#et sales $ost of goods sold
En%ing 6alance K/!F; /!;; /!>D;
/!F F!>9;
5f all sales are on credit! what are the firm"s operating and cash conversion cycles?
9ol&tion8
We calculate the operating and cash conversion cycles for Elue 7idge as follows 5nventory = K/!F; 6ccounts receivable = K/!;; 6ccounts payable = K/!>D; #et sales = K/!F $ost of goods sold = KF!>9; 0+3 =
0+5 =
6ccounts receivable K/!L;; = = -.> days $redit sales 9>? K/!?LF 9>?
5nventory $3I+ 9>?
0C3 =
=
K/!LF; K-F!>9; 9>?
= ?9.D days
6ccounts payable K/!>D; = = F.> days $3I+ 9>? K-F!>9; 9>?
3perating cycle
= 0+3 + 0+5 = -.> + ?9.D = @/, %a*s
$ash conversion cycle
14)
= 0+3 + 0+5 − 0C3 = -.> + ?9.D − F.> = 4/ %a*s
1errifield $osmetics calculates that its operating cycle for last year was D> days. 'he company had K/9;!;;; in its accounts receivable account and had sales of K.F/ million. What can you say about 1errifield"s inventory management?
9ol&tion8
'he following information describes 1errifield"s inventory management 3perating cycle = D> days 6ccounts receivables = K/9;!;;; #et sales = K!F/;!;;;
0+3 =
6ccounts receivable s $redit sales 9>?
=
K/9;!;;; = 9.D days K-!F/;!;;; 9>?
= 0+3 + 0+5 D> = 9.D + 0+5 0+5 = ,), %a*s
3perating cycle
1errifield $osmetics takes 9/.9 days to move the inventory through as finished products.
14,
Eelow is a partial aging of accounts receivable for Eitar 7oofing +ervices. )ill in the rest of the information and determine its days" sales outstanding. How does it compare to the industry average of ; days?
Age o" Acco&nts -in %a*s. ;-; -9; 9- >->; 3ver >; Total
;al&e o" Acco&nt -. K/!;;; /;!9>; ;9!//; D/!;; /9!D; K9!/;
B o" Total Acco&nt
9ol&tion8
'he missing information for Eitar 7oofing is as follows Age o" Acco&nts -in %a*s. ;-; -9; 9- >->; 3ver >; 'otal
;al&e o" Acco&nt -. K/!;;; /;!9>; ;9!//; D/!;; /9!D; K9!/;
B o" Total Acco&nt 9F.DM //.D F. 9.D . ;;M
,ffective 0+3 = (;.9FD × -; + (;.//D × 9; + (;.-F × ? + (;.-9D × >; + (;.;? × 9>?
= 9.FD + >.L- + L.D9 + L.// + ->.9 = 44) %a*s Eitar takes about days more than the industry average of ; to collect on its receivables. 'he firm should focus collection efforts on all credit sales that take >; days or more to collect.
144
Ey obtaining a lockbox! #i4am"s 1anufacturing was able to reduce its total cash collection time by two days. 'he firm has annual sales of KD;!;;; and can earn .D percent annual interest. 6ssuming that the lockbox costs K; per year! calculate the savings that can be attributed to the lockbox.
9ol&tion8
'he following information applies to #i4am"s lockbox 6nnual sales = KD;!;;; 6nnual interest rate = .DM 6nnual cost of lockbox = K; $ollection time saved = / days verage daily sales =
K?D;!;;;
= K-!?>-.> 9>? Savings = K-!?>-.> × ;.;D? × / − K?; = A@C,2
'he firm can save KF.9> each year by using the lockbox.
14/
7ockville $orporation is looking to borrow K/;!;;; at a stated . percent 6C7 from its bank! which re%uires its customers to maintain a ; percent compensating balance. What is the effective interest rate on this loan for 7ockville $orporation?
9ol&tion8
7ockville $orporation"s loan information is as follows 6mount to be borrowed = K/;!;;; +tated annual interest rate = .M $ompensating balance = ;M 6mount deposited as compensating balance = K/;!;;; x ;.; = K/!;;; ,ffective borrowing amount e%ual to K/;!;;; G K/!;;; = K//!;;; 5nterest expense = K/;!;;; x ;.; = K/!/; ,ffective interest rate =
5nterest expense ,ffective borrowing amount
=
K/-!/?; K//?!;;;
. B = @
Ey setting aside a compensating balance of ; percent or K/!;;; on the loan! the firm increases its interest rate effectively to F. percent.
;55 Critical T'inking ?&estions 141
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. 'he financial manager should keep close track of both the aging schedule and the effective 0+3. 5f either or both show consistent deterioration! it may be time to reconsider the firm"s credit policy or the characteristics of its customers. 5n addition! in some industries! sales vary by season. 6 firm must be aware of seasonal patterns and make the necessary adBustments before drawing any conclusions about its accounts receivable.
14)
List some of the working capital management characteristics you would expect a computer manufacturing company following Bust-in-time delivery system! such as 0ell.
)irms like 0ell are likely to do an exceptional Bob of managing their inventory and collecting on their receivables. 0ell employs a strategy similar to Bust-in-time management where they maintain Bust sufficient inventory to meet the nee ds for a very short time. 'his saves the firm a huge investment in inventory. 'hus their days sales in inventory (0+5 will be very low compared to other industries. +imilar to 0ell! firms will have a short collection period! and their operating cycle will be much lower than firms in other industries. 5f other computer manufacturing firms follow the 0ell operating philosophy! they will extend their days payables (0C3 to the point that tier cash
conversion cycle is negative. 5n 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,
What costs would a firm following a flexible current asset investment strategy worry about! and why?
