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Managing Working Capital

MANAGING WORKING CAPITAL Cash Budgets and Current Assets Learning Objectives Upon reading this chapter, students should: •        Be able to compare and contrast working and fixed capital •        Understand the impact of the operating cycle on the size of investment in accounts receivable and inventories •        Know the differences between the three motives •        Be able to differentiate between float, collection float, and disbursement float •        Know how to appraise a firm’s credit worthiness •        Be able to appraise the effectiveness of a firm’s inventory management policies

Chapter Summary A firm can invest in both working capital and fixed capital. Working capital is a firm’s current assets and includes cash, marketable securities, inventory, and accounts receivable. Fixed capital is a firm’s fixed assets and includes plant, equipment and property.

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Firms that cannot obtain short-term financing become candidates for bankruptcy. Management of working capital is particularly important to the entrepreneurial or venture firm because there is such a pull on resources.

Two important concepts in managing working capital are the operating cycle and the cash conversion cycle: •        The operating cycle measures the time between receiving raw materials and collecting the cash from credit sales posted to accounts receivable •        The cash conversion cycle measures the time it takes to collect money from the company’s customers and use those funds to pay its suppliers Calculating three ratios will reveal the average length of these cycles: 1. Inventory days              =  365 / (Cost of goods sold / Inventories) 2.

Accounts receivable period (average collection period) =  Accounts receivable / (Net sales / 365) 3. Average payment period  =  Accounts payable / (Cost of goods sold / 365) The operating cycle is the inventory conversion period plus the average collection period. The cash conversion cycle is the operating cycle minus the average payment period. In order to determine average investment in accounts receivable, multiply net sales per day by the average collection period. With this number, a manager can now estimate what the investment in accounts receivable will be fore ht following year given sales increases and average collection period.

In order to determine investment required in inventories, multiply average cost of goods sold per day by inventory conversion period. The required amount of accounts payable can be found by multiplying the cost of goods sold per day by average payment period. Armed with these numbers, a manager can tweak the business practices and use these numbers as metrics for improvement. If savings can be wrung out of the operating cycle and conversion cycle, this means less money will have to be raised in financing. A cash budget details the cash inflows and outflows of a firm over a specific time frame.

Small firms may prepare annual or monthly cash budgets while larger firms will forecast cash flows weekly or daily. Most firms have a minimum desired cash balance that depends on the firm’s ability to acquire financing on short notice, management preferences, and the predictability of cash inflows and outflows. Estimates of cash inflows are driven by two main factors: 1. Sales forecast (may exhibit seasonality) 2. Customer payment patterns Cash outflows will go to suppliers, payroll, taxes, operating expenses, and purchases of plant and equipment.

In order to construct the cash budget, list all expected cash inflows and then all expected cash outflows for the particular period, generating a net cash flow amount. As a general rule of thumb, the average firm has 1/3 or more of its assets in the form of current assets (cash, accounts receivable and inventory). Seasonal production and forecasting can lead to idle plant capacity and laid-off workers during the off-season. Under a level production plan, the same amount of raw material is purchased and the same amount of finished product is manufactured every month.

There are three types of motives for holding cash: 1. The transactions motives are demands for holding cash – cash is needed to conduct day-to-day operations 2. Precautionary motives are demands that may be caused by unpredictable events, such as delays in production or in the collection of receivables; marketable securities are held in such a contingency 3. Speculative motives are demands for funds to take advantage of unusual cash discounts for needed materials Cash and marketable securities include: •        Cash itself •        U. S. Treasury bills         Commercial paper – short-term, unsecured notes of well-known business firms •        Negotiable certificates of deposit – a receipt issued by a bank in exchange for a deposit of funds •        Bankers’ acceptances – primarily used to finance exports and imports •        Eurodollars – deposits placed in foreign banks that remain denominated in U. S. dollars There are several reasons why U. S. banks have entered the Eurodollar market through overseas branches: 1. To finance business activity abroad 2. To switch Eurodollars into other currencies 3. To lend to other Eurodollar banks

In general, managers try to speed up cash collections while slowing down the payment process. The float is the time between sending out payments and having them actually be charged to the bank account. The collection float is the time between when a payer sends payment and funds are credited to the payee’s bank account. The disbursement float is the time between when a payer sends payment and when the funds are deducted from the payer’s bank account. Float has three components: 1. Delivery or transmission float – the delay in transferring the means of payment from the payer (customer) to the payee (provider of goods/services) 2.

