CH-15 Managing Working Capital – Introduction to Finance: Markets, Investments, and Financial Management : Book Guide

Chapter 15 Managing Working Capital CHAPTER PREVIEW Proper management of a firm’s short-term assets and liabilities is essential for on going operations and maximizing shareholder wealth. This chapter focuses on managing current assets; the next chapter will review short-term financing sources. Working capital is important to businesses! The average Fortune 500 firm has 20 cents in working capital for every $1 in sales. Thus, significant cost savings and profit enhancement is possible from optimal management of current assets. The focus of this chapter is the cash flows that arise from a firm’s day-to-day operations. The operating cycle and cash conversion cycle help show that cash, not matching revenues and expenses, is what determines the firm’s ability to pay bills on time. We show how seasonal effects and the business cycle affect a firm’s cash flows, as does the strategic choice of using level or seasonal production. The cash budget assists the treasurer in forecasting cash needs and planning ahead to invest funds in marketable securities or to borrow funds to cover shortfalls. A firm’s credit policy and how they manage their accounts receivable affects sales, marketing efforts, and cash flows. LEARNING OBJECTIVES Explain what is meant by a firm’s operating cycle and its cash conversion cycle. Describe the impact of the operating cycle on the size of investment in accounts receivable and inventories. Explain how seasonal and cyclical trends affect the operating cycle, cash conversion cycle, and investments in current assets. Explain how a cash budget is developed and how a treasurer will use it. Describe the motives underlying the management of cash and marketable securities. Briefly explain what is involved in accounts receivable management and indicate how it is carried out. Describe inventory management from the standpoint of the financial manager. CHAPTER OUTLINE I. OPERATING AND CASH CONVERSION CYCLES A. Operating Cycle B. Cash Conversion Cycle C. Determining the Length of the Operating Cycle and Cash Conversion Cycle 1. Inventory Period Accounts Receivable Period Average Payment Period D. Working Capital Requirements II. CASH BUDGETS A. Minimum Desired Cash Balance B. Cash Inflows C. Cash Outflows D. Constructing the Cash Budget E. Seasonal Versus Level Production III. MANAGEMENT OF CURRENT ASSETS A. Cash and Marketable Securities Management U.S. Treasury Bills Federal Funds Commercial Paper Negotiable Certificates of Deposit Bankers’ Acceptances Eurodollars Municipal Securities Short-term Investment Policy Statement B. Getting—and Keeping—the Cash C. Accounts Receivable Management 1. Credit Analysis 2. Credit-Reporting Agencies 3. Credit Terms and Collection Efforts D. Inventory Management IV. TECHNOLOGY AND WORKING CAPITAL MANAGEMENT A. Cash Management B. Processing Invoices and Float C. Tracking Inventory V. Summary LECTURE notes I. OPERATING AND CASH CONVERSION CYCLES The cash flow timeline, as shown in Figure 15.3, is a good tool to use to show the difference between the timing of cash flows and accounting revenue and expense concepts. In Figure 15.3, accountants would typically recognize revenue and its matched expenses in the middle of the timeline, when finished goods are sold. The timeline shows cash flows occur before and after the sale. Typically, cash outflows occur before cash inflows as payables are paid before receivables are collected. The time difference between these flows is the cash conversion cycle. The operating cycle is the time it takes for raw materials to be transformed into a finished product, sold, and cash collected from the sale. The cash conversion cycle is the operating cycle minus the accounts payable period. Accounting ratios from Chapter 14 are used to estimate the length of the operating and cash conversion cycles and their components. Some financial planning techniques can use the receivables period, inventory period, and payables period to estimate how their corresponding accounts will change should sales rise or fall or should the periods lengthen or shorten. (Use Discussion Questions 1 through 6 here.) II. CASH BUDGETS The cash budget is one of the most important tools used by financial managers. To avoid surprises and to pay bills and workers on time, the treasurer must keep track of the firm’s cash and its forecasted levels. Financing can be arranged to cover expected shortfalls. Plans can be made to invest excess cash to earn higher returns in marketable securities or to return the cash to investors by calling in bonds, repurchasing shares, or increasing dividends. Most firms want to keep some cash on hand. When funds dip below this minimum desired cash balance, arrangements are made to borrow money. When expected cash balances are above the minimum desired level, plans can be made to invest or distribute the extra cash. A cash budget is little more than a listing, by period (it could be daily, weekly, monthly, or quarterly), of expected cash inflows and outflows. A sales forecast from marketing drives the cash budget, as forecasted sales lead to raw material purchases now and expected cash receipts in the future. Cash inflows are determined using the sales forecast and expected customer payment patterns (e.g., 10% of sales are cash with the remainder paid within 30 days). Cash outflows are determined by materials purchases driven by the sales forecast and the firm’s policy of how it pays its suppliers. Regular labor and overhead cash expenses should be listed in the cash budget, as well as expected outflows arising from loan interest, dividends, asset acquisitions, taxes, etc. Tables 15.4 and 15.5 provide examples of cash inflow and outflow schedules. Tables 15.6 and 15.7 complete the example of constructing a cash budget. The choice of seasonal versus level production has accounting and financial implications as well as implications for production and human resources (e.g., peak hiring and off-season layoffs can increase training costs and hurt morale). If level production is used, current assets such as inventory will become quite large prior to the firm’s selling season; as the inventory is sold off, cash inflows can be used to repay short-term inventory financing loans. All else being equal, the firm’s need to obtain short-term financing, as seen in its cash budget, will probably be greater in the months just before its peak selling season under seasonal production. (Use Discussion Questions 7 through 13 here.) III. MANAGEMENT OF CURRENT ASSETS As the cash budget discussion shows, levels of current asset accounts will fluctuate over the course of a year. Financial managers must work with marketing (accounts receivable and inventory), production (inventory), and short-term financing sources to effectively manage current asset accounts. They try to lower financing costs while at the same time minimizing risks associated with current asset balances that are too small or too large. For example, a small inventory may increase the chance of stock-outs, unhappy customers, and lost sales. An excessive inventory, however, runs the risk of sitting in a warehouse and becoming out-of-date before it can be sold. There are three motives for holding cash: 1. Transactions motive: need for day-to-day bill paying 2. Precautionary motive: hold funds to meet unexpected needs—a safety level of cash 3. Speculative motive: hold funds to take advantage of attractive input prices or discounts Excess cash and cash held for precautionary and speculative needs can be invested in marketable securities. Such securities must be highly liquid with little chance of price risk or default risk. Marketable securities that can be used as a means to “park” the firm’s excess