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CHAPTER 14Working Capital Management

Learning Objectives

1. Define net working capital, discuss the importance of working capital management,

and be able to compute a firm’s net working capital.

2. Define the operating and cash cycles, explain how they are used, and be able to

compute their values for a firm.

3. Discuss the relative advantages and disadvantages of pursuing (1) flexible and (2)

restrictive current asset investment strategies.

4. Explain how accounts receivable are created and managed, and be able to compute

the cost of trade credit.

5. Explain the trade-off between carrying costs and reorder costs, and be able to

compute the economic order quantity for a firm’s inventory orders.

6. Define cash collection time, discuss how a firm can minimize this time, and be able

to compute the cash collection costs and benefits of a lockbox.

7. Identify three current asset financing strategies and discuss the main sources of

short-term financing.

I. Chapter Outline

14.1 Working Capital Basics

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.

Current assets are cash and other assets that the firm expects to convert

into cash in a year or less.

Current liabilities (or short-term liabilities) are obligations that the firm

expects to pay off in a year or less.

Working capital, also called gross working capital, is the funds invested

in a company’s cash account, account receivables, inventory, and other

current assets.

Net working capital (NWC) refers to the difference between current

assets and current liabilities.

o NWC is important because it is a measure of liquidity 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 efficiency refers to the length of time between when a

working capital asset is acquired and when it is converted into cash.

Liquidity is the ability of a company to convert assets—real or financial

—into cash quickly without suffering a financial loss.

A. Working Capital Accounts and Trade-Offs

The various working capital accounts are:

Cash: This account includes cash and marketable securities like

Treasury securities.

o The higher the cash balance, the better the ability of the

firm to meet its short-term financial obligations.

Receivables: These represent the amount owed by customers who

have taken advantage of the firm’s trade credit policy.

Inventory: Firms maintain inventory of raw materials and work in

process and finished goods.

Payables: The payables balance represents the amount owed to the

firm’s vendors and suppliers on materials purchased on credit.

o The accrual accounts are liabilities incurred but not yet

paid, such as accrued wages or taxes.

14.2 The Operating and Cash Conversion Cycles

The cash conversion cycle begins when the firm invests cash to purchase the raw

materials that would be used to produce the goods that the firm manufactures and ends

not with the finished goods being sold to customers and the cash collected on the sales;

but when you take into account the time taken by the firm to pay for its purchases.

See Exhibit 14.2 for a graphical representation of the cash conversion cycle.

When managing working capital accounts, financial managers want to do the following:

Delay paying accounts payable as long as possible without suffering any

penalties.

Maintain minimal raw material inventories without causing manufacturing delays.

Use as little labor as possible to manufacture the product while producing a

quality product.

Maintain minimal finished goods inventories without losing sales.

Offer customers the most attractive credit terms possible on trade credit to

maximize sales while minimizing the risk of nonpayment.

Collect cash payments on accounts receivable as fast as possible to close the loop.

With the financial manager’s goal being to maximize the value of the firm, each of the

decisions above is intended to shorten the cash conversion cycle and improve the firm’s

liquidity.

Two tools to measure the working capital management efficiency are the operating cycle

and the cash conversion cycle.

A. Operating Cycle

The operating cycle begins when the firm receives the raw materials it purchased

and ends when the firm collects cash payments on its credit sales.

Two measures—days’ sales outstanding and days’ sales in inventory—help

determine the operating cycle.

Days’ sales in inventory (DSI) shows how long the firm keeps its

inventory before selling it.

o It is the ratio of the inventory balance to the daily cost of goods

sold.

o The quicker a firm can move out its raw materials as finished

goods, the shorter the duration when the firm holds it inventory,

and the more efficient it is in managing its inventory.

Days’ sales outstanding (DSO) estimates how long it takes on average

for the firm to collect its outstanding accounts receivable balance.

o This ratio is also called the average collection period (ACP).

o An efficient firm with good working capital management should

have a low average collection period compared to its industry.

The operating cycle is calculated by summing the days’ sales outstanding and the

days’ sales in inventory.

(14.1)

B. Cash Conversion Cycle

The cash conversion cycle is related to the operating cycle, but it does not start

until the firm actually pays for its inventory.

The cash conversion cycle is the length of time between the cash outflow

for materials and the cash inflow from sales.

To measure the cash conversion cycle, we need another measure called the day’s

payables outstanding.

Days’ payable outstanding (DPO) shows how long a firm takes to pay off its

suppliers for the cost of inventory.

The cash conversion cycle is then calculated by summing the days’ sales

outstanding and the days’ sales in inventory and subtracting the days’ payables

outstanding.

The formula is shown in Equation 14.2:

14.3 Working Capital Investment Strategies

Financial managers use two types of strategies for current assets investments: flexible and

restrictive.

A. Flexible Current Asset Investment Strategy

The flexible strategy has a high percent of current assets to sales, whereas a

restrictive policy has a low percent of current assets to sales.

The flexible strategy calls for management to invest large amounts in cash,

marketable securities, and inventory.

The strategy also promotes a liberal trade credit policy for customers, which

results in high levels of accounts receivable.

The flexible strategy is perceived be a low risk and low return course of action for

management to follow.

The advantage of this policy is the large working capital balances the firm holds.

The strategy’s downside is the high inventory-carrying cost associated with

owning a high level of inventory and providing liberal credit terms for its

customers.

The higher carrying costs result for two reasons

The investment in the low return current assets deprives the higher returns

that management could earn on longer term assets like plant and

equipment.

Higher amounts of inventory results in higher warehousing and storage

costs.

B. Restrictive Current Asset Investment Strategy

Current assets are kept to a minimum in the restrictive strategy.

The firm barely invests in cash and inventory, and has tight terms of sale intended

to curb credit sales and accounts receivable.

The restrictive strategy is a high-risk, high-return alternative to the flexible

strategy.

The high risk comes in the form of shortage costs that can be either

financial or operating.

Financial shortage costs arise mainly from the illiquidity shortage of cash

and a lack of marketable securities to sell for cash.

o If unpaid bills are due, the firm will be forced to use expensive

external emergency borrowing.

o If 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 If the firm does not hold enough raw materials in inventory, time

may be wasted by a halt in production.

o If the firm runs out of finished goods, sales may also be lost, and

customer dissatisfaction may arise.

o Restrictive sale policies such as allowing no credit sales will also

result in lost sales.

o Overall, operating shortage costs can be substantial, especially if

the product markets are competitive.

C. The Working Capital Trade-off

The optimal current asset investment strategy will depend on the relative

magnitudes of carrying costs versus shortage costs. This conflict is often referred

to as the working capital trade-off.

Financial managers need to balance shortage costs against carrying costs

to find an optimal strategy.

If carrying costs are larger than shortage costs, then the firm will

maximize value by adopting a more restrictive strategy.

On the other hand, if shortage costs dominate carrying costs, the firm will

need to move toward a more flexible policy.

Overall, management will try to find the level of current assets that

minimizes the sum of the carrying costs and shortage costs.