'he strategy"s downside is the high carrying cost associated with owning a high level of inventory and providing liberal credit terms for customers. Ey investing in current assets! management foregoes the higher rate of return it could have earned by investing in longterm assets. 'herefore! there is an opportunity cost involved when investing in current assets. +econd! large investments in some types of inventory can re%uire significant warehousing and storage costs! which can be expensive.
144
How are customers and suppliers affected by a firm"s working capital management decisions?
$ustomers 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. 5n general! large inventory helps stimulate sales and increase customer satisfaction! but they can be a costly item on a firm"s balance sheet. 1anagement"s decisions on the firm"s receivables policy is driven by the industry type. $ompanies selling perishable products! such as food companies! might ask for payment in full in less than ; days. 3n the other hand! if the firm is selling
durable goods! the terms of credit are likely to be more generous. 'he terms of sale are also affected by the creditworthiness of the customer. 5f 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. 5f 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. 'hus! when the financial manager makes a decision to increase working capital! good things are likely to happen to the firm&sales should increase! relationships with vendors and suppliers should improve! and work or manufacturing stoppages should be less likely.
14/
6 beverage bottling company in Nermont has days" sales outstanding of /9.D days. 5s this good? ,xplain.
5n general! a lower 0+3 reflects the fact that the firm is managing its receivables very well. However! it is not possible to decide whether a 0+3 of /9 .D days is good or bad unless you have a basis for comparison. 'hat basis of comparison could be a peer group! historical data for the firm itself! or targets set by the management.
142
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
)avorable credit terms from suppliers allow the firm to use the suppliers" funds to finance their working capital. 5t also reduces the firm"s cash conversion cycle.
(b
6n increase in the inventory turnover! that is! the 0+5 decreases! reduces both the firm"s operating cycle and the cash conversion cycle.
(c
6s the accounts receivables turnover (0+3 decreases! the firm improves its receivables management and reduces its operating cycle and hence! its cash conversion cycle.
14
What are some industries in which the use of lockboxes would especially benefit companies? ,xplain.
Lockboxes are a useful tool to speed up collection of receivables when the customer base is dispersed across a large geographical area. #ormally! this would mean customer payments would have to be mailed in! consolidated! and then deposited at the firm"s bank. 'he alternative of setting up a lockbox system allows the firm to redirect customer payments to regional locations for %uicker consolidation and cashing of payments. 'his is typical in the retail industry where each store of a chain is located in a different city or state.
14
+uppose 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?
6t a large firm! management would have access to the commercial paper market! which can provide cheaper funding than short-term bank financing. 'o borrow in the
commercial paper market! a firm has to be financially strong. 5f interest rates are expected to decline! such firms can plan on raising working capital by issuing commercial paper. 'hus! 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@
Why is commercial paper only available to the most creditworthy customers?
$ommercial paper is available only to firms that are financially strong for two reasons. )irst! there is no secondary market for investors to li%uidate prior to maturity. $onse%uently! investors must hold it to maturity and have the confidence that the issuer would pay them back at that time. +econd! this type of debt is not secured by any real assets of the issuing firm. 'hus! firms that are the most creditworthy are able to raise funds in this market at costs that are lower than bank loans.
141D ,xplain what a negative cash conversion cycle means.
7ecogni4e the cash conversion cycle is a function of a firm"s receivables turnover! inventory turnover! and payables turnover. )irms that are highly efficient in managing their inventory and receivables will have a short operating cycle and not need a large investment in working capital. 6 large payables turnover implies that the firm is making use of their suppliers" funds to fund their working capital needs. 'he difference between the operating cycle and the payables turnover is the cash conversion cycle. 6 negative cash conversion cycle means that the time taken by the firm to meet its payables exceeds
its operating cycle. 5n 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.
;555
?&estions an% Problems
6A95C 141
Cas' conversion c*cle8 Wolfgang"s 1asonry estimates that it takes the company /D days
on average to pay off its suppliers. 5t also knows that it has days" sales in inventory of > days and days sales" outstanding of 9/ days. How does Wolfgang"s cash conversion cycle compare to that of an industry average of D days?
9ol&tion8
0C3 = /D days 0+5 = > days 0+3 = 9/ days 5ndustry average for cash conversion cycle = D days. Wolfgang"s cash conversion cycle = $ash conversion cycle
= 0+3 + 0+5 − 0C3 = 9/ + > − /D = 2@ %a*s
+ince the firm"s cycle is less than the industry average of D days! the firm is more efficient than other firms in the industry in managing its working capital.
14)
Cas' conversion c*cle8 #orthern 1anufacturing $ompany found that during the last
year! they took D days to pay off its suppliers! while they took >9 days to collect their receivables. 'he company"s days" sales in inventory was F days. What is #orthern"s cash conversion cycle?
9ol&tion8
0C3 = D days 0+5 = F days 0+3 = >9 days #orthern"s cash conversion cycle = $ash conversion cycle
14,
= 0+3 + 0+5 − 0C3 = >9 + F − D = 2/ %a*s
Cas' conversion c*cle8 0evon 6utomotive estimates that it takes the company about >/
days to collect cash from customers on finished goods from the day it receives raw materials and about > days to pay its suppliers. What is the company"s cash conversion cycle? 5nterpret your answer.