cash include 1. U.S. Treasury Bills 2. Federal Funds 3. Commercial Paper 4. Negotiable Certificates of Deposit 5. Bankers’ Acceptances 6. Eurodollars 7. Municipal Securities (these are attractive if the firm has a high marginal tax rate and if the municipal securities are short-term and liquid). Many corporate treasurers will develop a guideline, called an investment policy statement, for how excess cash should be invested. A policy statement includes the firm’s goals for holding marketable securities and its criteria for investing. Common criteria include ratings on short-term debt in which the firm invests; maximum maturity for securities, and restrictions on the dollar amount or percentage of excess cash that can be invested in different securities. For example, to limit risk, a policy statement may state that no more an 5% of the firm’s marketable security portfolio can be invested in the securities of any one issuer (except for, say, U.S. Treasury securities) or in securities that have lower ratings. Table 15.11 provides a sample table summary of some guidelines to assist class discussion. A main concern for company treasurers is collecting cash, carefully investing it to maximize return while maintaining its safety, and disbursing cash. The quicker cash can be collected—and the slower it is disbursed—the more cash the firm has to invest and the less it will need to borrow. Managing collection float (via lockboxes and pre-authorized checks, remote capture, and on-line bill pay) and disbursement float (via zero balance accounts) are means of managing the cash flow timeline. The growing use of technology lessens the amount of float that is available to use. Accounts receivable management includes who receives credit, how much, the length of the credit period, and how attempts to collect late accounts should be handled. Credit analysis includes examining the 5 C’s of credit for a potential customer: 1. Character: willingness to repay debts 2. Capacity: ability to repay debts (liquidity) 3. Capital: equity cushion 4. Collateral: what assets can provide security of the credit? 5. Conditions: the state of the business cycle and its expected movement during the credit period Some look at a sixth C: control; this relates to the control over the collateral that can be exercised by the lender. Others use “customers” as a sixth C; credit cannot be repaid without cash inflows from steady customers. Repeat customers are preferred to the analyst; it shows customer satisfaction with the product and lessens expenses as the cost of continually seeking new or replacement customers is higher than retaining the firm’s current customer base. Credit bureaus provide firms with information about a firm’s financial condition and its record on paying its past debts. Local credit bureaus service community credit information needs. The National Credit Interchange System facilitates the exchange of information between bureaus. The National Association of Credit Management established the Foreign Credit Interchange Bureau to service firms with overseas customers. Dun & Bradstreet is perhaps the best-known private firm supplying credit information. Easier credit terms will lead to larger receivables account balances. Deviating credit terms from industry norms may lead to lost sales if the firm’s terms are too stringent or retaliatory reactions from competitors if they are too lax. The chapter reviews the process for analyzing a change in credit policy by comparing the net benefits and costs of changing credit policy or terms. Collecting from overseas accounts presents its own set of challenges, including the effect of changing exchange rates on home currency collections. Techniques for collecting past due accounts include reminders on invoices, letters, phone calls, personal visits, turning the account over to a collection agency, or taking legal action. Taking action which is overly strident too soon can hurt relations with a customer who is experiencing a temporary cash flow squeeze. Collecting overdue accounts is perhaps more of an art than a science. Inventory management concerns the financial manager because inventory, like all other assets, must be financed. Overly large inventories use warehouse space and have larger financing costs and insurance costs. Smaller inventories run the risk of selling out and causing customer dissatisfaction. You may want to discuss this trade-off in the context of the economic ordering quantity (EOQ) model. The EOQ for inventory is defined as where C = carry cost per unit; S = total usage of an item of inventory; and O = ordering cost per unit. Suppose Chrill Shirts orders 50,000 t-shirts during a 200-day period, ordering costs are $200 per order, and carrying costs are $20 per unit per 200 days. The optimal order quantity is For an order quantity of 50,000 units, the firm would order (50,000/3,162), or 16 times during the 200-day period, or every 12–13 days. Great cost savings can occur if a firm is able to reduce its working capital needs. Frameworks such as JIT and JIT II use buyer-supplier relationships to reduce buyer inventory needs and increase production efficiencies. Web-enabled inventory purchases and monitoring allow for more efficient pricing, ordering, and inventory management. B2B web portals and the evolution of XML will allow technology to make inventory management, billing, and processing even more efficient. (Use Discussion Questions 14 through 35 here.) IV. TECHNOLOGY AND WORKING CAPITAL MANAGEMENT Technology is impacting all areas of short-term finance. Cash flows and communications between a firm and its lenders, customers, and vendors are enhanced when invoices, billing information, and cash settlement are sent electronically or digitally. Float will gradually disappear as more and more payments are made electronically. Efficient electronic tracking of inventory will reduce inventory conversion periods, reduce theft, and diminish spoilage. (Use Discussion Questions 36 and 37 here) DISCUSSION QUESTIONS AND ANSWERS 1. What is meant by working capital? Working capital is a firm’s current assets: cash, marketable securities, receivables, and inventory. 2. Briefly describe a manufacturing firm’s operating cycle. The operating cycle measures the time between receiving materials and collecting cash from receivables. Raw materials are purchased and products are manufactured from them to become finished goods. Effort then is made to sell the finished goods. If the goods are sold on credit, then the receivables must be collected. 3. Explain how the cash conversion cycle differs from the operating cycle. The cash conversion cycle typically is shorter than the operating cycle. The cash conversion cycle measures the time between when a firm pays for its supplies or raw materials and when it collects cash from receivables. 4. Describe how the length of the cash conversion cycle is determined. It is equal to the operating cycle (inventory period minus the accounts receivable period) minus the payables period. 5. Explain how the length of the operating cycle affects the amount of funds invested in accounts receivable and inventories. All else being equal, a longer (shorter) inventory period and receivables period will increase (decrease) the amount of inventory and accounts receivable carried by the firm. 6. What affects the amount of financing provided by accounts payable as viewed in terms of the cash conversion cycle? The level of the firm’s cost of goods sold and the average payment period affect the amount of financing provided by accounts payable. 7. What is a cash budget? How does the treasurer use forecasts of cash surpluses and cash deficits? A cash budget lists, period by period, expected cash inflows and outflows. The treasurer can plan ahead to find suitable marketable securities in which to invest excess cash. If cash deficits are forecast, the treasurer can arrange for short-term financing sources. 