Managing current-assets

Chapter 15
Managing Current Assets
LEARNING OBJECTIVES

After reading this chapter, students should be able to:

• Define basic working capital terminology.

• Calculate the inventory conversion period, the receivables collection
period, and the payables deferral period to determine the cash
conversion cycle.

• Briefly explain the basic idea of zero working capital.

• Briefly explain how a negative cash conversion cycle works.

• Distinguish among relaxed, restricted, and moderate current asset
investment policies, and explain the effect of each on risk and
expected return.

• Explain how EVA methodology provides a useful way of thinking about
working capital.

• List the reasons for holding cash.

• Construct a cash budget, and explain its purpose.

• Briefly explain useful tools and procedures for effectively managing
cash inflows and outflows.

• Explain why firms are likely to hold marketable securities.

• State the goal of inventory management and identify the three
categories of inventory costs.

• Identify and briefly explain the use of several inventory control
systems.

• Monitor a firm’s receivables position by calculating its DSO and
reviewing aging schedules.

• List and explain the four elements of a firm’s credit policy, and
identify other factors influencing credit policy.

Learning Objectives: 15 - 1

LECTURE SUGGESTIONS

We have never found working capital an interesting topic to students, hence
it is, to us, a somewhat more difficult subject to teach than most. Perhaps
that’s because it comes near the end of the course, when everyone is tired.
More likely, though, the problem is that working capital management is really
more a matter of operating efficiently than thinking conceptually correctly--
i.e., it is more practice than theory--and theory lends itself better to
classroom teaching than practice. Still, working capital management is
important, and it is something that students are likely to be involved with
after they graduate.
Since we have only one chapter on current asset management, we try to
go all the way through it. However, the chapter is modular, so it is easy to
omit sections if time pressures require.
Assuming you are going to cover the entire chapter, the details of what
we cover, and the way we cover it, can be seen by scanning Blueprints,
Chapter 15. For other suggestions about the lecture, please see the “Lecture
Suggestions” in Chapter 2, where we describe how we conduct our classes.

DAYS ON CHAPTER: 3 OF 58 DAYS (50-minute periods)

Lecture Suggestions: 15 - 2

ANSWERS TO END-OF-CHAPTER QUESTIONS

15-1 When money is tight, interest rates are generally high. This means
that near-cash assets have high returns; hence, it is expensive to hold
idle cash balances. Firms tend to economize on their cash balance
holdings during tight-money periods.

15-2 The two principal reasons for holding cash are for transactions and
compensating balances. The target cash balance is not equal to the sum
of the holdings for each reason because the same money can often
partially satisfy both motives.

15-3 a. Better synchronization of cash inflows and outflows would allow the
firm to keep its transactions balance at a minimum, and would
therefore lower the target cash balance.

b. Improved sales forecasts would tend to lower the target cash balance.

c. A reduction in the portfolio of U. S. Treasury bills (marketable
securities) would cause the firm’s cash balance to rise if the
Treasury bills had been held in lieu of cash balances.

d. An overdraft system will enable the firm to hold less cash.

e. If the amount borrowed equals the increase in check-writing, the
target cash balance will not change. Otherwise, the target cash
balance may rise or fall, depending on the relationship between the
amount borrowed and the number of checks written.

f. The firm will tend to hold more Treasury bills, and the target cash
balance will tend to decline.

15-4 A lockbox would probably make more sense for a firm that operated
nationwide. Lockboxes reduce the time required for a firm to receive
incoming checks, to deposit them, and to get them cleared through the
banking system so that the funds are available for use. However, even
a local firm with enough volume may want its bank to receive and
process checks before the firm adjusts its accounts receivable ledgers.

15-5 False. Both accounts will record the same transaction amount.

15-6 The four elements in a firm’s credit policy are (1) credit standards,
(2) credit period, (3) discount policy, and (4) collection policy. The
firm is not required to accept the credit policies employed by its
competition, but the optimal credit policy cannot be determined without
considering competitors’ credit policies. A firm’s credit policy has

Integrated Case: 15 - 3

an important influence on its volume of sales, and thus on its
profitability.
15-7 The latest date for paying and taking discounts is May 10. The date by
which the payment must be made is June 9.