9ol&tion8
0C3 = > days 3perating cycle = >/ days 0evon"s cash conversion cycle = $ash conversion cycle = 3perating cycle 0C3 = >/ O > = -9 days
'his firm has a negative cash conversion cycle. 'he 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.
144
Operating c*cle8 Lilly Eakery distributes its products to more than D restaurants and
delis. 'he company"s collection period is /D days! and it keeps its inventory for four da ys. What is Lilly"s operating cycle?
9ol&tion8
0+5 = days 0+3 = /D days Lilly"s operating cycle = 3perating cycle
14/
= 0+3 + 0+5 = /D + = ,- %a*s
Operating c*cle8 #et+peed 'echnologies is a telecom component manufacturer. 'he
firm typically has a collection period of days and days" sales in inventory of /F days. What is the operating cycle for #et+peed?
9ol&tion8
0+5 = /F days 0+3 = days #et+peed"s operating cycle =
3perating cycle
142
= 0+3 + 0+5 = + /F = , %a*s
Cost o" tra%e cre%it +ybex $orp. sells its goods with terms of /:; ,31! net 9;. What
is the implicit cost of the trade credit?
9ol&tion8
$redit terms = /:; ,31! net 9; 9>? : days credit
,ffective annual rate
0iscount - + 0iscounted price =
−-
= ( @ /:F9>:/; O = (.;/;./;; O = .F O = ;.F! or 44/@ percent
14
Cost o" tra%e cre%it Puggs! 5nc.! sells its goods with terms of :; ,31! net >;. What is
the implicit cost of the trade credit?
9ol&tion8 9>? : days credit
0iscount - + 0iscounted price ,ffective annual rate = = ( @ :F>9>:; O = (.;DD.9 O
−-
= .9D/ O = ;.9D/! or ,4)B
14
Lockbo+8 7osenthal 0esign has daily sales of KF!;;;. 'he financial management team
determined that a lockbox would reduce the collection time by .> days. 6ssuming the company can earn ./ percent interest per year! what are the savings from the lockbox?
9ol&tion8
6ll sales are assumed to be credit sales. 6nnual interest rate = ./M $ollection time saved = .> days
= K?F!;;; = K?F!;;; × ;.;?/ × -.> = A4$@DCCD
6verage daily sales +avings
'he firm can save K!F;.; due to the use of lockbox.
14@
Lockbo+8 Cacific 'raders has annual sales of K!F!;;;. 'he firm"s financial manager
has determined that using a lockbox will reduce collection time by /.9 days. 5f the firm"s opportunity cost on savings is ./ percent! what are the savings from using the lockbox?
9ol&tion8
6nnual sales = K!F!;;; 6nnual interest rate = ./M $ollection time saved = /.9 days
K-!LF?!;;; = K?!-F-.DL 9>? +avings = K?!-F-.DL × ;.;?/? × /.9 = A2)2@1 6verage daily sales
=
'he firm can save K>/>.F due to the use of lockbox.
141D E""ective interest rate8 'he Qellog Eank re%uires borrowers to keep an percent
compensating balance. Iorman Pewels borrows K9;!;;; at a D percent stated 6C7. What is the effective interest rate on the loan?
9ol&tion8
6mount to be borrowed = K9;!;;; +tated annual interest rate = D.;M $ompensating balance = M 6mount deposited as compensating balance = K9;!;;; ;.; = K/D!/;; ,ffective borrowing amount = K9;!;;; G K/D!/;; = K9/!;; 5nterest expense = K9;!;;; ;.;D = K/9!;; ,ffective interest rate =
5nterest expense ,ffective borrowing amount
=
K/9!L;; K9-/!L;;
= 21B
Ey setting aside a compensating balance of percent or K/D!/;; on the loan! the firm increases its interest rate effectively to D.> percent.
1411 E""ective interest rate8 1organ $ontractors borrowed K.D million at an 6C7 of ;./
percent. 'he loan called for a compensating balance of / percent. What is the effective interest rate on the loan?
9ol&tion8
6mount to be borrowed = K!D;!;;; +tated annual interest rate = ;./M $ompensating balance = /M 6mount deposited as compensating balance = K!D;!;;; ;.;/ = K/;!;;; ,ffective borrowing amount e%ual to K!D;!;;; G K/;!;;; = K!;!;;; 5nterest expense = K!D;!;;; x ;.;./ = KD!;; ,ffective interest rate =
5nterest expense ,ffective borrowing amount
=
K-DL!?;; K-!?;!;;;
= 112B
Ey setting aside a compensating balance of / percent or K/;!;;; on the loan! the firm increases its interest rate effectively to .> percent.
141) :ormal line o" cre%it8 Winegartner $osmetics is setting up a line of credit at its bank for
K million for up to two years. 'he loan rate is .D percent and also calls for an annual fee of ; basis points on any unused balance for the year. 5f the firm borrows K/ million on the day the loan agreement was signed! what is the firm"s effective rate?
9ol&tion8
Line of credit limit = K!;;;!;;; Loan rate = .DM 6nnual fee on used balance = ;.M 6mount borrowed = K/!;;;!;;; 2nused balance = K9!;;;!;;; 6nnual fee = K9!;;;!;;; x ;.;; = K/!;;;
5nterest expense = K/!;;;!;;; x ;.;D = KD!;; ,ffective interest rate =
=
5nterest expense + 6nnual fee Eorrowed amount (K--D!?;; + K-/!;;; = 24CB K/!;;;!;;;
'he effective borrowing rate for the firm is >.M with the annua l fee of ; basis points.