8. Three sets of information are needed to construct a cash budget. Explain what they are. The firm’s minimum desired cash balance, forecasted cash inflows, and forecasted cash outflows are needed to construct a cash budget. 9. Why might firms want to maintain minimum desired cash balances? Firms want to maintain minimum desired cash balance to ensure they can pay bills on time (transactions motive) and to have a cushion, as forecasts of cash flows may differ from actual future cash flows. 10. What are the sources of cash inflows to a firm over any time frame? The main sources of cash inflows are cash sales and customer payments on credit sales. 11. What are the sources of cash outflows from a firm over any time frame? The main sources of cash outflows are payments for raw materials, labor and overhead expenses, rent/lease payments, plant and equipment purchases, interest and principal payments, dividend payments, and taxes. 12. How does the choice of level or seasonal production affect a firm’s cash over the course of a year? Under level production, inventory becomes large before the peak selling season; whatever cash the firm has will probably be borrowed funds as cash is used to pay workers and suppliers over the course of the year as inventories are building. Under seasonal production, there is still a build-up of inventories prior to the selling season but probably less than under level production, as inventory can be sold shortly after it is made. Cash is conserved for much of the year; materials and labor expenses are less during the off-peak times when production is low. 13. Describe what happens to a firm’s current asset accounts if the firm has seasonal sales and they use (a) level production, or (b) seasonal production. a. Under a level production plan, the same amount of raw materials are purchased and the same amount of finished product is manufactured every month. Inventory builds up in anticipation of higher seasonal sales while cash and accounts receivable are quite low. When the selling season begins, inventories fall and receivables rise. After a time, inventories are nearly exhausted, and the firm is collecting cash from its customers. The changing composition of current assets for a firm with a seasonal sales pattern is illustrated in Figure 15.5. b. Under seasonal production, raw material purchases will rise or fall in anticipation of higher or lower sales. Such a strategy can help minimize the effect of seasonal sales on inventory; goods are manufactured shortly before sale. Receivables will rise during the peak selling season but will fall thereafter as cash is collected. 14. Describe the three motives or reasons for holding cash. The three motives for holding cash are a. Transactions motive: need for day-to-day bill-paying b. Precautionary motive: hold funds to meet unexpected needs—a safety level of cash c. Speculative motive: hold funds to take advantage of attractive input prices or discounts 15. What characteristics should an investment have to qualify as an acceptable marketable security? Marketable securities must be highly liquid (easily converted into cash at a price close to fair market value) with little chance of price risk or default risk. 16. Identify and briefly describe several financial instruments that are used as marketable securities. Marketable securities that can be used as a means to “park” the firm’s excess cash include a. U.S. Treasury Bills: short-term securities issued and backed by the U.S. government b. Federal Funds: a bank’s temporary excess reserves that are lent to other banks on a day-to-day basis c. Commercial Paper: short-term unsecured notes of large financially stable firms d. Negotiable Certificates of Deposit: large dollar CDs ($100,000 or more) for which a secondary market has evolved e. Bankers’ Acceptances: business paper used to finance international trade, backed (accepted) by a bank with a high quality rating f. Eurodollars: deposits placed in foreign banks that remain denominated in U.S. dollars (so there is no currency risk) g. Municipal securities: interest paid on many municipal securities is exempt from Federal taxation so short-term, liquid municipals can be attractive places to invest excess cash if the firm has a high marginal tax rate. 17. Why would a corporation want to invest excess cash in securities issued by a municipality? Interest paid on qualifying municipal securities is exempt from Federal taxation (and state taxes, in some states). Treasurers can compute the equivalent after-tax yield by dividing the muni’s interest yield by (1 – firm’s marginal tax rate). For a firm in a high tax bracket, municipals may offer attractive yields compared to taxable investments. Of course, care must be taken to ensure the securities are sufficiently liquid, have short maturities, and have very low risk of default. 18. What are the three main concerns of a treasurer when investing a firm’s excess cash? The three main concerns a treasurer has are first, safety; there must be a very low risk of loss of principal (the amount invested). The cash will be needed at a future time to pay bills, dividends, interest, spend on projects, etc. so the primary concern is safety of principal. The second concern is liquidity. The firm may need to raise funds quickly by selling securities before they mature so high liquidity is necessary. The third concern is return. Given the risk/expected return tradeoff we know higher returns arise from higher risk. Given the emphasis on safety when investing excess funds, return is not a high priority. But investing solely in U.S. Treasury securities will lower the return on the marketable securities portfolio. Thus, higher returns can be sought but only using securities with low credit/default risk and high liquidity. 19. Why is a short-term investment policy statement necessary? A written policy helps prevent mistakes or mis-management of a firm’s excess cash. It makes the firm’s treasurer or cash manager accountable for their investment decisions. The policy statement will detail the firm’s investment philosophy, goals for marketable securities investments, and guidelines for investing (such as type of securities, maturities, risk ratings, maximum dollar or percentage allotments, etc. 20. What is float? Why is it important to cash management? Float is the delay between when funds are sent by a payer to a payee. Collection float is the time between when a payer sends payment and the funds are credited to the payee’s bank account. Disbursement float is the time lag between when a payer sends payment and when the funds are deducted from the payer’s bank account. It is important to cash management as the firm will have larger cash balances to invest and can reduce its own financing needs, all else being equal, the shorter the collection float and the larger the disbursement float. 21. What are the three components of float? Which are under the control of the firm seeking to reduce collection float? The three components of float are delivery (or transmission) float, processing float, and clearing float. Delivery float and processing float are most directly under the control of the firm. Clearing float is controlled mainly by the banking system’s check-clearing process but the firm can try to reduce it (and delivery float) by using lockboxes that are geographically closer to customers then the firm’s main office; other methods include electronic payment forms, such as pre-authorized checks, remote capture, and on-line bill pay. 22. What are some strategies a firm can use to speed up its collections by reducing float? Using a lockbox, incoming receipts are placed in a Post Office box which can be emptied several times a day by bank personnel, who process the payments and deposit the incoming funds into the firm’s accounts. This reduces mail delivery delay and processing delay, as the bank processes the payments rather than the firm. A second popular method, best used for regular payments such as utility, cable bills, or insurance premiums, is the use of preauthorized checks that allow the firm to deduct funds from the payer’s bank account. Remote capture allows the firm to scan in paper checks so they can be processed electronically; on-line bill pay also eliminates paper and reduces float by allowing the transaction to be processed electronically. 