D a y ss a l e s Accountsreceivable $312, 000
15-8 a. = =
outs tandg n i Sales/365 $2 920,
, 000 /365
$312 000
,
= = 39 days.
$8,000/day

b. False. While it appears that most customers pay on time (because 39
days is less than the 40 days stipulated in the credit terms), this
does not mean that all customers are paying on time. In fact, it is
very likely that some are not, since some customers are paying on
the tenth day and are taking the discount.

15-9 False. An aging schedule will give more detail, especially as to what
percentage of accounts are past due and what percentage of accounts are
taking discounts.

15-10 No. Although B sustains slightly more losses due to uncollectible
accounts, its credit manager may have a wise policy that is generating
more sales revenues (and thus profits) than would be the case if he had
a policy which cut those losses to zero.

15-11 A/R Sales Profit
a. The firm tightens its credit
standards. - - 0
b. The terms of trade are
changed from 2/10, net 30,
to 3/10, net 30. 0 + 0
c. The terms are changed from
2/10 net 30, to 3/10, net 40. 0 + 0
d. The credit manager gets tough
with past-due accounts. - - 0

Explanations:

a. When a firm “tightens” its credit standards, it sells on credit more
selectively. It will likely sell less and certainly will make fewer
credit sales. Profit may be affected in either direction.

b. The larger cash discount will probably induce more sales, but they
will likely be from customers who pay bills quickly. Further, some of
the current customers who do not take the 2 percent discount may be
induced to start paying earlier. The effect of this would be to
reduce accounts receivable, so accounts receivable and profits could
go either way.

c. A less stringent credit policy in terms of the credit period should
stimulate sales. The accounts receivable could go up or down


depending upon whether customers take the new higher discount or
delay payments for the 10 additional days, and depending upon the
amount of new sales generated.
d. If the credit manager gets tough with past due accounts, sales will
decline, as will accounts receivable.

15-12 The firm could have its suppliers ship by air freight, reducing lead
time, or on consignment, reducing the firm’s purchasing costs. The
firm can reduce its finished goods inventory by manufacturing to meet
orders, or by shipping goods to customers at the firm’s discretion, or
by using seasonal dating in its accounts receivable policy.
Unless the firm is in a strong bargaining position, or offers some
financial incentive, shifting inventory burdens to suppliers and
customers may result in higher costs and fewer sales. If a supplier
has to carry larger raw material inventory, it may charge a higher
price to the firm to cover its increased inventory costs. Shifting
inventory burdens to customers may result in lost sales if customers
can obtain better service from other firms.


SOLUTIONS TO END-OF-CHAPTER PROBLEMS

15-1 Net Float = Disbursement float - Collections float
= (4 × $10,000) - (3 × $10,000)
= $10,000.

15-2 Sales = $10,000,000; S/I = 2× .

Inventory = S/2
$10,000,000
= = $5,000,000.
2

If S/I = 5× , how much cash is freed up?

Inventory = S/5
$10,000,000
= = $2,000,000.
5

Cash freed = $5,000,000 - $2,000,000 = $3,000,000.

15-3 DSO = 17; Credit sales/Day = $3,500; A/R = ?

A/R
DSO =
S/365
A/R
17 =
$3,500
A/R = 17 × $3,500 = $59,500.

15-4 a. Cost = (Number of locations)(Number of transfers)(Cost per transfer)
+ (Monthly cost)(12)
= (10)(260)($9.75) + ($6,500)(12) = $25,350 + $78,000
= $103,350.

b. Reduction in days of float = 3 days.

Benefit =  R e d u c t ii n  D a i l y   O p p o r t u y i t
on n
 d a y s f f l o a t c o l l e c t s o n c o s t 
o i
= (3)($325,000)(0.10) = $97,500.

c. Net gain (loss) = $97,500 - $103,350 = -$5,850.