Processing float – once payment reaches the destination, it needs to be entered and processed 3. Clearing float – delay in transferring funds because of the banking system itself In order to speed up the process: •        Preauthorized checks are regular (typically monthly) deductions by a vendor from a customer’s checking account. •        Under the Check 21 law, enacted in 2004, payee banks can present electronic or digital images of checks to payer banks rather than having to physically deliver the paper checks for payment.

In order to facilitate sales, firms often offer the customers credit for purchases; this process calls in credit analysis. The five Cs of credit analysis are: 1. Character – ethical quality of the applicant and the history of paying bills on time (credit checks) 2. Capacity – the ability to pay bills (liquidity ratios) 3. Capital – adequacy of owners’ equity relative to existing liabilities 4. Collateral – whether assets are available to provide security 5. Conditions – current economic climate and state of the business cycle

Credit bureaus obtain credit information about business firms and individuals; two such organizations are Experian and Equifax. Dun & Bradstreet reports contain information assembled through many channels and is one of the best sources of information on privately-held companies; reports are typically divided into five sections:  (1) rating and summary; (2) trade payments; (3) financial information; (4) operation and location; and (5) history. Trade credit is extended on purchases to a firm’s customers. Sometimes, customers are given a discount if they pay early.

The financial manager must be careful not to impose onerous credit terms that will alienate customers and lower sales. With respect to global credit, the concern is forex. There are two ways to handle the issue: 1. Invoice customers in the firm’s home currency 2. Hedge the forex risk Inventory management: •        The just-in-time (JIT) inventory control system is a system where there are enough materials in inventory to cover needs for a short time, but not more inventory than is needed for short-term needs.

Vendor and manufacturer work together to reduce lead time, setup time, and production time so that inventory shows up “just in time”  •        JIT II further integrates the activity of vendor and purchaser, wherein the position of buyer’s purchasers or materials planners is eliminated and replaced by a representative of the supplier •        Tracking inventory also allows firms to reduce the inventory conversion period and the cash conversion cycle. RFID (radio frequency identification) tags send out a radio signal to electronic readers that allow companies to know the location of inventory at any time

Inventory management can result in reduced cost of warehousing and handling inventory. Cost savings and smaller asset bases should lead to higher return on assets and increasing shareholder wealth. Technology is improving asset management by making information available with which managers make business decisions in a real-time setting. Technology may be the key to reducing procurement and supply chain costs. Portals are specialized and secure Web sites through which clients can access order and account information. Key Terms

Capacity                                 The ability to pay bills and often involves an examination of liquidity ratios. Capital                                    The adequacy of owners’ equity relative to existing liabilities as the underlying support for creditworthiness. Cash budget                           The cash inflows and cash outflows of a firm over a specific time frame. Cash conversion cycle           The time it takes to collect money from the company’s customers and use those funds to pay its suppliers.

Character                               The ethical quality of the applicant and his/her willingness to pay bills on time and is best judged by reviewing the past credit history for the company or person. Collateral                                Assets that secure credit. Collection float                       The time between when a payer sends payment and the             funds are credited to the payee’s bank account. Conditions                              The current economic climate and state of the business cycle.

They are an important consideration in assessing whether the applicant can meet credit obligations. Credit bureaus                       Firms that obtain credit information about          business firms and individuals. Disbursement float                The time between when a payer sends payment and when the funds are deducted from the payer’s bank account. Fixed capital                           A firm’s fixed assets, which include plant, equipment, and property. Float                                        The time between sending out payments and having them actually be charged to the bank account.

Level production plan            Schedule where the same amount of raw material is purchased and the same amount of finished product is manufactured every month. Operating cycle                      The time between receiving raw materials and collecting the cash from credit sales posted to accounts receivables. Portals                                    Specialized and secure web sites through which clients can access order and account information. Pre-authorized checks           Regular (typically monthly) deductions by a vendor from a customer’s checking account.

Precautionary motives           Demands for funds that may be caused by  unpredictable events, such as delays in production  or in the collection of receivables. Speculative motives               Demands for funds to take advantage of unusual cash discounts for needed materials. Trade credit                            Credit that is extended on purchases to a firm’s customers. Transactions motives             Demands for holding cash is that cash is needed to conduct day-to-day operations.