14.4 Accounts Receivables

A. Terms of Sale

Whenever a firm sells a product, the seller spells out the terms and conditions of

the sale in a document called the terms of sale.

The agreement specifies when the cash payment is due and the amount of any

discount if early payment is made.

Trade credit, which is short-term financing, is typically made with a discount for

early payment rather an explicit interest charge.

An offer of “3/10, net 40” means that the selling firm offers a 3 percent

discount if the buyer pays the full amount of the purchase in cash within

10 days of the invoice date.

o Otherwise, the buyer has 40 days to pay the balance in full from

the date of delivery.

To calculate the cost, we need to determine the interest rate the buyer is paying

and convert it to an equivalent annual rate.

The formula for calculating the EAR for a problem like this is shown below, in

Equation 14.4,

Effective annual rate =

Trade credit is a loan from the supplier and it can be a very costly form of credit.

B. Aging Accounts Receivables

A common tool that credit managers use is called an aging schedule.

The 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.

Its purpose is to identify and then track delinquent accounts and to see that they

are paid.

Aging schedules are also an important financial tool for analyzing the quality of a

company’s receivables.

The aging schedule reveals patterns of delinquency and shows where

collection efforts should be concentrated.

Exhibit 14.6 shows aging schedules for three different firms.

14.5 Inventory Management

Inventory management is largely a function of operations management, not financial

management.

Manufacturing companies generally carry three types of inventory: raw materials, work

in process, and finished goods.

A. Economic Order Quantity

The economic order quantity (EOQ) mathematically determines the minimum

total inventory cost, taking into account reorder costs and inventory-carrying

costs.

The optimal order size strikes the balance between these two costs.

Equation 14.5 shows how to calculate EOQ.

B. Just-in-Time Inventory Management

In this system the exact day-by-day, or even hour-by-hour, raw material needs

are delivered by the suppliers, who deliver the goods “just in time” for them to

be used on the production line.

A big advantage of this system is that there are essentially no raw inventory

costs and no chance of obsolescence or loss to theft.

On the other hand, if the supplier fails to make the needed deliveries, then

production shuts down.

If the system works for a firm, it cuts down their investment in working capital

dramatically.

14.6 Cash Management and Budgeting

A. Reasons for Holding Cash

Two reasons exist for holding a cash balance. First, it facilitates transactions

with suppliers, customers and employees.

The second reason is simply that most banks require firms to hold minimum cash

balances, or compensating balances, in exchange for the services they provide.

B. Cash Collection

Collection time, or float, is the time between when a customer makes a payment

and when the cash becomes available to the firm.

Collection time can be broken down into three components.

First is delivery time, or mailing time.

o When a customer mails payment, it may take several days before

that payment arrives.

Second is processing delay.

o Once the payment is received, it must be opened, examined,

accounted for, and deposited at the firm’s bank.

Finally, there is a delay between the time of the deposit and the time when

the cash is available for withdrawal.

Payments in cash at the point of sale reduce the collection time to zero.

o Payment by check or credit card at the point of sale eliminates the

mail time but not the processing time.

A 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 by a local branch,

which receives the mailings, processes the payments, and makes the deposits.

Either approach will reduce the collection time to an extent, but there is a cost

associated with it.

Another increasingly popular means of reducing cash collection time is through

the use of electronic funds transfers, which reduces cash collection times in

every phase.

First, mailing time is eliminated.

Second, processing time is reduced or eliminated since no data entry is

necessary.

Finally, electronic funds transfers typically have little or no delay in funds

availability.

14.7 Financing Working Capital

A. Strategies for Financing Working Capital

Exhibit 14.7 shows the three basic strategies that a firm can follow to finance its

working capital and fixed assets.

Each of the three panels show: (1) the total long-term financing needed,

which consists of long-term debt and equity, and (2) the seasonal needs for

working capital that fluctuates with the level of sales.

The maturity matching strategy is shown in Figure A of Exhibit 14.7.

All working capital is funded with short-term borrowing, and, as the level of

sales varies seasonally, short-term borrowing fluctuates between some

minimum and maximum level.

All fixed assets are funded with long-term financing.

The “matching of maturities” is one of the most basic techniques used by

financial managers to reduce risk when financing assets.

The long-term funding strategy is shown in Figure B in Exhibit 14.7.

This strategy relies on long-term debt to finance both capital assets and

working capital.

This strategy reduces the risk of funding current assets because there is no

need to worry about refinancing assets since all funding is long term.

Figure C in Exhibit 14.7 shows the short-term funding strategy whereby all

working capital and a portion of fixed assets are funded with short-term debt.

While this lowers the cost under some interest rate scenarios, it forces the

firm to continually refinance the funding of the long-term assets in a changing

interest rate environment.

B. Financing Working Capital in Practice

Many financial managers try to match the maturities of assets and liabilities when

funding the firm.

That is, short-term assets are funded with short-term financing, and long-

term assets are funded with long-term financing.

Most financial managers like to fund some of their currents assets with long-term

debt as shown in Figure A of Exhibit 14.7, so-called permanent working capital.

In 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. Sources of Short-Term Financing

Accounts payable (trade credit), bank loans, and commercial paper are common

sources of short-term financing.

Between 1990 and 2003, accounts payable constituted 37 percent of total current

liabilities for all publicly traded manufacturing firms.

The buyer needs to figure out whether it makes financial sense to pay early

and take advantage of the discount or to wait and pay in full when the account

is due.

Between 1990 and 2003, short-term bank loans accounted for 19 percent of total

current liabilities for all publicly traded manufacturing firms.

An informal line of credit is a verbal agreement between the firm and the

bank, allowing the firm to borrow up to an agreed-upon upper limit.

In exchange for providing the line of credit, a bank may require that the

firm holds a compensating balance with them.

A formal line of credit is also known as “revolving credit,” whereby the

bank has a legal obligation to lend to the firm an amount of money up to a

preset limit.

o The firm pays a yearly fee, in addition to the interest expense on the

amount they borrow.

If the firm backs the loan with an asset, the loan is defined as secured;

otherwise, the loan is unsecured.

Secured loans allow the borrower to borrow at a lower interest rate, all

else being equal.

Commercial paper is a promissory note issued by large financially secure firms,

which have high credit ratings.

Commercial paper is not “secured,” 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.

Therefore, 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.

For medium-size and small businesses, accounts receivable financing is an

important source of funds.

A company can secure a bank loan by pledging the firm’s accounts

receivable as security.

A second way for a business to finance itself with accounts receivables is

to sell the receivables to a factor at a discount.

The firm that sold the receivables has no further legal obligation to the

factor.

II. Suggested and Alternative Approaches to the Material

This chapter focuses on short-term financial decisions that involve cash inflows and outflows

that will occur within a year or less. Examples include the purchase of raw materials, payment

for the purchases of raw materials, sale of finished inventory, and the collection of cash for sales

made on credit. This chapter focuses on these types of decisions, which are called working

capital management.