Malitz should not initiate the lockbox system since it will cost the
firm $5,850 more than it will earn on the freed funds.
15-5 a. 0.4(10) + 0.6(40) = 28 days.

b. $912,500/365 = $2,500 sales per day.

$2,500(28) = $70,000 = Average receivables.

c. 0.4(10) + 0.6(30) = 22 days. $912,500/365 = $2,500 sales per day.

$2,500(22) = $55,000 = Average receivables.

Sales may also decline as a result of the tighter credit. This
would further reduce receivables. Also, some customers may now take
discounts further reducing receivables.

15-6 a. Setting up the formula for the cash conversion cycle, sales can be
calculated.

Acct. Rec. Inv. Acct. Pay.
CCC = + −
Avg. Daily Sales Avg. Daily Sales Avg. Daily COGS
16.79 = ($47,000/ADS) + ($66,000/ADS) - ($72,000/0.8ADS)
16.79 = ($47,000/ADS) + ($66,000/ADS) - ($90,000/ADS)
16.79 = $23,000/ADS
16.79ADS = $23,000
ADS = $1,369.863.

Therefore, annual sales equal $500,000 ($1,369.863 × 365 =
$500,000).

b. Based upon the given information, the firm's current assets equal
$148,750 ($35,750 + $47,000 + $66,000). Therefore, for its current
ratio to increase to 2.0, it must reduce accounts payable to a level
such that current liabilities total $74,375 ($148,750/2). If
accrued liabilities on the balance sheet equal $13,000, accounts
payable must be reduced to $61,375 ($74,375 - $13,000). The firm's
new average daily cost of goods sold would equal $1,369.863 × 0.70 =
$958.90. Combined with the original information, the new CCC can be
determined as follows:

CCC = (AR/Avg. Daily Sales) + (Inv/Avg. Daily Sales) - (AP/Avg. Daily
COGS)
CCC = ($47,000/$1,369.863) + ($66,000/$1,369.863) - ($61,375/$958.90)
CCC = 34.31 + 48.18 - 64.01
CCC = 18.48 days.

15-7 a. Cash conversion cycle = 22 + 40 - 30 = 32 days.

b. Working capital financing = 1,500 × 32 × $6 = $288,000.


c. If the payables deferral period was increased by 5 days, then its
cash conversion cycle would decrease by 5 days, so its working
capital financing needs would decrease by
Decrease in working capital financing = 1,500 × 5 × $6 = $45,000.
d. Cash conversion cycle = 20 + 40 - 30 = 30 days.
Working capital financing = 1,800 × 30 × $7 = $378,000.

I n v e n t o r y R e c e i v a b l eP a y a b l e s
s
15-8 a. CCC = c o n v e r s i + nc o l l e c t i o nd e f e r r a l
o −
period period period
= 75 + 38 - 30 = 83 days.

b. Average sales per day = $3,421,875/365 = $9,375.
Investment in receivables = $9,375 × 38 = $356,250.

c. Inventory turnover = 365/75 = 4.87× .

15-9 a. Inventory conversion period = 365/Inventory turnover ratio
= 365/6 = 60.83 days.

Receivables collection period = DSO = 36.5 days.

I n v e n t o r y R e c e i v a b l eP a y a b l e s
s
CCC = c o n v e r s i + nc o l l e c t i o nd e f e r r a l
o −
period period period
= 60.83 + 36.5 - 40 = 57.33 days.

b. Total assets = Inventory + Receivables + Fixed assets
= $150,000/6 + [($150,000/365) × 36.5] + $35,000
= $25,000 + $15,000 + $35,000 = $75,000.

Total assets turnover = Sales/Total assets
= $150,000/$75,000 = 2× .

ROA = Profit margin × Total assets turnover
= 0.06 × 2 = 0.12 = 12%.

c. Inventory conversion period = 365/7.3 = 50 days.

Cash conversion cycle = 50 + 36.5 - 40 = 46.5 days.

Total assets = Inventory + Receivables + Fixed assets
= $150,000/7.3 + $15,000 + $35,000
= $20,548 + $15,000 + $35,000 = $70,548.