Working capital                      A firm’s current assets as shown on the balance sheet and includes cash in the bank accounts, marketable securities, inventory, and accounts receivable. Suggestions for Additional Resources 1. http://en. wikipedia. org/wiki/Just_In_Time_%28business%29 2. http://www. lean. org/ 3. http://www. equifax. com/ 4. http://www. experian. com/ 5. http://www. investopedia. com/terms/c/creditbureau. asp 6. http://en. wikipedia. org/wiki/Credit_bureau 7. http://www. investopedia. com/terms/w/workingcapital. asp 8. http://en. wikipedia. org/wiki/Working_capital

Answers to Summary Questions 2. Fixed capital would be defined as the firm’s fixed assets, which include plant, equipment and property. True or false? True. .  3. The operating cycle measures the time it takes between ordering materials and collecting cash from receivables. True or false? True. .  4. If a firm has $50,000 in profit and pays out about one half to the owners of the company, the amount of profit retained in the firm would show up as: (a) an increase in owners’ equity (b) a decrease in owners’ equity (c) a decrease in retained earnings (d) a decrease in long-term debt .  5.

The accounts payable period is the time between a firm’s paying its suppliers for inventory and collecting cash from inventories. True or false? False. .  6. Increases in the cash conversion cycle will lower the firm’s short-term financing needs. True or false? False. .  7. The inventory conversion period is calculated by inventory divided by costs of goods sold. True or false? False. .  8. Activities that decrease the cash conversion cycle will increase the firm’s need to obtain financing. True or false? False. .  9. More efficient management of working capital assets will lessen the firm’s needs for financing.

True or false? True. . 10. A cash budget is a tool the treasurer uses to forecast future cash flows and estimate future short-term borrowing needs. True or false? True. . 11. To construct a cash budget, two sets of information are needed: estimated cash inflows and estimated cash outflows. True or false? True. . 12. The estimated cash inflows are affected by the sales forecast and customer payment patterns. True or false? True. . 13. Assume a firm’s production process requires an average of 80 days to go from raw materials to finished products and another 40 days before the finished goods are sold.

If the accounts receivable cycle is 70 days and the accounts payable cycle is 80 days, what would the short-term operating cycle be? (a) 110 days (b) 130 days (c) 190 days (d) 270 days . 14. If a firm has net sales of $400,000, annual cost of goods sold of $315,000, an inventory turnover of 4. 5 times a year, and an accounts receivable turnover of five times a year, the combined investment in inventories and accounts receivable would be: (a) $64,500 (b) $92,000 (c) $122,500 (d) $150,000 . 15. Calculation of a firm’s average collection period is the same as calculating the: (a) accounts receivable cycle (b) inventory cycle c) accounts payable cycle (d) short-term operating cycle . 17. A level production plan has problems, such as idle plant and laid-off workers during slow sales months and production bottlenecks during busy times. True or false? False. . 18. The account receivable period may be calculated as accounts receivable divided by sales. True or false? False. . 19. The account receivable period may be calculated as accounts receivable divided by daily sales. True or false? True. . 20. The transactions motive is the demand for holding cash. True or false? True. . 22. The federal funds rate is normally several points lower than the Treasury Bill rate.

True or false? False. . 23. The five C’s of credit analysis is a popular concept used by inventory managers. True or false? False. . 24. A mercantile credit bureau serves primarily as a (n): (a) collection agency for delinquent accounts (b) common meeting place where credit managers may exchange information (c) organization through which accounts receivable may be sold to other businesses (d) central record-keeping organization for credit information on business firms . 25. The objective of just-in-time (JIT) inventory control is to carry a minimum level of inventories.

