1

Financial Management
Week 10
Chapter 14.

Review Question 3.

Why does an increase in the ratio of current to total assets decrease both profits and risk
as measured by net working capital? How do changes in the ratio of current liabilities to
total assets affect profitability and risk?

If a firm increases the ratio of current-to-total assets, it will have a larger proportion of current
assets. Because current assets are less profitable, overall profitability will decrease. The firm
will have more net working capital (due to increased current assets), lower risk of technical
insolvency, and also may have greater liquidity. It is also important to consider the composition
of current assets. The "nearer" a current asset is to cash, the greater its liquidity may be and
the lower its risk. For example, an investment in accounts receivable is less risky than
inventory.

The higher the ratio of current liabilities to total assets, the more current liabilities in relation
to long-term funds held by the firm. Since in most economic conditions, current liabilities are
a cheaper form of financing than long-term funds, the reduced financing costs should increase
the firm's profits. At the same time, the firm has less net working capital, thereby reducing
liquidity and increasing the risk of technical insolvency. A decrease in the ratio would increase
both profits and risk.

Review Question 4.

What is the difference between the firm's operating cycle and its cash conversion cycle?

A firm's operating cycle is the period when a firm has its money tied up in inventory and
accounts receivable until cash is collected from the sale of the finished product. It is calculated
by adding the average age of inventory (AAI) to the average collection period (ACP). The
cash conversion cycle (CCC) is the number of days in the firm's operating cycle (OC) minus
the average payment period (APP) for inputs to production. The CCC takes into account the
time at which payment is made for material; this spontaneous form of financing partially or
fully offsets the need for negotiated financing while resources are tied up in the operating cycle.

Review Question 5.

Why is it helpful to divide the funding needs of a seasonal business into its permanent
and seasonal funding requirements when developing a funding strategy?

If a firm does not face a seasonal cycle then they will face only a permanent funding
requirement. With seasonal needs the firm must also make a decision as to how they wish to
meet the short-term nature of their seasonal cash demands. They may choose either an
aggressive or conservative policy toward this cyclical need.
 2

Review Question 6.

What are the benefits, costs and risks of an aggressive funding strategy and of a
conservative strategy? Under which strategy is the borrowing often in excess of the actual
need?

An aggressive strategy finances a firm's seasonal needs, and possibly some of its permanent
needs, with short-term funds, including trade credit as well as bank lines of credit or
commercial paper. This approach seeks to increase profit by using as much of the less
expensive short-term financing as possible, but increases risk since the firm operates with
minimum net working capital, which could become negative. Another factor contributing to
risk is the potential to quickly arrange for long-term funding, which is generally more difficult
to negotiate, to cover shortfalls in seasonal needs.

The conservative strategy finances all expected funding requirements with long-term funds,
while short-term funds are reserved for use in the event of an emergency. This strategy results
in relatively lower profits, since the firm uses more of the expensive long-term financing and
may pay interest on unneeded funds. The conservative approach has less risk because of the
high level of net working capital (i.e. liquidity) which is maintained; the firm has reserved
short-term borrowing power for meeting unexpected fund demands.

Review Question 7.

Why is it important for a firm to minimise the length of its cash conversion cycle?

The longer the cash conversion cycle the greater the amount of investment tied up in low return
assets. Any extension of the cycle can result in higher costs and lower profits.

Review Question 9.

Briefly describe each of the following techniques for managing inventory: (a) ABC
Systems (b) economic order quantity (EOQ) model; (c) just-in-time system; (d)
computerised systems resource control: MRP and ERP.

The ABC system divides inventory into three categories of descending importance based on
certain criteria established by the firm, such as total dollar investment and cost per item.
Control of the A items is the most sophisticated due to the high investment involved, while B
and C items would be subject to less strict controls.

The economic order quantity (EOQ) looks at all of the various costs of inventory and
determines what order size minimises total inventory cost. The model analyses the trade-off
between order cost and carrying cost and determines the order quantity that minimises the total
inventory cost.

The just-in-time (JIT) system is a form of inventory control that attempts to reduce (at least
theoretically) raw materials and finished goods inventory to zero. Ideally, the firm has only
work-in-process inventory. JIT relies on timely receipt of high quality materials and
workmanship; this system requires extensive cooperation among all parties.
 3

Materials Requirement Planning (MRP) is a computerised system that breaks down the bill
of materials for each product in order to determine what to order, when to order it and what
priorities to assign to ordering. MRP relies on EOQ and reorder point concepts to determine
how much to order. Enterprise Resource Planning (ERP) is similar to MRP but expands the
focus to the external environment, including information about suppliers

Review Question 13.

What are the basic trade-offs in a tightening of credit standards?

The trade-offs in tightening credit standards are that, while investment in accounts receivable
and bad debt expenses may decrease, sales volume may also decrease.

Problem 2.

Robbie Industries provides you with the following data:

Sales $1 887 200

Cost of goods sold $1 226 700
Inventory purchases $1 314 200
Average inventory $223 000
Average receivables $257 900
Average payables $190 200

Calculate the company's cash conversion cycle.