57TERME!5ATE
141, Cas' conversion c*cle8 Jour boss asks you to compute the company"s cash conversion
cycle. Looking at the financial statements! you see that the average inventory for the year was K/>!9;;! accounts receivable were KD!F;;! and accounts payable were at K!;;. Jou also see that the company had sales of K!;;; and that cost of goods sold was K//!;;;. 5nterpret your firm"s cash conversion cycle.
9ol&tion8
6ll sales are assumed to be credit sales. 6ccounts receivables = KD!F;; 6ccounts payables = K!;; +ales = K!;;; 5nventory = K/>!9;; $ost of goods sold = K//!;;; 0+3 =
6ccounts receivable K-D!F;; = = /. days $redit sales 9>? K-?!;;; 9>?
0+5 =
5nventory = K/>!9;; = DL.D days $3I+ 9>? K-//!;;; 9>?
0C3 =
6ccounts payable $3I+ 9>?
$ash conversion cycle
=
K-?!-;; K-//!;;; 9>?
= ?./ days
= 0+3 + 0+5 − 0C3 = /. + DL.D − ?./ = /@ %a*s
'he firm takes nearly D> days from the time it pays for its raw materials to the time it reali4es cash from its credit sales. Ey taking a couple of more days to pay it suppliers relative to the time it takes to collect on its receivables! it reduces the cash conversion cycle.
1414 Cas' conversion c*cle8 Elackwell 6utomotive! 5nc.! reported the following information
for the last fiscal year.
Assets $ash and marketable sec. 6ccounts receivable 5nventories 3ther current assets 'otal current assets
6lack#ell A&tomotive$ 5nc As o" ,,1)DD Liabilities an% E&it* K /9!; 6ccounts payable and accruals !/ #otes payable //! !//9 K9D!F; 'otal current liabilities
#et sales $ost of goods sold
F/!99/ D!;;
$alculate the firm"s cash conversion cycle and operating cycles.
9ol&tion8
6ccounts receivables = K!/ 6ccounts payables = K>9!/D
K>9!/D /!
K!9D/
#et sales = KF/!99/ 5nventory = K//! $ost of goods sold = KD!;; 0+3 =
0+5 =
6ccounts receivable K--!/?L = = ?>.? days $redit sales 9>? KF-/!99/ 9>?
5nventory = K/-/! = --.D days $3I+ 9>? K?D!;; 9>?
0C3 =
6ccounts payable $3I+ 9>?
3perating cycle
=
K->9!/?D K?D!;; 9>?
= -;L.F days
= 0+3 + 0+5 = ?>.? + --.D = 1@C) %a*s
$ash conversion cycle = 0+3 @ 0+5 O 0C3 = >. @ .D O ;.F = @, %a*s 141/ Cas' conversion c*cle8 ,lsee! 5nc.! has net sales of K9 million with D percent of it
being credit sales. 5ts cost of goods sold is > percent of annual sales. 'he firm"s cash conversion cycle is .9 days. 'he inventory for the firm is K!D!9! while its accounts payable is K/!D!>F;. What is the firm"s accounts receivable balance?
9ol&tion8
#et sales = K9!;;;!;;; $redit sales = (;.D K9!;;;!;;; = KF!D;!;;; 6ccounts payable = K/!D!>F; 5nventory = K!D!9
$ost of goods sold = (;.> +ales = (;.> K9!;;;!;;; = K!;!;;; $ash conversion cycle = .9 days 0C3 =
0+5 =
6ccounts payable $3I+ 9>? 5nventory
$3I+ 9>?
=
=
K/!-D-!>F; KL!?;!;;; 9>?
K-!L-D!9 KL!?;!;;; 9>?
= F9.L days
= DL.? days
= 0+3 + 0+5 − 0C3 -.9 = 0+3 + DL.? − F9.L 0+3 = /22 %a*s
$ash conversion cycle
2sing the 0+3 e%uation! we can solve for the accounts receivable. +"O =
6ccounts receivables $redit sales 9>?
6ccounts receivables
=
=
A# ,F * D?; * ;;; 9>?
= ?>.> days
?>.> × K/>!D-/.99 = A1$/11$@1C1
'he firm has accounts receivables of 1$/11$@1.
1412 Cas' conversion c*cle8 Poanna Handicrafts! 5nc.! has net sales of K./9 million with ;
percent of it being credit sales. 5ts cost of goods sold is K/. million. 'he firm"s cash conversion cycle is D.F days. 'he firm"s operating cycle is >.9 days. What is the firm"s accounts payable?
9ol&tion8
#et sales = K!/9;!;;; $redit sales = (;. x K!/9;!;;; = K/!!;;; $ash conversion cycle = D.F days
3perating cycle = >.9 days $ost of goods sold = K/!;!;;;
= ( 0+3 + 0+5 − 0C3 D.F = L>.9 − 0C3 0C3 = ,C4 %a*s
$ash conversion cycle
0C3 =
6ccounts payable 6ccounts payable = = 9L. days $3I+ 9>? K/!?;!;;; 9>?
6ccounts payable = 9L.HK>!F?L.F; = A)2$ ))1@) 'he firm has accounts payable of )2$))) .