The chapter begins by reviewing some basic definitions and concepts that are necessary

to further our study of working capital management. Next, the authors examine the individual

working capital accounts and then learn how to construct and analyze the operating and cash

conversion cycles. Then they examine how the different working capital accounts are managed:

the cash account, accounts receivables, and inventory. Finally, the different financing options

that financial managers consider, and the risks involved, are discussed.

Instructors may choose to cover this chapter at any point in the semester. The material is

sufficiently independent of previous material to allow that. It is important to recognize that many

undergraduates are more likely to deal with working capital management issues on their first job

than with issues like capital budgeting decisions or capital structure decisions.

None of the quantitative material is likely to be overwhelming, and as in previous

chapters, the end-of-chapter problems emphasize repetition to allow instructors to work some

problems in class and assign others for the students to work on their own.

III. Summary of Learning Objectives

1. Define net working capital, discuss the importance of working capital management, and

be able compute a firm’s net working capital.

Net working capital is the difference between current assets and current liabilities. Working

capital management refers to the decisions made regarding the use of current assets and how

they are financed. The goal of working capital management is to ensure that the firm can

continue its day-to-day operations and pay its short-term debt obligations. The computation

of net working capital for Dell Computer is illustrated in Section 14.1

2. Discuss the operating and cash cycles, explain how are they used, and be able to

compute their values for a firm

The operating cycle can be defined as the period starting with the receipt of raw materials

and ending with the receipt of cash for finished goods made from those raw materials. It can

be broken into two components: (1) days’ sales in inventory, which shows how long a firm

keeps its inventory before selling it, and (2) days’ sales outstanding, which indicates how

long it takes on average for the firm to collect its outstanding accounts receivable. Related to

the operating cycle is the cash conversion cycle, which is the length of time between the cash

outflow for materials and the cash inflow from sales. An additional measure, that of days’

payables outstanding, is required to calculate the cash conversion cycle. Both cycles are

simple tools to help the financial manager measure working capital efficiency and control

liquidity. The computations are illustrated in Section 14.2.

3. Discuss the relative advantages and disadvantages of pursuing (1) flexible and (2)

restrictive current asset investment strategies.

A flexible strategy involves maintaining relatively high levels of cash, marketable securities,

and inventory, while a restrictive strategy keeps the levels of current assets relatively low. In

general, a flexible strategy is thought to be low risk and low return; its downsides include

low returns on current assets, potentially high inventory-carrying costs, and the cost of the

money necessary to provide liberal credit terms. The restrictive strategy involves higher risk

and return, with higher potential financial and operating shortage costs as its major

drawbacks.

4. Explain how accounts receivable are created and managed, and be able to compute the

cost of trade credit.

Accounts receivable are promises of future payment from customers that buy goods or

services on credit. The details are defined in the terms of sale, which include the due date, the

interest rate charge, and any discounts for early payment. The terms of sale are affected by

the practice in the industry and the creditworthiness of the customer. To manage accounts

receivable, the financial manager should keep close track of both days’ sales outstanding and

the aging schedule.

5. Explain the terms inventory-carrying costs and reorder costs, and be able to compute the

economic order quantity for a firm’s inventory orders.

The trade-off between carrying costs and reorder costs exists because as the size of a firm’s

orders for materials increases, the number of orders and total reorder costs decline. At the

same time, larger order size increases the average inventory size, and, therefore, average

inventory-carrying costs. The economic order quantity (EOQ) is a tool for mathematically

finding the combination of the two costs that minimizes the firm’s total inventory cost.

Learning by Doing Application 14.3 offers practice in computing a firm’s EOQ.

6. Define cash collection time, discuss how a firm can minimize this time, and be able to

compute the economic costs or benefits of a lockbox.

Cash collection time is the time between when a customer makes a payment and when the

cash becomes available to the firm. It has three components: (1) delivery or mailing time, (2)

processing delay, and (3) delay between deposit time and availability. Possible methods a

firm can use to minimize this time include lockboxes, concentration accounts, and electronic

funds transfers. Work through Learn by Doing Application 14.4 to decide whether a lockbox

is worth keeping.

7. Identify three current asset financing strategies and discuss the main sources of short-

term financing.

There are three main current asset financing strategies: (1) the matching maturity strategy,

which matches the maturities of assets with the maturities of liabilities; (2) the long-term

funding strategy, which finances both working capital and long-term assets with long-term

debt; and (3) the aggressive funding strategy, which uses short-term debt for both working

capital and long-term assets. Sources of short-term financing include accounts payable, short-

term bank loans, lines of credit, and commercial paper.

IV. Summary of Key Equations

Equation Description Formula

14.1 Operating cycle Operating cycle = DSO + DSI

14.2 Cash conversion cycle Cash conversion cycle =DSO + DSI − DPO

14.3 Cash conversion cycle Cash conversion cycle = Operating cycle − DPO

14.4Effective annual rate (EAR)

EAR =

14.5Economic order quantity (EOQ)

EOQ =

V. Before You Go On Questions and Answers

Section 14.1

1. How do you calculate net working capital, and why is it important?

Net working capital is calculated as the difference between the current assets and current

liabilities. It is important for a firm to keep a positive net working capital balance, as

these funds are used to cover the day-to-day expenses and short-term liabilities as they

come due.

2. What are some of the trade-offs required in the management of working capital accounts?

When managing working capital accounts, a financial manager is looking to delay paying

accounts payable as long as possible without suffering any penalties, maintain minimal

finished goods inventories without losing sales, and collect cash payments on accounts

receivable as fast as possible to close the loop, among other things.

Section 14.2

1. What is the operating cycle, and how is it related to the cash conversion cycle?

The operating cycle starts with the receipt of raw materials and ends with the collection

of cash from customers for the sale of finished goods. The operating cycle can be

described in terms of two components: days’ sales in inventory and days’ sales

outstanding. The cash conversion cycle is the length of time between the actual cash

outflow for materials and the actual cash inflow from sales. To calculate it, we need all of

the information used to calculate the operating cycle plus one additional measure: days’

payables outstanding.

Section 14.3

1. What are the two general current asset investment strategies discussed in this section, and

how do they differ?

Typically, the two main current asset investment strategies are flexible and restrictive

strategies. The flexible strategy prompts management to keep large balances of cash,

marketable securities, and inventory. This strategy is perceived to be a relatively low-risk

and low-return course of action for management to follow. The restrictive strategy, on the

other hand, prompts management to keep the usage of current assets to a minimum and is

perceived to be high risk and high return.

2. What are the types of costs associated with each of these strategies?

The flexible strategy is associated with a high level of carrying costs because of a firm’s

high levels of inventory and providing liberal credit for customers. The restrictive

strategy is associated with shortage costs, which can be either financial or operating in

nature.

Section 14.4

1. What does “4/15, net 30” mean?

If a company declares a “4/15, net 30” means of sale, it signifies that it will grant the

customer a 4 percent discount if the customer pays the full amount within 15 days of the

invoice date. Otherwise the customer has 30 days to pay the balance in full from the date

of the delivery.