23. How can processing float be reduced? Vendors reduce processing float by improving the process of receiving payments and depositing them. Large incoming payments (say, over $1 million) are automatically flagged and deposited expeditiously. Electronic check images and electronic payments (rather than the use of paper checks) remove the human component and thus can reduce processing delays. Lockboxes and preauthorized checks reduce processing delays, as processing is handled by banks, speeding deposit of incoming receipts. 24. How can a firm use float to slow down its disbursements? A firm can increase mail float by mailing payments from out-of-the-way locations, but that may hurt its reputation with suppliers who can direct the firm to send payments to another, closer, lockbox location. Another means are to use disbursement banks that are located around the country to increase disbursement float via the check-clearing process. So excess (and noninterest bearing) funds are not kept in a disbursement account, a firm can arrange to use a zero balance account for its disbursements. A bank will transfer sufficient funds every day into the ZBA to cover the day’s presented checks; other funds can remain invested in marketable securities. 25. Why can’t a firm that wants to increase disbursement float simply make payments after the stated due date? There is an ethical issue with paying invoices late. If a vendor has provided needed goods and services the customer should pay for them in a timely and appropriate manner. Paying late can lead to negative notations on credit reports. Credit availability to late payers can be discontinued if the vendor’s credit standards are tightened. 26. How does remote capture reduce float? Remote capture scans a paper check and allows its payment information to be transmitted electronically. Rather than transporting paper checks, the electronic file containing payment information from customers can be used to initiate funds transfers between banks. It allows for speedier funds transfers and eliminates/reduces human error in keying in check information and completing deposit slips. 27. Besides lower expenses, explain another advantage of using electronic payments rather than paper checks. Remote capture scans a paper check and from then on, electronic files and images are transferred rather than paper. This reduces handling costs and reduces human error in keying in information, writing deposit slips, and so on. Transferring information electronic through the banking system reduces processing and clearing float, too. 28. What is credit analysis? Identify the five C’s of credit analysis. Credit analysis involves appraising the creditworthiness or quality of a potential credit customer. Credit analysis includes examining the 5 C’s of credit. a. Character: willingness to repay debts b. Capacity: ability to repay debts (liquidity) c. Capital: equity cushion d. Collateral: what assets can provide security for the credit? e. Conditions: the state of the business cycle and its expected movement during the credit period 29. Describe various credit-reporting agencies that provide information on business credit applicants. Credit bureaus provide firms with information about a firm’s financial condition and its record on paying its past debts. Local credit bureaus service community credit information needs. The National Credit Interchange System facilitates exchange of information between bureaus. The National Association of Credit Management established the Foreign Credit Interchange Bureau to service firms with overseas customers. Dun & Bradstreet is perhaps the best-known private firm supplying credit information. 30. How can a firm control the risk of changing exchange rates when billing an overseas customer? First, a firm can invoice the overseas customer in the firm’s home currency; this transfers the risk of changing exchange rates to the customer. Second, if the customer may pay in their own currency, the supplier can use currency futures or options contracts to hedge or reduce the risk of changing exchange rates. 31. What risks arise when a firm lowers its credit standards to try to increase sales volume? Marginal and poor-risk customers may purchase the firm’s goods/services on credit. If they are unable to make payment, the firm must revise its sales figures and faces the added expense of trying to recover the goods and whatever funds it can from the delinquent customer. 32. How do credit terms and collection efforts affect the investment in accounts receivable? All else being equal, lax credit terms increase the investment in accounts receivable and increase the chance for larger bad debts. Stricter credit terms will likely reduce receivables balances, but at the cost of possibly losing sales to competitors with easier standards. Collection efforts are aimed at having customers with overdue accounts pay their bills. Thus, successful collection efforts can reduce receivable balances and bad debt expense. On the other hand, collection efforts that offend customers can lead to lost future business. 33. How is the financial manager involved in the management of inventories? Inventory management concerns the financial manager because inventory, like all other assets, must be financed. Overly large inventories use warehouse space and have larger financing costs and insurance costs. Smaller inventories run the risk of selling out and causing customer dissatisfaction. 34. What are the benefits to the firm of reducing working capital? Benefits include less financing needs, lower financing costs, increases in cash flow, and higher earnings. 35. What is JIT II? JIT II involves a close relationship between a customer and vendor. The vendor, or supplier, becomes the customer’s purchasing agent and helps to manage the customer’s inventories as well as issue purchase orders. The goal is to take just-in-time inventory management one step further with the vendor working with the customer to minimize the customer’s inventory needs and to increase production and scheduling efficiencies. 36. How is technology affecting cash management? Order processing? Cash management: technology allows closer tracking of the firm’s cash flows. Information on bank balances, incoming checks, and the status of disbursements are available electronically. The web allows fund transfers between corporate accounts and the initiation of electronic payments. Order processing: EDI and XML speed the processing of payments by allowing computer systems to handle payments, thus eliminating the element of (slower) human intervention from payment processing. XML has the potential to automate further customer/vendor relations; it tells computer systems what kind of information is being transmitted: financial, invoice, ordering, pictures, and so on, so different computer systems can recognize data and communicate with each other. Electronic invoice presentment and payments systems (EIPP) have a goal of totally automating many routine order, invoice, and payment processing issues. 