141 Operating c*cle8 6viva 'echnology"s operating cycle is days. 5ts inventory level was
at K9!;;; last year! and the company had a K. million cost of goods sold. How long does it take 6viva to collect on its receivables?
9ol&tion8
3perating cycle = days 5nventory = K9!;;; $ost of goods sold = K!;;!;;;
0+5 =
5nventory = K-9!;;; = .? days $3I+ 9>? K-!-;;!;;; 9>?
= 0+3 + 0+5 L- = 0+3 + .? 0+3 = ,2/ %a*s
3perating cycle
5t takes 6viva 9>. days to collect on its receivable.
141 Operating c*cle8 Cremier $orp. has sales of K/!9! and its cost of goods sold is D;
percent of sales. 6ssume all sales are credit sales. 5f the firm"s accounts receivable total K9!F;/ and its operating cycle is .> days! how much inventory does the firm have?
9ol&tion8
$redit sales = K/!9 3perating cycle = .> days $ost of goods sold = (;.D x K/!9 = K>!> 6ccounts receivable = K9!F;/ 0+3 =
6ccounts receivable K--9!F;/ = = ?-./ days $redit sales 9>? KL-/!9 9>?
= 0+3 + 0+5 L-.> = ?-./ + 0+5 0+5 = ,D4 %a*s
3perating cycle
0+5 =
5nventory = 5nventory = 9;. days $3I+ 9>? K?>L!>- 9>?
5nventory
= A4$,2DC
'he firm has inventory of 4$,21 .
141@ Economic or%er &antit*8 Longhorn 'raders is one of the largest 7N dealers in 6ustin
and sells about /!;; recreational vehicles a year. 'he cost of placing an order with their supplier is K;;! and the inventory-carrying costs are K; for each 7N. 'he company likes to maintain safety stock of / 7Ns. 1ost of their sales are either in spring or the fall of each year. How many orders will the firm need to place this year?
9ol&tion8
6nnual sales = /!;; units $ost of placing an order = K;; 5nventory-carrying cost per 7N = K; +afety stock = / 7Ns ,3A =
=
/ × 7eorder costs × +ales per period $arrying cos ts / × KL;; × /!L;; K-?;
= -D/.L
,conomic order %uantity = D9 7Ns #o. of orders the firm needs to place = /!;; : D9 = 12
14)D E""ective interest rate8 'he $larkson 0esigner $ompany is looking for a loan of
KD;!;;;.'he bank will provide the loan at an 6C7 of >.D. +ince the loan calls for a compensating balance! the effective interest rate on the loan increased to F./ percent. What is the compensating balance on this loan?
9ol&tion8
6mount to be borrowed = KD;!;;; +tated annual interest rate = >.DM $ompensating balance = ? ,ffective interest rate = F./M 5nterest expense = KD;!;;; x ;.;>D = K!>/.;
,ffective interest rate = F./?M = ,ffective borrowing amount
5nterest expense ,ffective borrowing amount K?-!?>/.?; ,ffective borrowing amount
= K?-!?>/.?; = K??D!9/.9 ;.;F/?
,ffective borrowing amount = KD;!;;; G K$E = KD!9/.9 $ompensating balance deposit = KD;!;;; - KD!9/.9 = KF/!>D.D $ompensating balance = KF/!>D.D : KD;!;;; = )/2B Ey setting aside a compensating balance of /.>M on the loan! the firm increases its interest rate effectively from >.D to F./ percent.
14)1 E""ective interest rate8 'he $olonial Window 'reatments $ompany is borrowing
K!;;!;;;. 'he loan re%uires a ; percent compensating balance! and the effective interest rate on the loan is F.D percent. What is the stated 6C7 on this loan?
9ol&tion8
6mount to be borrowed = K!;;!;;; +tated annual interest rate = ? $ompensating balance = ;M ,ffective interest rate = F.DM $ompensating balance = (;.; x K!;;!;;; = K;!;;; ,ffective borrowing amount = K!;;!;;; G K;!;;; = K!9;!;;;
,ffective interest rate =
5nterest expense ,ffective borrowing amount
F.D?M =
5nterest expense ,ffective borrowing amount
5nterest expense
= ;.;FD? × K-!9?;!;;; = K-9-!>/?
+tated interest rate = K9!>/ : K!;;!;;; = /B
14)) :ormal line o" cre%it8 Iruppa! 5nc.! has Bust set up a formal line of credit of K; million
with )irst $ommunity $ommercial Eank. 'he line of credit is good for up to five years. 'he bank will be charging them an interest rate of >./ percent on the loan! and in addition the firm will pay an annual fee of >; basis points on the unused balance. 'he firm borrowed KD. million on the first day the credit line became available. What is the firm"s effective interest rate on this line of credit?
9ol&tion8
Line of credit limit = K;!;;;!;;; Loan rate = >./M 6nnual fee on used balance = ;.>M 6mount borrowed = KD!;;!;;; 2nused balance = K9!;;;!;;; 6nnual fee = K/!;;!;;; x ;.;;> = K!;;; 5nterest expense = KD!;;!;;; x ;.;>/ = K>!D; ,ffective interest rate =
=
5nterest expense + 6nnual fee Eorrowed amount (K>L!D?; + K-?!;;; = 24/B KD!?;;!;;;
14), :ormal line o" cre%it8 Lansdowne ,lectronics has a formal line of credit of K million up
to three years with H#0 Eank. 'he interest rate on the loan is .9 percent! and under the agreement! Lansdowne has to pay ; basis points on the unused amount as the annual fee. +uppose the firm borrows K>D!;;; the first day of the agreement. What is the fee the company must pay? What is the effective interest rate?