2. What is an aging schedule, and what is its purpose?

The aging schedule for a firm lists the accounts receivable broken down by the number of

days until they are due or past due. Firms use aging schedules to keep track of their

accounts receivables and to assess how effective they are collecting on these accounts.

Section 14.5

1. What is the economic order quantity model?

The economic order quantity model is an inventory management tool that mathematically

determines the minimum total inventory cost, taking into account reorder costs and

inventory-carrying costs. The main objective of the model is to find the trade-off between

the two costs.

2. Why is an investment in inventory considered to be costly?

Investment in inventory is considered costly, because inventory must be stored, which

results in rental and maintenance costs. Furthermore, inventory on hand is subject to loss

and theft, and faces the possibility of becoming obsolete. Finally, investment in inventory

provides no return unlike an investment in financial or real assets would.

Section 14.6

1. What is float?

The collection time, which is the time between when a customer makes a payment and

the time the cash becomes available is to the firm, is also referred to as float.

2. Explain 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. The post office then

collects these payments and delivers them to the bank. The main purpose of lockboxes is

to minimize collection time for firms through cutting down on postal time and through

processing the payments directly at the bank.

Section 14.7

1. List and briefly describe the three main short-term financing strategies.

The three main short-term financing strategies are (1) self-liquidating strategy, in which

the maturity of the liabilities is matched with that of assets; (2) conservative strategy,

which relies more heavily on long-term financing; and (3) restrictive strategy, which

relies primarily on short-term financing.

2. What are the advantages and disadvantages of short-term financing?

Short-term financing offers companies greater flexibility and usually a lower cost of

capital. On the other hand, short-term financing often comes with some illiquidity

problems as well as uncertainty due to increased exposure to interest rate fluctuations.

3. Give examples of sources of short-term financing.

Examples of short-term financing include accounts payable, short-term bank loans,

informal lines of credit, formal lines of credit, or commercial paper. The two main

current asset investment strategies are (1) flexible strategy, which encourages

management to keep large balances of current assets, and (2) restrictive strategy, which

keeps the usage of current assets to a minimum.

VI. Self Study Problems

14.1 You are provided the following working capital information for the Blue Ridge

Company:

Account Beginning Balance Ending Balance

Inventory $ 2,600 $2,890

Accounts receivable 3,222 2,800

Accounts payable 2,500 2,670

Net sales 24,589

Cost of goods sold 19,630

If all sales are on credit, what are the firm’s operating and cash conversion cycles?

Solution:

We calculate the operating and cash conversion cycles for Blue Ridge as follows:

Inventory = $2,890

Accounts receivable = $2,800

Accounts payable = $2,670

Net sales = $24,589

Cost of goods sold = $19,630

14.2 Merrifield Cosmetics calculates that its operating cycle for last year was 76 days. The

company had $230,000 in its accounts receivable account and had sales of $1.92 million.

What can you say about Merrifield’s inventory management?

Solution:

The following information describes Merrifield’s inventory management:

Operating cycle = 76 days

Accounts receivables = $230,000

Net sales = $1,920,000

Merrifield Cosmetics takes 32.3 days to move the inventory through as finished products.

14.3 Below is a partial aging of accounts receivable for Bitar Roofing Services. Fill in the rest

of the information and determine its days’ sales outstanding. How does it compare to the

industry average of 40 days?

Age of Accounts (in days) Value of Account ($) % of Total Account

0-10 $211,000

11-30 120,360

31-45 103,220

46-60 72,800

Over 60 23,740

Total $531,120

Solution:

The missing information for Bitar Roofing is as follows:


0-10 $211,000 39.7%

11-30 120,360 22.7

31-45 103,220 19.4

46-60 72,800 13.7

Over 60 23,740 4.5

Total $531,120 100%

Bitar takes about 4 days more than the industry average of 40 to collect on its receivables.

The firm should focus collection efforts on all credit sales that take 60 days or more to

collect.

14.4 By obtaining a lockbox, Nizam’s Manufacturing was able to reduce its total cash

collection time by two days. The firm has annual sales of $570,000 and can earn 4.75

percent annual interest. Assuming that the lockbox costs $50 per year, calculate the

savings that can be attributed to the lockbox.

Solution:

The following information applies to Nizam’s lockbox:

Annual sales = $570,000

Annual interest rate = 4.75%

Annual cost of lockbox = $50

Collection time saved = 2 days

The firm can save $98.36 each year by using the lockbox.

14.5 Rockville Corporation is looking to borrow $250,000 at a stated 8.5 percent APR from

its bank, which requires its customers to maintain a 10 percent compensating balance.

What is the effective interest rate on this loan for Rockville Corporation?

Solution:

Rockville Corporation’s loan information is as follows:

Amount to be borrowed = $250,000

Stated annual interest rate = 8.5%

Compensating balance = 10%

Amount deposited as compensating balance = $250,000 x 0.10 = $25,000

Effective borrowing amount equal to $250,000 − $25,000 = $225,000

Interest expense = $250,000 x 0.085 = $21,250

By setting aside a compensating balance of 10 percent or $25,000 on the loan, the firm

increases its interest rate effectively to 9.44 percent.

VII. Critical Thinking Questions

14.1 What factors must a financial manager consider when making decisions about account

receivables?

When dealing with accounts receivables, important decisions for the financial manager

include the amount of credit offered to various customers and the term of the credit. The

financial manager should keep close track of both the aging schedule and the effective

DSO. If either or both show consistent deterioration, it may be time to reconsider the

firm’s credit policy or the characteristics of its customers. In addition, in some industries,

sales vary by season. A firm must be aware of seasonal patterns and make the necessary

adjustments before drawing any conclusions about its accounts receivable.

14.2 List some of the working capital management characteristics you would expect a

computer manufacturing company following just-in-time delivery system, such as Dell.

Firms like Dell are likely to do an exceptional job of managing their inventory and

collecting on their receivables. Dell employs a strategy similar to just-in-time

management where they maintain just sufficient inventory to meet the needs for a very

short time. This saves the firm a huge investment in inventory. Thus their days sales in

inventory (DSI) will be very low compared to other industries. Similar to Dell, firms will

have a short collection period, and their operating cycle will be much lower than firms in

other industries. If other computer manufacturing firms follow the Dell operating

philosophy, they will extend their days payables (DPO) to the point that tier cash

conversion cycle is negative. In other words, instead of having to invest in its working

capital, these firms will end up taking more time to pay their suppliers than the time taken

to produce, sell, and collect on the receivables.

14.3 What costs would a firm following a flexible current asset investment strategy worry

about, and why?

The strategy’s downside is the high carrying cost associated with owning a high level of

inventory and providing liberal credit terms for customers. By investing in current assets,

management foregoes the higher rate of return it could have earned by investing in long-

term assets. Therefore, there is an opportunity cost involved when investing in current

assets. Second, large investments in some types of inventory can require significant

warehousing and storage costs, which can be expensive.