37. How is technology changing inventory management? Scanners at check-out lines keep vendors and their suppliers informed of product sales and inventory needs. Bar codes on inventory containers in transit help vendors and customers track the location and status of goods. RFID (radio frequency identification) tags assist inventory tracking and can send information if preset conditions (container opened, temperature, movement, etc.) are violated. PROBLEMS and answers 1. Pretty Lady Cosmetic Products has an average production process time of 40 days. Finished goods are kept on hand for an average of 15 days before they are sold. Accounts receivable are outstanding an average of 35 days, and the firm receives 40-days credit on its purchases from suppliers. a. Estimate the average length of the firm’s short-term operating cycle. How often would the cycle turn over in a year? Operating cycle = Inventory period + Receivable period = (40 days + 15 days) + 35 days = 90 days # turns per year = 365/90 = 4.06 times b. Assume net sales of $1,200,000 and cost of goods sold of $900,000. Determine the average investment in accounts receivable, inventories, and accounts payable. What would be the net financing need considering only these three accounts? Inventory period = Inventory/(COGS/365) 55 = Inventory/(900,000/365)  Inventory = $135,616.44 Receivables period = AR/(Sales/365) 35 = AR/($1,200,000/365)  AR = $115,068.49 Payment period = AP/(COGS/365) 40 = AP/($900,000/365)  AP = $98,630.14 Net financing = AR + Inventory – AP = $115,068.49 + $135,616.44 – $98,630.14 = $152,054.79 2. The Robinson Company has the current assets and current liabilities for the two years listed in the text. If sales in 2010 were $1.2 million and sales in 2011 were $1.3 million, and cost of goods sold were 70 percent of sales, how long were Robinson’s operating cycles and cash conversion cycles in each of these years? What caused them to change during this time? AR period = $350,000/($1,300,000/365) = 98.27 days (2011) = $300,000/($1,200,000/365) = 91.25 days (2010) Inventory period = $500,000/($910,000/365) = 200.55 days (2011) = $350,000/($840,000/365) = 152.08 days (2010) AP period = $250,000/($910,000/365 ) = 100.27 days (2011) = $200,000/($840,000/365) = 86.90 days (2010) Operating cycle = AR period + Inventory period = 98.27 + 200.55 = 298.82 days (2011) = 91.25 + 152.08 = 243.33 days (2010) Cash conversion cycle = Operating cycle – AP period = 298.82 – 100.27 = 198.55 days (2011) = 243.33 – 86.90 = 156.43 days (2010) Both the OC and CCC rose in 2011, primarily because of a large rise (almost 48 days) in the inventory period. 3. The Robinson Company from Problem 2 had net sales of $1,200,000 in 2010 and $1,300,000 in 2011. a. Determine the receivables turnover in each year. AR turnover = Sales/AR = $1,300,000/$350,000 = 3.71 (2011) = $1,200,000/$300,000 = 4.00 (2010) b. Calculate the average collection period for each year. Average collection period = AR/(Sales/365) = $350,000/($1,300,000/365) = 98.27 days (2011) = $300,000/($1,200,000/365) = 91.25 days (2010) c. Based on the receivables turnover for 2010, estimate the investment in receivables if net sales were $1,300,000 in 2011. How much of a change in the 2011 receivables occurred? Receivables investment = Sales per day × Average collection period = ($1,300,000/365) × 91.25 days = $325,000 A $25,000 rise was expected; AR actually rose by $50,000. 4. Suppose the Robinson Company had a cost of goods sold of $1,000,000 in 2010 and $1,200,000 in 2011. a. Calculate the inventory turnover for each year. Comment on your findings. Inventory turnover = COGS/Inventory = $1,200,000/$500,000 = 2.40 (2011) = $1,000,000/$350,000 = 2.86 (2010) Inventory turnover fell in 2011; inventory rose more quickly than cost of goods sold. b. What would have been the amount of inventories in 2011 if the 2010 turnover ratio had been maintained? Inventories investment = COGS per day × Inventory period = $1,200,000/365 × (365/2.86) = $419,580.42 5. Given Robinson’s 2010 and 2011 financial information presented in problems 3 and 4, a. Compute its operating and cash conversion cycle in each year. Robinson Company 2010 2011 Sales $1,200,000 $1,300,000 Cost of Goods sold $1,000,000 $1,200,000 profit margin 5.0% 5.0% Accounts Receivable $300,000 $350,000 Inventory $350,000 $500,000 Accounts Payable $200,000 $250,000 Sales/ day = $3,287.67 $3,561.64 = $1,300,000/365 COGS/day= $2,739.73 $3,287.67 = $1,200,000/366 Inventory conversion period = Inventory/COGS per day 127.75 days 152.08 days Average collection period = AR/sales per day 91.25 days 98.27 days Average payment period = AP/COGS per day 73.0 days 76.04 days Operating cycle = Inventory conversion + collection periods 219.00 days 250.35 days Cash cycle = Inventory conversion + collection period - payment period 146.00 days 174.31 days b. What was Robinson’s net investment in working capital each year? Net investment in working capital = AR + Inventory - AP (as used in this chapter) 2010 2011 =$300,000+$350,000-$200,000 =$350,000+$500,000-$250,000 =$450,000 =$600,000 6. Robinson expects its 2012 sales and cost of goods sold to grow by 5 percent over their 2011 levels. a. What will be the effect on its levels of receivables, inventories, and payments if the components of its cash conversion cycle remain at their 2011 levels? What will be its net investment in working capital? If the ratios remain the same, a 5 percent increase in sales and COGS will increase AR, inventory, and AP proportionately in 2012 AR: $350,000 + 5%= $367,500 Inv: $500,000 + 5%= $525,000 AP: $250,000 + 5%= $262,500 Net investment in working capital = AR + Inventory - AP =$367,500 + $525,000 - $262,500 = $630,000 The new sales will be $1,300,000 + 5% = $1,365,000 Sales/day = $3,739.73 The new COGS will be $1,200,000 + 5% = $1,260,000 COGS/day = $3,452.05 b. What will be the impact on its net investment in working capital in 2012 if Robinson is able to reduce its collection period by 5 days, its inventory period by 6 days, and increase its payment period by 2 day? The new sales will be $1,300,000 + 5% = $1,365,000 Sales/day = $3,739.73 The new COGS will be $1,200,000 + 5% = $1,260,000 COGS/day = $3,452.05 Estimated AR if collection period reduced by 5 days: New AR = sales/day x collection period Sales/ day = $3,739.73 Old collection period 98.27 New collection period 93.27 New AR estimate= $348,801.37 Estimated inventory if conversion period reduced by 6 days: New Inv = COGS/day x conversion period COGS/day $3,452.05 Old conversion period 152.08 New conversion period 146.08 New Inv estimate= $504,287.67 Estimated AP if payment period increased by 2 days: New AP = sales/day x payment period COGS/day $3,452.05 Old payment period 76.04 New payment period 78.04 New AP estimate= $269,404.11 2012 working capital = AR + Inventory - AP =$360,020.55 + $514,643.84 - $259,047.95 =$583,684.93 which is a reduction of $46,315.07 from part a) 7. Robinson expects its 2012 sales and cost of goods sold to grow by 20 percent over their 2011 levels. a. What will be the effect on its levels of receivables, inventories, and payments if the components of its cash conversion cycle remain at their 2011 levels? What will be its net investment in working capital? If the ratios remain the same, a 20 percent increase in sales and COGS will increase AR, inventory, and AP proportionately in 2012 AR: $350,000 + 5%= $420,000 Inv: $500,000 + 5%= $600,000 AP: $250,000 + 5%= $300,000 Net investment in working capital = AR + Inventory - AP =$367,500 + $525,000 - $262,500 = $720,000 The new sales will be $1,300,000 + 20% = $1,560,000 Sales/day = $4,273.97 The new COGS will be $1,200,000 + 20% = $1,440,000 COGS/day = $3,945.21 b. What will be the impact on its net investment in working capital in 2012 if Robinson is able to reduce its inventory period by 10 days? Estimated AR if collection period reduced by 0 days: New AR = sales/day x collection