True or false? True. . 26. The delivery or transmission float is the delay in transferring the means of payment from the payer (customer) to the payee (the provider of goods or services). True or false? True. . 27. The disbursement float is the delay in transferring the means of payment from the payer (customer) to the payee (the provider of goods or services). True or false? False. Answers to “Review Questions” .  1. What is meant by working capital? Net working capital is defined as current assets minus current liabilities. .  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; (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. 4. 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. a. need for day-to-day bill-paying? Transactions motive: b. hold funds to meet unexpected needs—a safety level of? Precautionary motive: cash hold funds? c. Speculative motive: 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 used as marketable securities. Marketable securities that can be used as a means to “park” the firm’s excess cash include a. short-term securities issued and backed by the U. S.? U. S. Treasury Bills: government b. a bank’s temporary excess reserves that are lent to other banks? Federal Funds: on a day-to-day basis c. short-term unsecured notes of large financially stable? Commercial Paper: firms . large dollar CDs ($100,000 or more) for? Negotiable Certificates of Deposit: which a secondary market has evolved e. business paper used to finance international trade, backed? Bankers’ Acceptances: (accepted) by a bank with a high quality rating f. deposits placed in foreign banks that remain denominated in U. S.? Eurodollars: dollars (so there is no currency risk) . 17. 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 to reduce its own financing needs, all else being equal, the shorter the collection float and the larger the disbursement float. . 18. 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. . 19. 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. . 20 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. .. 21. 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. . 22. 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. . 23. 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. illingness to repay debts? Character: b. ability to repay debts (liquidity)? Capacity: c. equity cushion? Capital: d. what assets can provide security for the credit? Collateral: e. the state of the business cycle and its expected movement during the? Conditions: credit period . 24. 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. . 25. 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. . 26. 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. . 27. 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. 28. 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. Answers to “Applying this Chapter” Questions 2. The Robinson Company has the following current assets and current liabilities for these two years: 2004             2005 Cash and marketable securities |$50,000 |$50,000 | |Accounts receivable |300,000 |350,000 | |Inventories |350,000 |500,000 | |Total current assets |$700,000 |$900,000 | |Accounts payable |$200,000 |$250,000 | |Bank loan |0 |150,000 | |Accruals |150,000 |200,000 | |Total current liabilities |$350,000 |$600,000 | |  |  |  | If sales in 2004 were $1. 2 million and sales in 2005 were $1. 3 million, and cost of goods sold was 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 (2005)                   = $300,000/($1,200,000/365) = 91. 25 days (2004) Inventory period            = $500,000/($910,000/365) = 200. 55 days (2005)                             = $350,000/($840,000/365) = 152. 08 days (2004) AP period  = $250,000/($910,000/365 ) = 100. 27 days (2005)                   = $200,000/($840,000/365) = 86. 90 days (2004) Operating cycle = AR period + Inventory period = 98. 27 + 200. 55 = 298. 82 days (2005)                            = 91. 25 + 152. 08 = 243. 33 days (2004) Cash conversion cycle = Operating cycle – AP period = 298. 82 – 100. 27 = 198. 5 days (2005)                                       = 243. 33 –  86. 90 = 156. 43 days (2004) Both the OC and CCC rose in 2005, primarily because of a large rise (almost 48 days) in the inventory period. 5. The Robinson Company from Problem 2 had net sales of $1,200,000 in 2004 and $1,300,000 in 2005. (a)       Determine the receivables turnover in each year. AR turnover       = Sales/AR = $1,300,000/$350,000 = 3. 71 (2005)                             = $1,200,000/$300,000 = 4. 00 (2004) (b)       Calculate the average collection period for each year. Average collection period        = AR/(Sales/365)                                                   = $350,000/($1,300,000/365) = 98. 7 days (2005)                                                   = $300,000/($1,200,000/365) = 91. 25 days (2004) (c)       Based on the receivables turnover for 2004, estimate the investment in receivables if net sales were $1,300,000 in 2005. How much of a change in the 2005 receivables occurred? Receivables investment      = Sales per day ? Average collection period                                               = ($1,300,000/365) ? 91. 25 days = $325,000 6. Suppose the Robinson Company had a cost of goods sold of $1,000,000 in 2004 and $1,200,000 in 2005. (a)       Calculate the inventory turnover for each year. Comment on your findings.

Inventory turnover       = COGS/Inventory = $1,200,000/$500,000 = 2. 40 (2005)                                       = $1,000,000/$350,000 = 2. 86 (2004) Inventory turnover fell in 2005; inventory rose more quickly than cost of goods sold. (b)       What would have been the amount of inventories in 2005 if the 2004 turnover ratio had been maintained? Inventories investment      = COGS per day ? Inventory period                                             = $1,200,000/365 ? (365/2. 86) = $419,580. 42 7. Given Robinson’s 2004 and 2005 financial information presented in problems 2 and 4,      (a)       Compute its operating and cash conversion cycle in each year. Robinson Company |  |  |  |  | |  |2004 |  |2005 |  | |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. 8 |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. 4 |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 his chapter) | |  |2004 |  |2005 |  | |  |=$300,000+$350,000-$200,000 |=$350,000+$500,000-$250,000 | |  |=$450,000 |  |=$600,000 |  | 8. Robinson expects its 2006 sales and cost of goods sold to grow by 5 percent over their 2005 levels. (a)       What will be the affect on its levels of receivables, inventories, and payments if the components of its cash conversion cycle remain at their 2005 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 2006 |  |  | |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. 3 |  | |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 2006 if Robinson is able to reduce its collection period by five days, its inventory period by six days, and increase its payment period by two days? |The new sales will be |$1,300,000 + 5% = |$1,365,000 | |Sales/day = |  |$3,739. 3 | |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. 7 |  |  | |  |  |  |  | |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. 7 |  |  | |  |  |  |  | |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. 1 |  |  | |  |  |  |  | |2006 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) | 9. Robinson expects its 2006 sales and cost of goods sold to grow by 20 percent over their 2005 levels. (a)       What will be the affect on its levels of receivables, inventories, and payments if the components of its cash conversion cycle remain at their 2005 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 2006 |  |  | |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 2006 if Robinson is able to reduce its inventory period by ten 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. 0 |  |  | |  |  |  |  | |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. 5 |  |  | |  |  |  |  | |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. 0 |  |  | |  |  |  |  | |2006 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) |  | 10. Following are financial statements for the Genatron Manufacturing Corporation for the years 2004 and 2005: Selected Balance Sheet Information 2004             2005 Cash | $ 50,000 |$ 40,000 | |Accounts receivable |200,000 |260,000 | |Inventory |450,000 |500,000 | |Total current assets |$700,000 |$800,000 | |Bank loan, 10% |$ 90,000 |$ 90,000 | |Accounts payable |130,000 |170,000 | |Accruals |50,000 |70,000 | |Total current liabilities |$270,000 |$330,000 | |Long-term debt, 12% |300,000 |400,000 | Selected Income Statement Information 2004             2005 |Net sales |$1,300,000 |$1,500,000 | |Cost of goods sold |780,000 |900,000 | |Gross profit |$ 520,000 |$ 600,000 | |Net income |$93,000 |$ 114,000 |