14.4 How are customers and suppliers affected by a firm’s working capital management

decisions?

Customers like firms to maintain large finished goods inventories because when they go

to make a purchase, the item they want will likely be in stock. In general, large inventory

helps stimulate sales and increase customer satisfaction, but they can be a costly item on

a firm’s balance sheet. Management’s decisions on the firm’s receivables policy is driven

by the industry type. Companies selling perishable products, such as food companies,

might ask for payment in full in less than 10 days. On the other hand, if the firm is selling

durable goods, the terms of credit are likely to be more generous. The terms of sale are

also affected by the creditworthiness of the customer. If the firm is confident that it will

be paid, it is far more likely to extend credit than if there was some doubt about payment.

If the customer is a particularly large firm or if there is a likelihood of repeat business,

then extending credit may be part of the marketing effect to secure the order. Thus, when

the financial manager makes a decision to increase working capital, good things are likely

to happen to the firm—sales should increase, relationships with vendors and suppliers

should improve, and work or manufacturing stoppages should be less likely.

14.5 A beverage bottling company in Vermont has days’ sales outstanding of 23.7 days. Is this

good? Explain.

In general, a lower DSO reflects the fact that the firm is managing its receivables very

well. However, it is not possible to decide whether a DSO of 23.7 days is good or bad

unless you have a basis for comparison. That basis of comparison could be a peer group,

historical data for the firm itself, or targets set by the management.

14.6 How do the following circumstances affect the cash conversion cycle: (a) favorable credit

terms allow the firm to pay its accounts payable more slowly, (b) inventory turnover

increases, and (c) accounts receivable turnover decreases?

(a) Favorable credit terms from suppliers allow the firm to use the suppliers’ funds to

finance their working capital. It also reduces the firm’s cash conversion cycle.

(b) An increase in the inventory turnover, that is, the DSI decreases, reduces both the

firm’s operating cycle and the cash conversion cycle.

(c) As the accounts receivables turnover (DSO) decreases, the firm improves its

receivables management and reduces its operating cycle and hence, its cash

conversion cycle.

14.7 What are some industries in which the use of lockboxes would especially benefit

companies? Explain.

Lockboxes are a useful tool to speed up collection of receivables when the customer base

is dispersed across a large geographical area. Normally, this would mean customer

payments would have to be mailed in, consolidated, and then deposited at the firm’s

bank. The alternative of setting up a lockbox system allows the firm to redirect customer

payments to regional locations for quicker consolidation and cashing of payments. This is

typical in the retail industry where each store of a chain is located in a different city or

state.

14.8 Suppose you are a financial manager at a big firm and you expect the interest rates to

decline in the near future. What current asset investment strategy would you recommend

the company pursue?

At a large firm, management would have access to the commercial paper market, which

can provide cheaper funding than short-term bank financing. To borrow in the

commercial paper market, a firm has to be financially strong. If interest rates are expected

to decline, such firms can plan on raising working capital by issuing commercial paper.

Thus, all or a portion of the working capital needs can be funded through short-term

funds that can be rolled over as long as interest rates are declining.

14.9 Why is commercial paper only available to the most creditworthy customers?

Commercial paper is available only to firms that are financially strong for two reasons.

First, there is no secondary market for investors to liquidate prior to maturity.

Consequently, investors must hold it to maturity and have the confidence that the issuer

would pay them back at that time. Second, this type of debt is not secured by any real

assets of the issuing firm. Thus, firms that are the most creditworthy are able to raise

funds in this market at costs that are lower than bank loans.

14.10 Explain what a negative cash conversion cycle means.

Recognize the cash conversion cycle is a function of a firm’s receivables turnover,

inventory turnover, and payables turnover. Firms 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. A large payables turnover implies that the firm is making

use of their suppliers’ funds to fund their working capital needs. The difference between

the operating cycle and the payables turnover is the cash conversion cycle. A negative

cash conversion cycle means that the time taken by the firm to meet its payables exceeds

its operating cycle. In other words, the amount of time to manage their inventory and the

time taken to collect its receivables is less than the time taken to pay its suppliers.

VIII. Questions and Problems

BASIC

14.1 Cash conversion cycle: Wolfgang’s Masonry estimates that it takes the company 27

days on average to pay off its suppliers. It also knows that it has days’ sales in inventory

of 64 days and days sales’ outstanding of 32 days. How does Wolfgang’s cash conversion

cycle compare to that of an industry average of 75 days?

Solution:

DPO = 27 days

DSI = 64 days

DSO = 32 days

Industry average for cash conversion cycle = 75 days.

Wolfgang’s cash conversion cycle =

Since the firm’s cycle is less than the industry average of 75 days, the firm is more

efficient than other firms in the industry in managing its working capital.

14.2 Cash conversion cycle: Northern Manufacturing Company found that during the last

year, they took 47 days to pay off its suppliers, while they took 63 days to collect their

receivables. The company’s days’ sales in inventory was 49 days. What is Northern’s

cash conversion cycle?

Solution:

DPO = 47 days

DSI = 49 days

DSO = 63 days

Northern’s cash conversion cycle =

14.3 Cash conversion cycle: Devon Automotive estimates that it takes the company about 62

days to collect cash from customers on finished goods from the day it receives raw

materials and about 65 days to pay its suppliers. What is the company’s cash conversion

cycle? Interpret your answer.

Solution:

DPO = 65 days


Devon’s cash conversion cycle =

Cash conversion cycle = Operating cycle DPO

= 62 – 65

= -3 days

This firm has a negative cash conversion cycle. The amount of time to manage its

inventory and the time taken to collect its receivables is less than the time taken to pay its

suppliers.

14.4 Operating cycle: Lilly Bakery distributes its products to more than 75 restaurants and

delis. The company’s collection period is 27 days, and it keeps its inventory for four

days. What is Lilly’s operating cycle?

Solution:

DSI = 4 days

DSO = 27 days

Lilly’s operating cycle =

14.5 Operating cycle: NetSpeed Technologies is a telecom component manufacturer. The

firm typically has a collection period of 44 days and days’ sales in inventory of 29 days.

What is the operating cycle for NetSpeed?

Solution:

DSI = 29 days

DSO = 44 days

NetSpeed’s operating cycle =

14.6 Cost of trade credit: Sybex Corp. sells its goods with terms of 2/10 EOM, net 30. What

is the implicit cost of the trade credit?

Solution:

Credit terms = 2/10 EOM, net 30


= (1 + 2/98)365/20 – 1

= (1.0204)18.2500 – 1

= 1.4459 – 1

= 0.4459, or 44.59 percent

14.7 Cost of trade credit: Juggs, Inc., sells its goods with terms of 4/10 EOM, net 60. What is

the implicit cost of the trade credit?

Solution:


= (1 + 4/96)365/50 – 1

= (1.0417)7.3 – 1

= 1.3472 – 1

= 0.3472, or 34.72%

14.8 Lockbox: Rosenthal Design has daily sales of $59,000. The financial management team

determined that a lockbox would reduce the collection time by 1.6 days. Assuming the

company can earn 5.2 percent interest per year, what are the savings from the lockbox?