period Sales/ day = $4,273.97 Old collection period 98.27 New collection period 98.27 New AR estimate= $420,000.00 Estimated inventory if conversion period reduced by 10 days: New Inv = COGS/day x conversion period COGS/day $3,945.21 Old conversion period 152.08 New conversion period 142.08 New Inv estimate= $560,547.95 Estimated AP if payment period increased by 0 days: New AP = sales/day x payment period COGS/day $3,945.21 Old payment period 76.04 New payment period 76.04 New AP estimate= $300,000.00 2012 working capital = AR + Inventory – AP =$360,020.55 + $514,643.84 - $259,047.95 $680,547.95 which is a reduction of $39,452.05 from part a) 8. Financial statements for the Genatron Manufacturing Corporation for the years 2010 and 2011 are listed in the text. Calculate Genatron’s operating cycle and cash conversion cycle for 2010 and 2011. Why did they change between 2010 and 2011? Inventory period = Inventory/(COGS/365) = $500,000/($900,000/365) = 202.78 days (2011) = $450,000/($780,000/365) = 210.58 days (2010) AR period = AR/(Sales/365) = $260,000/($1,500,000/365) = 63.27 days (2011) = $200,000/($1,300,000/365) = 56.15 days (2010) AP period = AP/(COGS/365) = $170,000/($900,000/365) = 68.94 days (2011) = $130,000/($780,000/365) = 60.83 days (2010) Operating cycle = Inventory period + AR period = 202.78 days + 63.27 days = 266.05 days (2011) = 210.58 days + 56.15 days = 266.73 days (2010) Cash conversion cycle = Operating cycle – Average payment period = 266.05 days – 68.94 days = 197.11 days (2011) = 266.73 days – 60.83 days = 205.90 days (2010) The operating cycle remained constant in 2010 and 2011 as a reduction in the inventory period was balanced by an increase in the average collection period. The cash conversion cycle sell for 2011 was longer. Genatron took, on average, longer to pay its suppliers. 9. Genatron Manufacturing expects its sales to increase by 10 percent in 2012. Estimate the firm’s investment in accounts receivable, inventory, and accounts payable in 2012. If the inventory, collection, and payment periods remain constant, each account should rise by 10 percent. Accounts receivable: $260,000 (1.10) = $286,000 Inventory: $500,000 (1.10) = $550,000 Accounts payable: $170,000 (1.10) = $187,000 10. With concerns of increased competition, Genatron is planning in case its 2012 sales fall by 5 percent from their 2011 levels. If cost of goods sold and the current asset and liability accounts decrease proportionately, a. Calculate the 2012 cash conversion cycle 5% decline 2010 2011 2012 Sales $1,300,000 $1,500,000 $1,425,000 Cost of Goods sold $780,000 $900,000 $855,000 profit margin 7.2% 7.6% Net income $93,000 $114,000 Accounts Receivable $200,000 $260,000 $247,000 Inventory $450,000 $500,000 $475,000 Accounts Payable $130,000 $170,000 $161,500 Sales/ day = $3,561.64 $4,109.59 = $1,500,000/365 $3,904.11 COGS/day= $2,136.99 $2,465.75 = $900,000/366 $2,342.47 Inventory conversion period = Inventory/COGS per day 210.58 days 202.78 202.78 Average collection period = AR/sales per day 56.15 days 63.27 63.27 Average payment period = AP/COGS per day 60.8 days 68.94 68.94 Operating cycle = Inventory conversion + collection periods 266.73 days 266.04 266.04 Cash cycle = Inventory conversion + collection period - payment period 205.90 days 197.10 197.10 b. Calculate the 2012 net investment in working capital Net investment in working capital = AR + Inventory - AP (as used in this chapter) 2010 2011 2012 =$247,000+$475,000-$161,500 $520,000 $590,000 =$560,500 11. In problem 10, we assumed the current asset and liability accounts decrease proportionately with Genatron’s sales. This is probably unrealistic following a decline in sales. What will be the impact on the working capital accounts if its collection period lengthens by five days, its inventory period lengthens by seven days, and its payment period lengthens by three days if Genatron’s sales and COGS fall 5 percent from their 2011 levels? The new sales will be $1,500,000 - 5% = $1,425,000 Sales/day = $3,904.11 The new COGS will be $900,000 - 5% = $855,000 COGS/day = $2,342.47 Estimated AR if collection period lengthens by 5 days: New AR = sales/day x collection period Sales/ day = $3,904.11 Old collection period 63.27 (from problem 10) New collection period 68.27 New AR estimate= $266,520.55 Estimated inventory if conversion period lengthens by 7 days: New Inv = COGS/day x conversion period COGS/day $2,342.47 Old conversion period 202.78 New conversion period 209.78 New Inv estimate= $491,397.26 Estimated AP if payment period increased by 3 day: New AP = sales/day x payment period COGS/day $2,342.47 Old payment period 68.94 New payment period 71.94 New AP estimate= $168,527.40 2012 working capital = AR + Inventory - AP =$266,520.55 + $491,397.26 - $168,527.40 =$589,390.41 which is an increase of $28,890.41 from problem 10. 12. Suppose Global Manufacturing is planning to change its credit policies next year. It anticipates that 10 percent of each month’s sales will be for cash; two-thirds of each month’s receivables will be collected in the following month, and one-third will be collected two months following their sale. Assuming the Global’s sales forecast in Table 15.4 remains the same and the expected cash outflows in Table 15.5 remain the same, determine Global’s revised cash budget. Nov. Dec. Jan. Feb. Mar. Apr. Sales $80,000 $100,000 $ 30,000 $ 40,000 $ 50,000 $ 60,000 Cash (10%) 3,000 4,000 5,000 6,000 1 Month Later (2/3) 60,000 18,000 24,000 30,000 2 Months Later (1/3) 24,000 30,000 9,000 12,000 Total Cash Receipts $ 87,000 $ 52,000 $ 38,000 $ 48,000 Less: Total Cash Payments 60,000 127,000 44,000 40,000 Net Cash Flow $ 27,000 $ –75,000 $ –6,000 $ 8,000 Beginning Cash Balance 25,000 52,000 25,000 25,000 Cumulative Cash Balance $ 52,000 $ –23,000 $ 19,000 $ 33,000 Monthly Loan (or repayment) 0 48,000 6,000 –8,000 Cumulative Loan Balance 0 48,000 54,000 46,000 Ending Cash Balance $ 52,000 $ 25,000 $ 25,000 $ 25,000 13. Global’s suppliers are upset that Global takes two months to pay their accounts payable; they demand that in the following year Global pay its bills within 30 days, or one month after the purchase. a. Using this new information, update Global’s cash outflow forecast shown in Table 15.5. Dec. Jan. Feb. Mar. Apr. Sales $100,000 $30,000 $40,000 $50,000 $60,000 Purchases (50% of sales) 50,000 15,000 20,000 25,000 30,000 Payments (100% of purchases from previous month) 50,000 15,000 20,000 25,000 Other Cash Outflows 20,000 77,000 29,000 20,000 Total Cash Purchases $70,000 $92,000 $49,000 $45,000 b. Using the cash inflows given in Table 15.4, construct a revised cash budget for Global. Jan. Feb. Mar. Apr. Total Cash Receipts $ 90,000 $ 65,000 $ 35,000 $ 45,000 Less: Total Cash Payments –70,000 –92,000 –49,000 –45,000 Net Cash Flow $ 20,000 $ –27,000 $ –14,000 $ 0 Beginning Cash Balance 25,000 45,000 25,000 25,000 Cumulative Cash Balance $ 45,000 $ 18,000 $ 11,000 $ 25,000 Monthly Loan 0 7,000 14,000 0 (or repayment) Cumulative Loan Balance 0 7,000 21,000 21,000 Ending Cash Balance $ 45,000 $ 25,000 $ 25,000 $ 25,000 14. Of its monthly sales, The Kingsman Company historically has had 25-percent cash sales with the remainder paid within one month. Each month’s purchases are equal to 75 percent of the next month’s sales forecast; suppliers are paid one month after the purchase. Salary expenses are $50,000 a month, except in January when bonuses equal to 1 percent of the previous year’s sales are paid out. Interest on a bond issue of $10,000 is due in March. Overhead and utilities are expected to be $25,000 monthly. Dividends of $45,000 are to be paid in March. Kingsman’s 2011 sales totaled $2 million; December sales were $200,000. Kingsman’s estimated sales for January are $100,000; February, $200,000; March, $250,000, and April, $300,000. a. What