9ol&tion8
Line of credit limit = K!;;;!;;; Loan rate = .9M 6nnual fee on used balance = ;.M 6mount borrowed = K>D!;;; 2nused balance = K9/!;;; 6nnual fee = K9/!;;; x ;.;; = 1$2)/ 5nterest expense = K>D!;;; x ;.;9 = K9!DD ,ffective interest rate =
=
5nterest expense + 6nnual fee Eorrowed amount (K9?!DD? + K-!>/? = //4B K>D?!;;;
14)4 Lockbo+8 Pennifer ,lectricals is evaluating whether a lockbox they are currently using is
worth keeping. 1anagement estimates that the lockbox reduces the mail float by . days and the processing by half a day. 'he remittances average K;!;;; a day for Pennifer ,lectricals! with the average check K;;. 'he bank charges K;.9 per processed check. 6ssume that there are /D; business days in a year and the firm"s opportunity cost of those
funds is > percent. What will the firm"s savings be from using the lockbox?
9ol&tion8
6verage daily sales = K;!;;; #o. of business days = /D; 3pportunity cost of funds = >M 6verage check amount = K;; #o. of checks processed per day = K;!;;; : K;; = ;; $ollection time saved = . days Crocessing time saved = ;. days Cer-check processing fee = K;.9 'he cost of a lockbox = ;; checks × K;.9 per check × /D; days = KF!; +avings from mail float = . days × K;!;;; = KF;!;;; +avings from processing float = ;. days × K;!;;; = K/!;;; 'otal savings = (+avings from mail float @ +avings from processing float = KF;!;;; @ K/!;;; = K!;;; +avings from lockbox = K!;;; ;.;>= 2$@DD +ince the savings from the lockbox is less than the cost of the lockbox! it is not worth keeping the lockbox for Pennifer ,lectricals.
14)/ Lockbo+8 Ha4el $orp. has Bust signed up for a lockbox. 1anagement expects the
lockbox to reduce the mail float by /. days. Ha4el $orp."s remittances average K9D!;;; a day for Ha4el! with the average check being K/. 'he bank charges K;.9D per processed
check. 6ssume that there are /D; business days in a year. What will the firm"s savings be from using the lockbox if the opportunity cost of those funds is / percent?
9ol&tion8
6verage daily sales = K9D!;;; #o. of business days = /D; 6verage check amount = K/ #o. of checks processed per day = K9D!;;; : K/ = /F> $ollection time saved = /. days Cer check processing fee = K;.9D 'he cost of a lockbox = /F> checks × K;.9D per check × /D; days = K/F!D;.; +avings from mail float = /. days × K9D!;;; = KDD!D;; 3pportunity cost of funds = /M +avings from lockbox = KDD!D;; ;./= @$,)4 +ince the savings from the lockbox is less than the cost of the lockbox! it is not worth keeping the lockbox for Ha4el $orp.
14)2 Aging sc'e%&le8 Iinseng $ompany collects ; percent of its receivables in ; days or
fewer! 9 percent in to 9; days! D percent in 9 to days! D percent in > to >; days! and percent in more than >; days. 'he company has K!/9!;;; in accounts receivable. Crepare an aging schedule for Iinseng $ompany.
9ol&tion8
6ccounts receivables = K!/9!;;; Age o" Acco&nts -in %a*s. ;-; -9; 9- >->; 3ver >; Total
;al&e o" Acco&nt -. K >;>!;; 9D>!;9; !F; !F; >;!>; K!/9!;;;
B o" Total Acco&nt ;.;M 9.; D.; D.; .; ;;.;M
14) Aging sc'e%&le8 6 partial aging of accounts receivable for Lincoln $leaning +ervices is
given in the following table. What percent of receivables are in the -day range? 0etermine the firm"s effective days" sales outstanding. How does it compare to the industry average of 9 days?
Age o" Acco&nts -in %a*s. ; 9; >; D Total
;al&e o" Acco&nt -. K/D!;;; !//;
B o" Total Acco&nt
9!F; 9!/ KF!/
;;.;M
;al&e o" Acco&nt -. K/D!;;; !//; $, 9!F; 9!/
B o" Total Acco&nt >.;M /.> 14@ F./ .9
9ol&tion8
6ccounts receivables = KF!/ Age o" Acco&nts -in %a*s. ; 9; >; D
KF!/
Total
;;.;M
,ffective 0+3= 6ge of the account category × Cercent of 67 for the account category = (; x ;.> @ 9; x ;./> @ x ;.F @ >; x ;.;F/ @ D x ;.;9 = /./ days 'he firm is more efficient than other firms in the industry as its effective 0+3 is lower.
14) 14) Agin Aging g sc' sc'e% e%&l &le8 e8 Qeswick )encing $ompany collects percent of its receivables in ;
days or fewer! 9 percent in ; to 9; days! / percent in 9 to days! percent in > to >; days! and percent in more than >; days. 'he company has KF9D!;;; in its accounts receivable account. Crepare an aging schedule for Qeswick )encing.