Solution:

All sales are assumed to be credit sales.


Collection time saved = 1.6 days

The firm can save $4,908.80 due to the use of lockbox.

14.9 Lockbox: Pacific Traders has annual sales of $1,895,000. The firm’s financial manager

has determined that using a lockbox will reduce collection time by 2.3 days. If the firm’s

opportunity cost on savings is 5.25 percent, what are the savings from using the lockbox?

Solution:

Annual sales = $1,895,000



The firm can save $626.91 due to the use of lockbox.

14.10 Effective interest rate: The Kellog Bank requires borrowers to keep an 8 percent

compensating balance. Gorman Jewels borrows $340,000 at a 7 percent stated APR.

What is the effective interest rate on the loan?

Solution:




Amount deposited as compensating balance = $340,000 × 0.08 = $27,200

Effective borrowing amount = $340,000 − $27,200 = $312,800

Interest expense = $340,000 × 0.07 = $23,800



14.11 Effective interest rate: Morgan Contractors borrowed $1.75 million at an APR of 10.2

percent. The loan called for a compensating balance of 12 percent. What is the effective

interest rate on the loan?

Solution:

Amount to be borrowed = $1,750,000



Amount deposited as compensating balance = $1,750,000 × 0.102 = $210,000

Effective borrowing amount equal to $1,750,000 − $210,000 = $1,540,000

Interest expense = $1,750,000 x 0.10.2 = $178,500



14.12 Formal line of credit: Winegartner Cosmetics is setting up a line of credit at its bank for

$5 million for up to two years. The loan rate is 5.875 percent and also calls for an annual

fee of 40 basis points on any unused balance for the year. If the firm borrows $2 million

on the day the loan agreement was signed, what is the firm’s effective rate?

Solution:

Line of credit limit = $5,000,000

Loan rate = 5.875%

Annual fee on used balance = 0.4%

Amount borrowed = $2,000,000

Unused balance = $3,000,000

Annual fee = $3,000,000 x 0.004 = $12,000

Interest expense = $2,000,000 x 0.05875 = $117,500

The effective borrowing rate for the firm is 6.48% with the annual fee of 40 basis points.

INTERMEDIATE

14.13 Cash conversion cycle: Your boss asks you to compute the company’s cash conversion

cycle. Looking at the financial statements, you see that the average inventory for the year

was $26,300, accounts receivable were $17,900, and accounts payable were at $15,100.

You also see that the company had sales of $154,000 and that cost of goods sold was

$122,000. Interpret your firm’s cash conversion cycle.

Solution:

All sales are assumed to be credit sales.


Accounts payables = $15,100

Sales = $154,000

Inventory = $26,300


The firm takes nearly 76 days from the time it pays for its raw materials to the time it

realizes cash from its credit sales. By 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.

14.14 Cash conversion cycle: Blackwell Automotive, Inc., reported the following information

for the last fiscal year.

Blackwell Automotive, Inc.

Assets As of 3/31/2008 Liabilities and Equity

Cash and marketable sec. $ 23,015 Accounts payable and accruals $163,257

Accounts receivable 141,258 Notes payable 21,115

Inventories 212,444

Other current assets 11,223

Total current assets $387,940 Total current liabilities $184,372

Net sales 912,332

Cost of goods sold 547,400

Calculate the firm’s cash conversion cycle and operating cycles.

Solution:


Accounts payables = $163,257

Net sales = $912,332

Inventory = $212,444


Cash conversion cycle = DSO + DSI – DPO

= 56.5 + 141.7 – 108.9

= 89.3 days

14.15 Cash conversion cycle: Elsee, Inc., has net sales of $13 million with 75 percent of it

being credit sales. Its cost of goods sold is 65 percent of annual sales. The firm’s cash

conversion cycle is 41.3 days. The inventory for the firm is $1,817,344, while its

accounts payable is $2,171,690. What is the firm’s accounts receivable balance?

Solution:

Net sales = $13,000,000

Credit sales = (0.75 × $13,000,000) = $9,750,000

Accounts payable = $2,171,690

Inventory = $1,817,344

Cost of goods sold = (0.65 × Sales) = (0.65 × $13,000,000) = $8,450,000

Cash conversion cycle = 41.3 days

Using the DSO equation, we can solve for the accounts receivable.

The firm has accounts receivables of $1,511,918.

14.16 Cash conversion cycle: Joanna Handicrafts, Inc., has net sales of $4.23 million with 50

percent of it being credit sales. Its cost of goods sold is $2.54 million. The firm’s cash

conversion cycle is 47.9 days. The firm’s operating cycle is 86.3 days. What is the firm’s

accounts payable?

Solution:

Net sales = $4,230,000

Credit sales = (0.5 x $4,230,000) = $2,115,000

Cash conversion cycle = 47.9 days

Operating cycle = 86.3 days

Cost of goods sold = $2,540,000

The firm has accounts payable of $267,222.

14.17 Operating cycle: Aviva Technology’s operating cycle is 81 days. Its inventory level was

at $134,000 last year, and the company had a $1.1 million cost of goods sold. How long

does it take Aviva to collect on its receivables?

Solution:


Inventory = $134,000

Cost of goods sold = $1,100,000

It takes Aviva 36.5 days to collect on its receivable.

14.18 Operating cycle: Premier Corp. has sales of $812,344, and its cost of goods sold is 70

percent of sales. Assume all sales are credit sales. If the firm’s accounts receivable total

$113,902 and its operating cycle is 81.6 days, how much inventory does the firm have?

Solution:

Credit sales = $812,344

Operating cycle = 81.6 days

Cost of goods sold = (0.7 x $812,344) = $568,641

Accounts receivable = $113,902

The firm has inventory of $47,361.

14.19 Economic order quantity: Longhorn Traders is one of the largest RV dealers in Austin

and sells about 2,800 recreational vehicles a year. The cost of placing an order with their

supplier is $800, and the inventory-carrying costs are $150 for each RV. The company

likes to maintain safety stock of 12 RVs. Most of their sales are either in spring or the fall

of each year. How many orders will the firm need to place this year?

Solution:

Annual sales = 2,800 units

Cost of placing an order = $800

Inventory-carrying cost per RV = $150

Safety stock = 12 RVs

Economic order quantity = 173 RVs

No. of orders the firm needs to place = 2,800 / 173 = 16

14.20 Effective interest rate: The Clarkson Designer Company is looking for a loan of

$750,000.The bank will provide the loan at an APR of 6.875. Since the loan calls for a

compensating balance, the effective interest rate on the loan increased to 9.25 percent.

What is the compensating balance on this loan?

Solution:



Compensating balance = ?

Effective interest rate = 9.25%

Interest expense = $750,000 x 0.06875 = $51,562.50

Effective borrowing amount = $750,000 − $CB = $557,432.43

Compensating balance deposit = $750,000 - $557,432.43 = $192,567.57

Compensating balance = $192,567.57 / $750,000 = 25.6%

By setting aside a compensating balance of 25.6% on the loan, the firm increases its

interest rate effectively from 6.875 to 9.25 percent.