are Kingsman’s expected monthly cash inflows during January through April? Dec. Jan. Feb. Mar. Apr. Sales $200,000 $100,000 $200,000 $250,000 $300,000 Cash Sales (25%) 25,000 50,000 62,500 75,000 1 Month Later (75%) 150,000 75,000 150,000 187,500 Total Cash Receipts $175,000 $125,000 $212,500 $262,500 b. What are Kingsman’s expected monthly cash outflows during January through April? Dec. Jan. Feb. Mar. Apr. Sales $200,000 $100,000 $200,000 $250,000 $300,000 Purchases (75% of next month’s sales) 75,000 150,000 187,500 225,000 Payments (1 month after purchase) 75,000 150,000 187,500 225,000 Salary 70,000 50,000 50,000 50,000 Interest 10,000 Overhead and Utilities 25,000 25,000 25,000 25,000 Dividends 45,000 Total Cash Payments $170,000 $225,000 $317,500 $300,000 c. Determine Kingman’s monthly cash budget for January through April. Assume a minimum desired cash balance of $40,000 and an ending December cash balance of $50,000. Jan. Feb. Mar. Apr. Total Cash Receipts $ 175,000 $ 125,000 $ 212,500 $ 262,500 Less: Total Cash Payments 170,000 225,000 317,500 300,000 Net Cash Flow $ 5,000 $ –100,000 $ –105,000 $ –37,500 Beginning Cash Balance 50,000 55,000 40,000 40,000 Cumulative Cash Balance $ 55,000 $ –45,000 $ –65,000 $ 2,500 Monthly Loan (repayment) 0 85,000 105,000 37,500 Cumulative Loan Balance 0 85,000 190,000 227,500 Ending Cash Balance $ 55,000 $ 40,000 $ 40,000 $ 40,000 15. Redo Problem number 14, using the monthly sales estimates listed in the text. Dec. Jan. Feb. Mar. Apr. Sales $200,000 $300,000 $250,000 $200,000 $100,000 Cash Sales (25%) 75,000 62,500 50,000 25,000 1 Month Later (75%) 150,000 225,000 187,500 150,000 Total Cash Receipts $225,000 $287,500 $237,500 $175,000 Dec. Jan. Feb. Mar. Apr. Sales $200,000 $300,000 $250,000 $200,000 $100,000 Purchases (75% of next month’s sales) 225,000 187,500 150,000 75,000 Payments (1 month after purchase) 225,000 187,500 150,000 75,000 Salary 70,000 50,000 50,000 50,000 Interest 10,000 Overhead and Utilities 25,000 25,000 25,000 25,000 Dividends 45,000 Total Cash Payments $320,000 $262,500 $280,000 $150,000 Jan. Feb. Mar. Apr. Total Cash Receipts $ 225,000 $ 287,500 $ 237,500 $ 175,000 Less: Total Cash Payments 320,000 262,500 280,000 150,000 Net Cash Flow $ –95,000 $ 25,000 $ –42,500 $ 25,000 Beginning Cash Balance 50,000 40,000 40,000 40,000 Cumulative Cash Balance $ –45,000 $ 65,000 $ –2,500 $ 65,000 Monthly Loan (repayment) 85,000 (25,000) 42,500 (25,000) Cumulative Loan Balance 85,000 60,000 102,500 77,500 Ending Cash Balance $ 40,000 $ 40,000 $ 40,000 $ 40,000 16. Using the information provided in problem 14, construct cash budgets from each of the following scenarios. Use the data from problem 14 as the “base case.” What insights do we obtain from a cash budget scenario analysis? As comparisons with the base case (problem 14) and the best/worst cases shows, cash budget scenarios give the treasurer insight into how sensitive inflows and outflows are to sales assumptions and thus the likely ranges for net cash flows, borrowing, and loan repayments. a. Best case: sales are 10-percent higher than the base; purchases are 5-percent lower than the base; cash sales are 30 percent of sales. Note that December sales revenues are historical and thus do not change. Dec. Jan. Feb. Mar. Apr. Sales $200,000 $110,000 $220,000 $275,000 $330,000 Cash Sales (30%) 33,000 66,000 82,500 99,000 1 Month Later (70%) 140,000 77,000 154,000 192,500 Total Cash Receipts $173,000 $143,000 $236,500 $291,500 Dec. Jan. Feb. Mar. Apr. Sales $200,000 $110,000 $220,000 $275,000 $330,000 Purchases (75%- 5%, or 70% of next month’s sales) 77,000 154,000 192,500 231,000 Payments (1 month after purchase) 77,000 154,000 192,500 231,000 Salary 70,000 50,000 50,000 50,000 Interest 10,000 Overhead and Utilities 25,000 25,000 25,000 25,000 Dividends 45,000 Total Cash Payments $172,000 $229,000 $322,500 $306,000 Jan. Feb. Mar. Apr. Total Cash Receipts $173,000 $143,000 $236,500 $291,500 Less: Total Cash Payments 172,000 229,000 322,500 306,000 Net Cash Flow $1,000 -$86,000 -$86,000 -$14,500 Beginning Cash Balance 50,000 51,000 40,000 40,000 Cumulative Cash Balance 51,000 -35,000 -46,000 25,500 Monthly Loan (repayment) 0 75,000 86,000 14,500 Cumulative Loan Balance 0 75,000 161,000 175,500 Ending Cash Balance 51,000 40,000 40,000 40,000 b. Worst case: sales are 10-percent lower than the base; purchases are 5-percent higher than the base; cash sales are 15 percent of sales. Note that December sales revenues are historical and thus do not change. Dec. Jan. Feb. Mar. Apr. Sales $200,000 $90,000 $180,000 $225,000 $270,000 Cash Sales (15%) 13,500 27,000 33,750 40,500 1 Month Later (85%) 170,000 76,500 153,000 191,250 Total Cash Receipts $183,500 $103,500 $186,750 $231,750 Dec. Jan. Feb. Mar. Apr. Sales $200,000 $90,000 $180,000 $225,000 $270,000 Purchases (75%+5%=80% of next month’s sales) 72,000 144,000 180,000 216,000 Payments (1 month after purchase) 72,000 144,000 180,000 216,000 Salary 70,000 50,000 50,000 50,000 Interest 10,000 Overhead and Utilities 25,000 25,000 25,000 25,000 Dividends 45,000 Total Cash Payments $167,000 $219,000 $310,000 $291,000 Jan. Feb. Mar. Apr. Total Cash Receipts $183,500 $103,500 $186,750 $231,750 Less: Total Cash Payments 167,000 219,000 310,000 291,000 Net Cash Flow $16,500 -$115,500 -$123,250 -$59,250 Beginning Cash Balance 50,000 66,500 40,000 40,000 Cumulative Cash Balance 66,500 -49,000 -83,250 -19,250 Monthly Loan (repayment) 0 89,000 123,250 59,250 Cumulative Loan Balance 0 89,000 212,250 271,500 Ending Cash Balance 66,500 40,000 40,000 40,000 17. CDLater’s projected sales for the first four months of 201X are January $60,000 February $55,000 March $65,000 April $70,000 The firm expects to collect 10 percent of sales in cash, 60 percent in one month and 25 percent in two months with 5 per cent in uncollectible bad debts. Sales for the previous November and December were $55,000 and $80,000, respectively. The firm buys raw materials 30 days prior to expected sales; that is, the materials for Janaury are bought by the beginning of December with payment made by the end of December. Materials costs are 58 percent of sales. Wages for the months of January, February, and March are expected to be $6,000 per month. Other monthly expenses are amount to $5,000 a month and are paid in cash each month. Taxes due for an earlier quarter are paid in the second month of the succeeding quarter. The taxes due for the prior quarter were $9,000. The firm plans to buy a new car in January for $18,000. An old vehicle will be sold for a net amount of $2,000. A note of $10,000 will be due for payment in February. A quarterly loan installment payment of $7,500 is due in March. The beginning cash balance in January is $8,000. The company policy is to maintain a minimum cash balance of $5,000. It has an outstanding loan balance of $10,000 at the end of December. Should the firm need to borrow to meet expected monthly shortfalls, the interest cost is 1.5 percent per month and is paid each month on the total amount of borrowed funds outstanding at the end of the previous month. Prepare a monthly cash budget for Janaury, February, and March. Cash inflows Nov. Dec. Jan. Feb. Mar. Apr. Sales $ 55,000 $ 80,000 $60,000 $55,000 $65,000 $ 70,000 Cash Sales (10%) 6,000 5,500 6,500 7,000 1 Month later (60%) 48,000 36,000 33,000 39,000 2 Month later (25%) 13,750 20,000 15,000 13,750 Income sale of old car 2,000 Total Cash Receipts $ 69,750 $ 61,500 $ 54,500 $ 59,750 Cash outflows Dec. Jan. Feb. Mar. Apr. Sales $ 80,000 $ 60,000 $ 55,000 $ 65,000 $ 70,000 Purchases 34,800 31,900 37,700 40,600 Payment (1 month after purchase) 31,900 37,700 40,600 Salary 6,000 6,000 6,000 Other expense 5,000 5,000 5,000 Tax expense 9,000 Buy new car 18,000 Note payable 10,000 Loan installment payment 7,500 Total