Total assets turnover = $150,000/$70,548 = 2.1262× .

ROA = $9,000/$70,548 = 12.76%.


15-10 a. Return on equity may be computed as follows:

Tight Moderate Relaxed
Current assets
(% of sales × Sales) $ 900,000 $1,000,000
$1,200,000
Fixed assets 1,000,000 1,000,000 1,000,000
Total assets $1,900,000 $2,000,000 $2,200,000

Debt (60% of assets) $1,140,000 $1,200,000
$1,320,000
Equity 760,000 800,000 880,000
Total liab./equity $1,900,000 $2,000,000 $2,200,000

EBIT (12% × $2 million) $ 240,000 $ 240,000 $
240,000
Interest (8%) 91,200 96,000 105,600
Earnings before taxes $ 148,800 $ 144,000 $ 134,400
Taxes (40%) 59,520 57,600 53,760
Net income $ 89,280 $ 86,400 $ 80,640
Return on equity 11.75% 10.80% 9.16%

b. No, this assumption would probably not be valid in a real world
situation. A firm’s current asset policies, particularly with
regard to accounts receivable, such as discounts, collection period,
and collection policy, may have a significant effect on sales. The
exact nature of this function may be difficult to quantify, however,
and determining an “optimal” current asset level may not be possible
in actuality.

c. As the answers to Part a indicate, the tighter policy leads to a
higher expected return. However, as the current asset level is
decreased, presumably some of this reduction comes from accounts
receivable. This can be accomplished only through higher discounts,
a shorter collection period, and/or tougher collection policies. As
outlined above, this would in turn have some effect on sales,
possibly lowering profits. More restrictive receivable policies
might involve some additional costs (collection, and so forth) but
would also probably reduce bad debt expenses. Lower current assets
would also imply lower liquid assets; thus, the firm’s ability to
handle contingencies would be impaired. Higher risk of inadequate
liquidity would increase the firm’s risk of insolvency and thus
increase its chance of failing to meet fixed charges. Also, lower
inventories might mean lost sales and/or expensive production
stoppages. Attempting to attach numerical values to these potential
losses and probabilities would be extremely difficult.


15-11 a. Firm’s Bank’s
checkbook records
Day 1 Deposit $1,200,000;
write check for
$1,600,000. -$ 400,000 $1,200,000

Day 2 Write check
for $1,600,000. -$2,000,000 $1,200,000

Day 3 Write check
for $1,600,000. -$3,600,000 $1,200,000

Day 4 Write check
for $1,600,000. -$5,200,000 $1,200,000

Day 5 Write check for
$1,600,000; deposit
$1,600,000. -$5,200,000 $1,200,000

After the firm has reached a steady state, it must deposit
$1,600,000 each day to cover the checks written four days earlier.

b. The firm has four days of float.

c. The firm should try to maintain a balance on the bank’s records of
$1,200,000. On its own books it will have a balance of minus
$5,200,000.

d. For any level of sales, the firm will probably have a higher rate of
return on assets and equity if it can reduce its total assets. By
using float, SSC can reduce its cash account, by (4 × $1,600,000)
- $1,200,000 = $5,200,000. However, they actually can reduce equity
and debt by $6,000,000 as the firm has gross float of $6,400,000 -
$400,000 (increase in the amount deposited in the bank) =
$6,000,000, so earnings per share will be higher. In terms of the
Du Pont equation, the rate of return on equity will be higher
because of the reduction in total assets.

15-12 a. Presently, HGC has 5 days of collection float; under the lockbox
system, this would drop to 2 days.