14.21 Effective interest rate: The Colonial Window Treatments Company is borrowing

$1,500,000. The loan requires a 10 percent compensating balance, and the effective

interest rate on the loan is 9.75 percent. What is the stated APR on this loan?

Solution:

Amount to be borrowed = $1,500,000

Stated annual interest rate = ?


Effective interest rate = 9.75%

Compensating balance = (0.10 x $1,500,000) = $150,000

Effective borrowing amount = $1,500,000 − $150,000 = $1,350,000

Stated interest rate = $131,625 / $1,500,000 = 8.775%

14.22 Formal line of credit: Gruppa, Inc., has just set up a formal line of credit of $10 million

with First Community Commercial Bank. The line of credit is good for up to five years.

The bank will be charging them an interest rate of 6.25 percent on the loan, and in

addition the firm will pay an annual fee of 60 basis points on the unused balance. The

firm borrowed $7.5 million on the first day the credit line became available. What is the

firm’s effective interest rate on this line of credit?

Solution:


Loan rate = 6.25%




Annual fee = $2,500,000 x 0.006 = $15,000


14.23 Formal line of credit: Lansdowne Electronics has a formal line of credit of $1 million

up to three years with HND Bank. The interest rate on the loan is 5.3 percent, and under

the agreement, Lansdowne has to pay 50 basis points on the unused amount as the annual

fee. Suppose the firm borrows $675,000 the first day of the agreement. What is the fee

the company must pay? What is the effective interest rate?

Solution:


Loan rate = 5.3%


Amount borrowed = $675,000

Unused balance = $325,000

Annual fee = $325,000 x 0.005 = $1,625


14.24 Lockbox: Jennifer Electricals is evaluating whether a lockbox they are currently using is

worth keeping. Management estimates that the lockbox reduces the mail float by 1.8 days

and the processing by half a day. The remittances average $50,000 a day for Jennifer

Electricals, with the average check $500. The bank charges $0.34 per processed check.

Assume that there are 270 business days in a year and the firm’s opportunity cost of those

funds is 6 percent. What will the firm’s savings be from using the lockbox?

Solution:

Average daily sales = $50,000

No. of business days = 270

Opportunity cost of funds = 6%

Average check amount = $500

No. of checks processed per day = $50,000 / $500 = 100


Processing time saved = 0.5 days

Per-check processing fee = $0.34

The cost of a lockbox = 100 checks $0.34 per check 270 days = $9,180

Savings from mail float = 1.8 days $50,000 = $90,000

Savings from processing float = 0.5 days $50,000 = $25,000

Total savings = (Savings from mail float + Savings from processing float)

= $90,000 + $25,000 = $115,000

Savings from lockbox = $115,000 × 0.06= $6,900

Since the savings from the lockbox is less than the cost of the lockbox, it is not worth

keeping the lockbox for Jennifer Electricals.

14.25 Lockbox: Hazel Corp. has just signed up for a lockbox. Management expects the

lockbox to reduce the mail float by 2.1 days. Hazel Corp.’s remittances average $37,000

a day for Hazel, with the average check being $125. The bank charges $0.37 per

processed check. Assume that there are 270 business days in a year. What will the firm’s

savings be from using the lockbox if the opportunity cost of those funds is 12 percent?

Solution:


No. of business days = 270

Average check amount = $125

No. of checks processed per day = $37,000 / $125 = 296


Per check processing fee = $0.37

The cost of a lockbox = 296 checks $0.37 per check 270 days = $29,570.40


Opportunity cost of funds = 12%

Savings from lockbox = $77,700 × 0.12= $9,324

Since the savings from the lockbox is less than the cost of the lockbox, it is not worth

keeping the lockbox for Hazel Corp.

14.26 Aging schedule: Ginseng Company collects 50 percent of its receivables in 10 days or

fewer, 31 percent in 11 to 30 days, 7 percent in 31 to 45 days, 7 percent in 46 to 60 days,

and 5 percent in more than 60 days. The company has $1,213,000 in accounts receivable.

Prepare an aging schedule for Ginseng Company.

Solution:

Accounts receivables = $1,213,000


0-10 $ 606,500 50.0%

11-30 376,030 31.0

31-45 84,910 7.0

46-60 84,910 7.0

Over 60 60,650 5.0

Total $1,213,000 100.0%

14.27 Aging schedule: A partial aging of accounts receivable for Lincoln Cleaning Services is

given in the following table. What percent of receivables are in the 45-day range?

Determine the firm’s effective days’ sales outstanding. How does it compare to the

industry average of 35 days?

Age of Accounts

(in days) Value of Account ($) % of Total Account

10 $271,000

30 145,220

45

60 53,980

75 31,245

Total $589,218 100.0%

Solution:


Age of Accounts


10 $271,000 46.0%

30 145,220 24.6

45 87,773 14.9

60 53,980 9.2

75 31,245 5.3

Total $589,218 100.0%

Effective DSO= Age of the account category Percent of AR for the account category

= (10 x 0.46 + 30 x 0.246 + 45 x 0.149 + 60 x 0.092 + 75 x 0.053)

= 28.2 days

The firm is more efficient than other firms in the industry as its effective DSO is lower.

14.28 Aging schedule: Keswick Fencing Company collects 45 percent of its receivables in 10

days or fewer, 34 percent in 10 to 30 days, 12 percent in 31 to 45 days, 5 percent in 46 to

60 days, and 4 percent in more than 60 days. The company has $937,000 in its accounts

receivable account. Prepare an aging schedule for Keswick Fencing.

Solution:


Age of Accounts


0-10 $421,650 45.0%

11-30 318,580 34.0

31-45 112,440 12.0

46-60 46,850 5.0

Over 60 37,480 4.0

Total $937,000 100.0%

14.29 Factoring: Zenex, Inc., sells $250,000 of its accounts receivable to factors at 3 percent

discount. The firm’s average collection period is 90 days. What is the dollar cost of the

factoring service? What is the simple annual interest cost of the factors loan?

Solution:

Accounts receivables sold = $250,000

Factor discount = 3%

Average collection period = 90 days

Dollar cost of factoring per month = $250,000 x 0.03 = $7,500

Dollar cost over 90 days = $7,500 x 3 = $22,500

Simple monthly interest cost of factoring = 3/97 = 0.03093

Simple interest cost of factoring = 0.03093 x 12 = 37.1%

14.30 Factoring: A firm sells $100,000 of its accounts receivable to factors at 2 percent

discount. The firm’s average collection period is one month. What is the dollar cost of the

factoring service?