Cash Payments $ 60,900 $ 67,700 $ 59,100 Cash Budget Dec. Jan. Feb. Mar. Total cash receipts 69,750.00 61,500.00 54,500.00 Less: total cash payment 60,900.00 67,700.00 59,100.00 Less short term loan interest 150.00 0.00 67.50 Net cash flow 8,700.00 -6,200.00 -4,667.50 Beginning cash balance 8,000.00 6,700.00 5,000.00 Cumulative cash balance 16,700.00 500.00 332.50 Monthly loan (repayment) -10,000.00 4,500.00 4,667.50 Cumulative Loan balance 10,000 0.00 4,500.00 9,167.50 Ending Cash Balance 6,700.00 5,000.00 5,000.00 18. Mattam Corporation’s year sales are $5 million and its average collection period is 32 days. Only 10 percent of sales are for cash and the remainder are credit sales. a. What is Mattam’s investment in accounts receivable? b. If Mattam extends its credit period, it estimates the average collection period will rise to 40 days and that credit sales will increase by 20 percent from current levels. What is the expected increase in Mattam’s accounts receivable balance if it extends its credit period? c. If Mattam’s net profit margin is 12 percent, the expected increase in bad debt expense is 10 percent of the new sales, and the cost of financing the increase in receivables is 18 percent, should Mattam extend the credit period? a. Year sales $5,000,000 cash sale $500,000 credit sale $4,500,000 Collection period 32 Investment in A/R $394,520.55 as ACP = AR/(credit sales/365) b. credit sale $5,400,000.00 increase 20% Collection period 40 increased to 40 days Investment in A/R $591,780.82 Expected increase in A/R investment $197,260.27 c. Increase in credit sales $900,000.00 bad debt expense $90,000.00 net increase in credit sales $810,000.00 profit margin 12% increase in profit $97,200.00 cost of financing the increase in A/R 18% cost of financing $35,506.85 net profit from financing in credit sale $61,693.15 Yes, it appears that extending the credit period will enhance profits given the assumptions behind this analysis. 19. Pa Bell, Inc., wants to increase its credit standards. They expect sales will fall by $50,000 and bad-debt expense will fall by 10 percent of this amount. The firm has a 15 percent profit margin on its sales. The tougher credit standards will lower the firm’s average receivables balance by $10,000 and the average inventory balance by $8,000. The cost of financing current assets is estimated to be 12 percent. Should Pa Bell adopt the tighter credit standards? Why or why not? We must compare the benefits and costs of tightening the credit standards. Costs: $–50,000 Lost Sales +5,000 Lower Bad Debt Expense $–45,000 Net Lost Sales × .15 15% Profit Margin $ –6,750 Lost Profit Benefits: $ 10,000 Reduction in AR 8,000 Reduction in inventory $ 18,000 Total Reduction in Assets × .12 12% Financing Cost $ 2,160 Reduction in Financing Cost Since the reduction in profits is greater than the cost reduction, Pa Bell should not adopt the tighter credit standards. 20. Robinson Company (recall their data from problems 2, 3, and 4) has a 2011 profit margin of 5 percent. They are examining the possibility of loosening their credit policy. Analysis shows that sales may rise 10 percent while bad debts on the change in sales will be 2 percent. The cost of financing the increase in current assets is 10 percent. a. Should Robinson change its credit policy? 2011 Sales $1,300,000 Cost of Goods sold $1,200,000 profit margin 5.0% Accounts Receivable $350,000 Inventory $500,000 Total $850,000 Expected sales increase 10.0% Expected extra bad debt expense 2.0% Increase in Benefits: $ change in sales $130,000 =$1,300,000 x 10% $ change in bad debts $2,600 =$130,000 x 2% Net $ change in sales $127,400 x profit margin 5.0% Expected change in profits $6,370 =$127,400 x 5% Increase in Costs: Increase in AR $35,000 =$350,000 x 10% Increase in Inventory $50,000 =$500,000 x 10% Total increase: $85,000 cost of financing 10% Expected increase in financing costs $8,500 =$85,000 x 10% Since the increase in benefits is less than the increase in costs, Robinson should NOT change its credit policy b. Using the information stated in the problem, at what profit margin is Robinson indifferent between changing the policy and maintaining its current standard? The profit margin for which Robinson is indifferent is the profit margin that makes the expected change in profits = $8,500, the expected increase in financing costs Expected change in profits = $127,400 x profit margin = $8,500 Profit margin = 6.67% c. Using the information stated in the problem, at what financing cost is Robinson indifferent between changing and maintaining the credit policy? The financing cost at which Robinson is indifferent is the financing cost that makes the expected change in cost = $6,370, the expected increase in profits Expected change in financing costs = $85,000 x financing cost = $6,370 Financing cost = 7.49% d. Using the information stated in the problem, by what amount can the current assets change so that Robinson is indifferent between changing and maintaining their credit policy? Given the profit margin and financing costs, the change in AR and inventory which makes Robinson indifferent is that which allows the expected increase in profits to equal the expected increase in financing costs: Expected change in financing costs = Change in Assets x 10% = $6,370 Change in Assets = $63,700 21. Genatron Manufacturing (from problem 8) is considering changing its credit standards. Analysis shows that sales may fall 5 percent from 2011 levels with no bad debts from the change in sales. The cost of financing the increase in current assets is 8 percent. a. Should Genatron change its credit policy? 2011 Sales $1,500,000 Cost of Goods sold $900,000 profit margin 7.6% Net income $114,000 Accounts Receivable $260,000 Inventory $500,000 Total $760,000 Expected sales change -5.0% Expected extra bad debt expense 0.0% Change in Benefits: $ change in sales -$75,000 =$1,500,000 x -5% $ change in bad debts $0 =$75,000 x 0% Net $ change in sales -$75,000 x profit margin 7.6% Expected change in profits -$5,700 =$-75,000 x 7.6% Change in Costs: Change in AR -$13,000 =$260,000 x 10% Change in Inventory -$25,000 =$500,000 x 10% Total change: -$38,000 cost of financing 8% Expected change in financing costs -$3,040 =$-38,000 x 8% Since the decrease in benefits exceeds the decline in costs, Genatron should NOT change its credit policy b. Using the information stated in the problem, at what profit margin is Genatron indifferent between changing its policy and maintaining its current standard? The profit margin for which Genatron is indifferent is the profit margin that makes the expected change in profits = $-3,040, the expected change in financing costs Expected change in profits = $-75,000 x profit margin = $-3,040 Profit margin = 4.05% c. Using the information stated in the problem, at what financing cost is Genatron indifferent between changing and maintaining the credit policy? The financing cost at which Genatron is indifferent is the financing cost that makes the expected change in cost = $-5,700, the expected change in profits Expected change in financing costs = $-38,000 x financing cost = $5,700 Financing cost = 15.00% d. Using the information stated in the problem, by what amount can the current assets change so that Genatron is indifferent between changing and maintaining their credit policy? Given the profit margin and financing costs, the change in AR and inventory which makes Genatron indifferent is that which allows the expected change in profits to equal the expected change in financing costs: Expected change in financing costs = Change in Assets x 8% = $5,700 Change in Assets = -$71,250 Solution Manual for Introduction to Finance: Markets, Investments, and Financial Management Ronald W. Melicher, Edgar A. Norton 9780470561072, 9781119560579, 9781119398288