9ol&tion8
6ccounts receivables = KF9D!;;; Age o" Acco&nts -in %a*s. ;-; -9; 9- >->; 3ver >; Total
;al&e o" Acco&nt -. K/!>; 9!; /!; >!; 9D!; KF9D!;;;
B o" Total Acco&nt .;M 9.; /.; .; .; ;;.;M
14) 14)@ @ :act :actor orin ing g Renex! 5nc.! sells K/;!;;; of its accounts receivable to factors at 9 percent
discount. 'he firm"s average collection period is F; days. da ys. What is the dollar cost of the factoring service? What is the simple annual interest cost of the factors loan?
9ol&tion8
6ccounts receivables sold = K/;!;;; )actor discount = 9M 6verage 6verage collection period = F; days da ys 0ollar cost of factoring per month = K/;!;;; x ;.;9 = $/DD 0ollar cost over F; days = KD!;; x 9 = K//!;; +imple monthly interest cost of factoring = 9:FD = ;.;9;F9 +imple interest cost of factoring = ;.;9;F9 x / = ,1B
./0 :actoring 6 firm sells K;;!;;; of its accounts receivable to factors at / percent perc ent discount. 'he firm"s average collection period is one month. What is the dollar cost of the factoring service?
9ol&tion8
6ccounts receivables sold = K;;!;;; )actor discount = /M 6verage 6verage collection period = 9; days da ys 0ollar cost of factoring per month = K;;!;;; x ;.;/ = )$DDD
A!;A7CE!
14,1 What impact would the following actions have on the operating and cash conversion
cycles? Would the cycles increase! decrease! or remain the unchanged?
a
1ore raw material than usual is purchased.
b
'he company enters into an off season! and inventory builds up.
c
Eetter terms of payment are negotiated with suppliers.
%
'he cash discounts offered to customers are decreased.
e
6ll else remaining the same! an improvement in manufacturing manufac turing techni%ue decreases the cost of goods sold.
9ol&tion8 Cas' conversion 9it&ation
Operating c*cle c*cle
a. 1ore 1ore raw raw materi material al than than usual usual is ncrease
ncrease
ncrease
ncrease
1o change change
+ecrease +ecrease
ncrease
ncrease
ncrease
2nchanged 2nchanged
purchased. b. 'he company enters into an off season! and inventory builds up. c. Eetter Eetter terms terms of of payme payment nt are are negoti negotiate ated d with suppliers. d. 'he cash cash disc discount ountss offere offered d to custo customer merss are decreased. e. 6ll 6ll else else rem remai aini ning ng the the same same!! an improvement in manufacturing techni%ue decreases the cost of goods sold.
14,) What impact would the following actions have on the operating and cash conversion
cycles? Would the cycles increase! decrease! or remain the unchanged? a
Less raw material than usual is purchased.
b
'he company encounters unseasonable demand! and inventory declines rapidly.
c
'ighter terms of payment are demanded by suppliers.
%
'he cash discounts offered to customers are increased.
e
6ll else remaining the same! due to labor turnover and poor efficiency! the cost of goods sold increases.
9ol&tion8 Cas' conversion 9it&ation
Operating c*cle c*cle
a. Less raw material than usual is +ecrease
+ecrease
+ecrease
+ecrease
1o change
ncrease
+ecrease
+ecrease
+ecrease
2nchanged
purchased. b. 'he company encounters unseasonable demand! and inventory declines rapidly. c. 'ighter terms of payment are demanded by suppliers. d. 'he cash discounts offered to customers are increased. e. 6ll else remaining the same! due to labor turnover and poor efficiency! the cost of goods sold increases.
14,, 1organ +ports $ompany Bust reported the following financial figures. Morgan 9ports E&ipment Compan* Liabilities an% E&it* K >DD!/9 6ccounts payable !!9 #otes payable !9/!D K9!9!; 'otal current liabilities
Assets $ash and marketable sec. 6ccounts receivable 5nventories 'otal current assets
#et sales $ost of goods sold
F!F/!/9/ !FD!9FF
a
$alculate the firm"s days" sales outstanding.
b
What is the firm"s days" sales in inventory?
c
What is the firm"s days" payable outstanding?
%
What is the firm"s operating cycle? How does it compare to the industry average of D/ days?
e
What is the firm"s cash conversion cycle? How does it compare to the industry average of / days?
9ol&tion8
0+3 = a
0+5 = b.
$redit sales 9>?
6ccounts Cayable $3I+ 9>?
3perating cycle
d.
=
K-!L?!--9 KF!F-/!99/ 9>?
= >@ %a*s
5nventory K-!9-/!DL = = CD2 %a*s $3I+ 9>? K?!FD!9FF 9>?
0C3 = c.
6ccounts receivable
=
K-!D/-!>>F K?!FD!9FF 9>?
= 0+3 + 0+5 = >D.F + L;.> = 14C/ %a*s
= 1D/ %a*s
K!D/!>>F /!9!9 K9!9!;
'he firm is very inefficient in managing its receivable and inventory as its operating cycle exceeds the industry average of D/ days by about DD days.
$ash conversion cycle
e.
= 0+3 + 0+5 − 0C3 = (>D.F + L;.> − -;?.D = 4)C %a*s
'he firm"s cash conversion cycle is on a par with the industry average of / days thanks to its suppliers" very generous credit policy.
14,4 Packson ,lectricals is one of the largest dealers of generators in Choenix and sells about
/!;;; of them a year. 'he cost of placing an order with their supplier is KD;!! and the inventory-carrying costs are KD; for each generator. 'hey like to maintain safety stock of at all times. a
What is the firm"s ,3A?
b.