Calculate Genatron’s operating cycle and cash conversion cycle for 2004 and 2005. Why did they change between these years? Inventory period            = Inventory/(COGS/365)                             = $500,000/($900,000/365) = 202. 78 days (2005)                             = $450,000/($780,000/365) = 210. 58 days (2004) AR period = AR/(Sales/365) = $260,000/($1,500,000/365) = 63. 27 days (2005)                   = $200,000/($1,300,000/365) = 56. 15 days (2004) AP period  = AP/(COGS/365) = $170,000/($900,000/365) = 68. 94 days (2005)                   = $130,000/($780,000/365) = 60. 83 days (2004) Operating cycle  = Inventory period + AR period 202. 78 days + 63. 27 days = 266. 05 days (2005)                             = 210. 58 days + 56. 15 days = 266. 73 days (2004) Cash conversion cycle = Operating cycle – Average payment period                                       = 266. 05 days – 68. 94 days = 197. 11 days (2005)                                       = 266. 73 days – 60. 83 days = 205. 90 days (2004) The operating cycle remained constant in 2004 and 2005 as a reduction in the inventory period was balanced by an increase in the average collection period. The cash conversion cycle sell for 2005 was longer. Genatron took, on average, longer to pay its suppliers. 11.

Genatron Manufacturing expects its sales to increase by 10 percent in 2006. Estimate the firm’s investment in accounts receivable, inventory, and accounts payable in 2006. If the inventory, collection, and payment periods remain constant, each account should rise by 10 percent. $260,000 (1. 10) =? Accounts receivable: $286,000 $500,000 (1. 10) = $550,000? Inventory: $170,000 (1. 10) = $187,000? Accounts payable: 12  . With concerns of increased competition, Genatron is planning in case its 2006 sales fall by 5 percent from their 2005 levels. If cost of goods sold and the current asset and liability accounts decrease proportionately, (a) Calculate the 2006 cash conversion cycle.   |  |  |  |  |5% decline | |  |2004 |  |2005 |  |2006 | |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. 8 | |  |  |  |  |  |  | |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. 4 | |  |  |  |  |  |  | |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 2006 net investment in working capital. Net investment in working capital = AR + Inventory – AP (as used in this chapter) | |2004 |2005 |2006 |  |  | |  |  |=$247,000+$475,000-$161,500 | |$520,000 |$590,000 |=$560,500 |  |  | 13. .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 2005 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. 7 |  | |  |  |  |  | |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. 5 |  |  | |  |  |  |  | |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. 8 |  |  | |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. 4 |  |  | |New payment period |71. 94 |  |  | |New AP estimate= |$168,527. 40 |  |  | |  |  |  |  | |2006 working capital = AR + Inventory – AP |  |  | |=$266,520. 55 + $491,397. 26 – $168,527. 40 |  |  | |=$589,390. 1 |  |  |  | |which is an increase of |$28,890. 41 |from problem 10. |  | 14. .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 10. 5 remains the same and the expected cash outflows in Table 10. 6 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 [pic][pic][pic][pic]       2 Months Later (1/3)                                         24,000       30,000         9,000       12,000        Total Cash Receipts                                        $ 87,000   $  52,000     $ 38,000     $ 48,000 [pic][pic][pic][pic]       Less: Total Cash Payments                              60,000     127,000       44,000       40,000        Net Cash Flow                                                  $ 27,000   $ –75,000     $ –6,000     $  8,000 [pic][pic][pic][pic]       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