$1,400,000 × 5 days = $7,000,000
$1,400,000 × 2 days = 2,800,000
$4,200,000

HGC can reduce its cash balances by the $4,200,000 reduction in
negative float.

b. 0.10($4,200,000) = $420,000 = the value of the lockbox system on an
annual basis.


c. $420,000/12 = $35,000 = maximum monthly charge HGC can pay for the
lockbox system.
15-13 a. Helen’s Fashion Designs
Cash Budget, July-December 2003

I. Collections and Payments:
May June July August September October November December January
Sales $180,000 $180,000 $360,000 $540,000 $720,000 $360,000 $360,000 $ 90,000 $180,000

Collections:
1st month 18,000 18,000 36,000 54,000 72,000 36,000 36,000 9,000
2nd month 0 135,000 135,000 270,000 405,000 540,000 270,000 270,000
3rd month 0 0 27,000 27,000 54,000 81,000 108,000 54,000
Total collections $198,000 $351,000 $531,000 $657,000 $414,000 $333,000

Purchases 90,000 90,000 126,000 882,000 306,000 234,000 162,000 90,000

Payments
(1-mo. lag) 90,000 90,000 126,000 882,000 306,000 234,000 162,000

II. Gain or Loss for Month:
July August September October November December
Receipts:
Collections $198,000 $351,000 $531,000 $657,000 $414,000 $333,000

Payments:
Labor and raw materials 90,000 126,000 882,000 306,000 234,000 162,000
Administrative salaries 27,000 27,000 27,000 27,000 27,000 27,000
Lease payment 9,000 9,000 9,000 9,000 9,000 9,000
Misc. expenses 2,700 2,700 2,700 2,700 2,700 2,700
Income tax 0 0 63,000 0 0 63,000
Progress payment 0 0 0 180,000 0 0
Total payments $128,700 $164,700 $983,700 $524,700 $272,700 $263,700

Net cash gain (loss) $ 69,300 $186,300 ($452,700) $132,300 $141,300 $ 69,300

III. Cash Surplus or Loan Requirements:
July August September October November December
Cash at start of month w/o loans $132,000 $201,300 $387,600 ($ 65,100) $ 67,200 $208,500

Cumulative cash 201,300 387,600 (65,100) 67,200 208,500 277,800
Less: Target cash balance 90,000 90,000 90,000 90,000 90,000 90,000
Cumulative surplus cash or total
loans outstanding to maintain
target balance $111,300 $297,600 ($155,100) ($22,800) $118,500 $187,800

b. The cash budget indicates that Helen will have surplus funds
available during July, August, November, and December. During
September the company will need to borrow $155,100. The cash
surplus that accrues during October will enable Helen to reduce the
loan balance outstanding to $22,800 by the end of October.

c. In a situation such as this, where inflows and outflows are not
synchronized during the month, it may not be possible to use a cash
budget centered on the end of the month. The cash budget should be
set up to show the cash positions of the firm on the 5th of each
month. In this way the company could establish its maximum cash
requirement and use these maximum figures to estimate its required
line of credit.
The table below shows the status of the cash account on selected
dates within the month of July. It shows how the inflows accumulate
steadily throughout the month and how the requirement of paying all


the outflows on the 5th of the month requires that the firm obtain
external financing. By July 14, however, the firm reaches the point
where the inflows have offset the outflows, and by July 30 we see
that the monthly totals agree with the cash budget developed earlier
in Part a.

7/2/03 7/4/03 7/5/03 7/6/03 7/14/03 7/30/03
Opening balance $132,000 $132,000 $132,000 $132,000 $132,000 $132,000

Cumulative inflows
(1/30 × receipts
× no. of days) 13,200 26,400 33,000 39,600 92,400 198,000

Total cash available $145,200 $158,400 $165,000 $171,600 $224,400 $330,000

Outflow 0 0 128,700 128,700 128,700 128,700

Net cash position $145,200 $158,400 $ 36,300 $ 42,900 $ 95,700 $201,300

Target cash balance 90,000 90,000 90,000 90,000 90,000 90,000

Cash above minimum needs
(borrowing needs) $ 55,200 $ 68,400 ($ 53,700)($ 47,100) $ 5,700 $111,300

d. The months preceding peak sales would show a decreased current ratio
and an increased debt ratio due to additional short-term bank loans.
In the following months as receipts are collected from sales, the
current ratio would increase and the debt ratio would decline.
Abnormal changes in these ratios would affect the firm’s ability to
obtain bank credit.


Managing current-assets

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