How many orders will the firm need to place this year?
c
What is the average inventory for the season?
9ol&tion8
6nnual sales = /!;;; units $ost of placing an order = KD; 5nventory-carrying cost per generator = KD; +afety stock = generators
,3A =
= a.
/ × 7eorder costs × +ales per period $arrying cos ts / × KD?; × /!;;; K-D;
= -9/.L
,conomic order %uantity = 1,, generators b.
#o. of orders the firm needs to place = /!;;; : 99 = 1/ or%ers
c.
6verage inventory = ((99 O ;:/ @ = ) generators
14,/ 'an4ani%e! 5nc.! sells K/;;!;;; of its accounts receivable to factors at percent discount.
'he firm"s average collection period is F; days. a
What is the dollar cost of the factoring service?
b
What is the simple annual interest cost of the factors loan?
c
What is the effective annual interest cost of the loan?
9ol&tion8
6ccounts receivables sold = K/;;!;;; )actor discount = M 6verage collection period = F; days a.
0ollar cost of factoring per month = K/;;!;;; x ;.; = 1D$DDD 0ollar cost over F; days = K;!;;; x 9 = K9;!;;;
b.
+imple monthly interest cost of factoring = :F = ;.;/> +imple interest cost of factoring = ;.;/> x / = 2,)B
m
c
Auoted rate − ,67 = - + m = (- + ;.;?/>-/ − = ;.L?;> = C/D2B
CFA )roble!s .9>. 6 company increasing its credit terms for customers from :;! net 9; to :;! net >; will likely experience 6. an increase in cash on hand. E. an increase in the average collection period. $. higher net income. 0. a higher level of uncollectible accounts. 9ol&tion8
E is correct. .9D. +uppose a company uses trade credit with the terms of /:;! net ;. 5f the company pays their account on the ;th day! the effective borrowing cost of skipping the discount on day ; is closest to 6. .>M E. .FM $. .;M 0. /;./M 9ol&tion8
0 is correct. ;.;/ $ost = -@ ÷ ;.FL
9>:;
− - = /;./ percent
.9. Which of the companies has the lowest accounts receivable turnover in the year /;S/? 6. $ompany 6 E. $ompany E $. $ompany $ 0. $ompany 0 9ol&tion8
E is correct.
$ompany 6 K>.; million:K./ million = .;; $ompany E K.; million:K. million = /.>D $ompany $ K9.; million:K.; million = 9.;; $ompany 0 K;.> million:K;./ million = 9.;; .9F. 'he industry average receivables collection period 6. increased from /;S to /;S/ E. decreased from /;S to /;S/ $. did not change from /;S to /;S/ 0. increased along with the increase in the industry accounts receivable turnover. 9ol&tion8
E is correct. /;S D9 days /;S/ D;.9F9 #ote 5f the number of days decreased from /;S to /;S/! the receivable turnover increased. .;. Which of the companies reduced the average time it took to collect on accounts receivable from /;S to /;S/? 6. $ompany 6 E. $ompany E $. $ompany $ 0. $ompany 0
9ol&tion8
E is correct. $ompany E increased its accounts receivable (6:7 turnover and reduced its number of days of receivables between /;S and /;S/. /;S /;S/ $ompany 6:7 #umber 67 #umber turnover of days of turnover of days of receivables receivables 6 .;;; D9.;;; .;;; D9.;;; E /.;; >.;;; /.>>D 9>.D $ 9./ >.;; 9.;;; /.>>D 0 .;;; D9.;;; 9.;;; /.>>D
9ample Test Problems
141
5f your firm"s 0+3 is D.9 days and the days" sales in inventory is 9F.> days! what is the firm"s operating cycle?
9ol&tion8
3perating cycle
14)
= 0+3 + 0+5 = D.9 + 9F.> = C2@ %a*s
5f $halet $orp. has an operating cycle of F9. days and days" payables outstanding of ./ days! what is the firm"s cash conversion cycle?
9ol&tion8
$ash conversion cycle
14,
= 0+3 + 0+5 − 0C3 = F9. − L./ = 4/) %a*s
7anger $leaning $ompany has borrowed KF;!;;; at a stated 6C7 of . percent. 'he loan calls for a compensating balance of percent. What is the effective interest rate for this company?
9ol&tion8
6mount to be borrowed = KF;!;;;
+tated annual interest rate = .M $ompensating balance = M 6mount deposited as compensating balance = KF;!;;; x ;.; = KD!/;; ,ffective borrowing amount = KF;!;;; G KD!/;; = K/!;; 5nterest expense = KF;!;;; x ;.; = KD!>; ,ffective interest rate =
144
5nterest expense ,ffective borrowing amount
=
KD!>?; KL/!L;;
= @)4B
7osemary $orp. has daily sales of K9F!;;;. 'he financial manager determined that a lockbox would reduce the collection time by /./ days. 6ssuming the company can earn . percent interest per year! what are the savings from the lockb ox?
9ol&tion8
6verage daily sales = K9F!;;; $ollection time saved = /./ days +avings from mail float = /./ days × K9F!;;; = K9;!;; +avings if invested = K9;!;; x (;.; = 12$1@
14/
$hoi ,xports is setting up a line of credit at its bank for KD. million for up to three years. 'he loan rate is D.D percent and also calls for an annual fee of ; basis points on any unused balance for the year. 5f the firm borrows K million on the d ay the loan agreement was signed! what is the firm"s effective rate?