Solution:




Dollar cost of factoring per month = $100,000 x 0.02 = $2,000

ADVANCED

14.31 What impact would the following actions have on the operating and cash conversion

cycles? Would the cycles increase, decrease, or remain the unchanged?

a. More raw material than usual is purchased.

b. The company enters into an off season, and inventory builds up.

c. Better terms of payment are negotiated with suppliers.

d. The cash discounts offered to customers are decreased.

e. All else remaining the same, an improvement in manufacturing technique decreases

the cost of goods sold.

Solution:

Situation Operating cycleCash conversion

cycle

a. More raw material than usual is

purchased.Increase Increase

b. The company enters into an off season, Increase Increase

and inventory builds up.

c. Better terms of payment are negotiated

with suppliers.No change Decrease

d. The cash discounts offered to customers

are decreased.Increase Increase

e. All else remaining the same, an

improvement in manufacturing

technique decreases the cost of goods

sold.

Increase Unchanged

14.32 What impact would the following actions have on the operating and cash conversion

cycles? Would the cycles increase, decrease, or remain the unchanged?

a. Less raw material than usual is purchased.

b. The company encounters unseasonable demand, and inventory declines rapidly.

c. Tighter terms of payment are demanded by suppliers.

d. The cash discounts offered to customers are increased.

e. All else remaining the same, due to labor turnover and poor efficiency, the cost of

goods sold increases.

Solution:

Situation Operating cycleCash conversion

cycle

a. Less raw material than usual is Decrease Decrease

purchased.

b. The company encounters unseasonable

demand, and inventory declines rapidly.Decrease Decrease

c. Tighter terms of payment are demanded

by suppliers.No change Increase

d. The cash discounts offered to customers

are increased.Decrease Decrease

e. All else remaining the same, due to

labor turnover and poor efficiency, the

cost of goods sold increases.Decrease Unchanged

14.33 Morgan Sports Company just reported the following financial figures.

Morgan Sports Equipment Company

Assets Liabilities and Equity

Cash and marketable sec. $ 677,423 Accounts payable $1,721,669

Accounts receivable 1,845,113 Notes payable 2,113,345

Inventories 1,312,478

Total current assets $3,835,014 Total current liabilities $3,835,014

Net sales 9,912,232

Cost of goods sold 5,947,399

a. Calculate 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?

d. What is the firm’s operating cycle? How does it compare to the industry average

of 72 days?

e. What is the firm’s cash conversion cycle? How does it compare to the industry

average of 42 days?

Solution:

a.

b.

c.

d.

The firm is very inefficient in managing its receivable and inventory as its

operating cycle exceeds the industry average of 72 days by about 77 days.

e.

The firm’s cash conversion cycle is on a par with the industry average of 42 days

thanks to its suppliers’ very generous credit policy.

14.34 Jackson Electricals is one of the largest dealers of generators in Phoenix and sells about

2,000 of them a year. The cost of placing an order with their supplier is $750,, and the

inventory-carrying costs are $170 for each generator. They like to maintain safety stock

of 15 at all times.

a. What is the firm’s EOQ?

b. How many orders will the firm need to place this year?

c. What is the average inventory for the season?

Solution:

Annual sales = 2,000 units

Cost of placing an order = $750

Inventory-carrying cost per generator = $170

Safety stock = 15 generators

a.

Economic order quantity = 133 generators

b. No. of orders the firm needs to place = 2,000 / 133 = 15 orders

c. Average inventory = ((133 – 0)/2 + 15) = 82 generators

14.35 Tanzaniqe, Inc., sells $200,000 of its accounts receivable to factors at 5 percent discount.

The firm’s average collection period is 90 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?

Solution:




a. Dollar cost of factoring per month = $200,000 x 0.05 = $10,000

Dollar cost over 90 days = $10,000 x 3 = $30,000

b. Simple monthly interest cost of factoring = 5/95 = 0.0526

Simple interest cost of factoring = 0.0526 x 12 = 63.2%

c.

CFA Problems

14.36. A company increasing its credit terms for customers from 1/10, net 30 to 1/10, net 60 will likely experience

A. an increase in cash on hand.B. an increase in the average collection period.C. higher net income.D. a higher level of uncollectible accounts.

Solution:B is correct.

14.37. Suppose a company uses trade credit with the terms of 2/10, net 50. If the company pays their account on the 50th day, the effective borrowing cost of skipping the discount on day 10 is closest to

A. 14.6%B. 14.9%C. 15.0%D. 20.2%

Solution:

D is correct.365/40

0.02Cost = 1+ 1 20.24 percent0.98

14.38. Which of the companies has the lowest accounts receivable turnover in the year 20X2?A. Company AB. Company BC. Company CD. Company D

Solution:

B is correct.Company A: $6.0 million/$1.2 million = 5.00

Company B: $4.0 million/$1.5 million = 2.67Company C: $3.0 million/$1.0 million = 3.00Company D: $0.6 million/$0.2 million = 3.00

14.39. The industry average receivables collection periodA. increased from 20X1 to 20X2B. decreased from 20X1 to 20X2C. did not change from 20X1 to 20X2D. increased along with the increase in the industry accounts receivable turnover.

Solution:

B is correct.20X1: 73 days20X2: 70.393Note: If the number of days decreased from 20X1 to 20X2, the receivable

turnover increased.

14.40. Which of the companies reduced the average time it took to collect on accounts receivable from 20X1 to 20X2?

A. Company AB. Company BC. Company CD. Company D

Solution:

B is correct.Company B increased its accounts receivable (A/R) turnover and reduced its number of days of receivables between 20X1 and 20X2.

20X1 20X2Company A/R Number AR Number

turnover of days of turnover of days ofreceivables receivables

A 5.000 73.000 5.000 73.000B 2.500 146.000 2.667 136.875C 3.125 116.800 3.000 121.667D 5.000 73.000 3.000 121.667

Sample Test Problems

14.1 If your firm’s DSO is 47.3 days and the days’ sales in inventory is 39.6 days, what is the

firm’s operating cycle?

Solution:

14.2 If Chalet Corp. has an operating cycle of 93.4 days and days’ payables outstanding of

48.2 days, what is the firm’s cash conversion cycle?

Solution:

14.3 Ranger Cleaning Company has borrowed $90,000 at a stated APR of 8.5 percent. The

loan calls for a compensating balance of 8 percent. What is the effective interest rate for

this company?

Solution:




Amount deposited as compensating balance = $90,000 x 0.08 = $7,200

Effective borrowing amount = $90,000 − $7,200 = $82,800


14.4 Rosemary Corp. has daily sales of $139,000. The financial manager determined that a

lockbox would reduce the collection time by 2.2 days. Assuming the company can earn

5.5 percent interest per year, what are the savings from the lockbox?

Solution:




Savings if invested = $305,800 x (0.055) = $16,819

14.5 Choi Exports is setting up a line of credit at its bank for $7.5 million for up to three years.

The loan rate is 7.875 percent and also calls for an annual fee of 50 basis points on any

unused balance for the year. If the firm borrows $5 million on the day the loan agreement

was signed, what is the firm’s effective rate?

Solution:


Loan rate = 7.875%




Annual fee = $2,500,000 x 0.005 = $12,500


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