Inventory turnover = CoGS / Average inventory

= 1,226,700 / 223,000 = 5.5 times
Average age of inventory = 365 / 5.5 = 66.36 days
Receivables turnover = Sales / Average receivables
= 1,887,200 / 257.900 = 7.32 times
Average collection period = 365 / 7.32 = 49.86 days
Payable turnover = Purchases / Average payables
= 1,314,200 / 190,200 = 6.91 times
Payables turnover = 365/ 6.91 = 52.82 days
Cash conversion cycle = AAI + ACP – APP
66.36 + 49.86 – 52.82 = 63.4 days
 4

Problem 6.

Garrett Industries turns over its inventory six times each year, has an ACP of 45 days and an
APP of 30 days. The firm's annual CC investment is $3 million. Assuming a 365-day year:

a) Calculate the firm's CCC, daily cash operating expenditure and the amount of
financing required to support its CCC.

AAI = 365 days ÷ Inventory turnover = 365  6 = 60.8 days

OC = AAl + ACP = 60.8 days + 45 days = 105.8 days
CCC = OC – APP = 105.8 days – 30 days = 75.8 days

Daily operating expenditure = Total outlays  365 days

= $3,000,000  365 = $8,219
Resources needed = Daily expenditure × CCC
= $8,219 × 75.8 = $623,000

b) Find the firm's CCC and financing requirement in the event that it makes the
following changes simultaneously:
(1) Shortens the average age of inventory by five days
(2) Speeds the collection of accounts receivable by an average of ten days
(3) Extends the APP by 10 days.

OC = AAl + ACP = 55.8 days + 35 days = 90.8 days

CCC = OC – APP = 90.8 days – 40 days = 50.8 days
Resources needed = Daily expenditure × CCC
= $8,219 × 50.8 = $417,525

c) If the firm pays 13% for its financing, by how much, if anything, could it increase its
annual profit as a result of the changes in part b?

Additional profit = (Daily expenditure × Reduction in CCC) × Financing rate

= ($8,219 × 25) × 0.13 = $26,711

d) If the annual cost of achieving the profit in part c is $35 000, what action would you
recommend to the firm? Why?

Reject the proposed techniques because the costs ($35,000) exceed the savings ($26,711).

Problem 15.

Gonzon Replacement Windows Limited uses 50 225 units of glass per unit costs $12.50. The
ordering cost for the glass is $50 per order and its carrying cost r unit per year. Gonzo operates
245 days per year and maintains a minimum inventory Jays' worth of glass. The lead time to
receive orders placed for glass is five days. What is economic order quantity (EOQ),
rounded up to the next whole unit, and b the reorder point?
 5

2  S O 2  50,225  50
EOQ    1,417.39  1,418 units (rounded up)
C 2.5
Daily usage = Yearly usage / Days in operation = 50,000 / 245 = 205
Reorder point = (Lead time + Safety stock) in days × Daily usage
= (5 + 12) × 205 = 3,485 units

Problem 18.

Alexis Limited uses 800 units of a product per year on a s basis. The product has a fixed cost
of $50 per order and its carrying cost is $2 per unit takes five days to receive a shipment after
an order is placed, and the firm wishes to hold in inventory 10 days' usage as a safety stock.

a) Calculate the EOQ.

2S O 2  800  $50

EOQ = = = 200 units
C $2

b) Determine the average level of inventory.

Daily usage = Yearly usage / Days in operation = 800 / 365 = 2.19

EOQ
Average level of inventory = Minimum inventory +
2
200
= 2.19 × 10 + = 121.9 units
2
c) Determine the reorder point,

Reorder point = (Lead time + Safety stock) in days × Daily usage

= (5 + 10) × 2.19 = 32.85 units

d) Which of the following variables change if the firm does not hold the safety stock: (1)
order cost (2) carrying cost, (3) reorder point, (4) total inventory cost, (5) average
level of inventory, (6) number of orders per year and (7) economic order quantity?
Explain.

Change Do Not Change

(2) carrying cost (1) order cost
(3) reorder point (6) number of orders per year
(4) total inventory cost (7) economic order quantity
(5) average level of inventory

(1) Order cost

The cost per order is determined by external forces related to the overheads
incurred in placing an order, and is not affected by how often an order is placed
or the size of the order. The total order cost is a function of the cost per order and
the number of orders placed per period, but the number of orders placed per period
is not affected by the existence of a safety stock.
(2) Carrying cost
 6

The carrying cost per unit is determined by external forces related to the
overheads incurred in carrying a unit of inventory, and is not affected by how
often an order is placed or the size of the order. However, the total carrying cost
is a function of the carrying cost per unit and average level of inventory, and the
average level of inventory is higher with a safety stock. Hence, that will increase
the total carrying cost.
(3) Re-order point
This is a function of the lead time and the safety stock in days, multiplied by the
daily usage, so a safety stock will impact upon the reorder point.
(4) Total inventory cost
This is a combination of the total order cost and the total carrying cost. The fact
that the total carrying cost changes with the addition or removal of a safety stock
indicates that the total inventory cost also changes.
(5) Average level of inventory
This increases with the addition of, and decreases with the removal of, a safety
stock.
(6) Number of orders per year
This is solely a function of the economic order quantity and daily usage, neither
of which are affected by the existence of a safety stock.
(7) Economic order quantity
The equation of EOQ shows that this is solely a function of the number of units
used per period, the order cost per order and the carrying cost per unit, none of
which are affected by the existence of a safety stock.

Chapter 15.

Review Question 1.

What are the two major sources of spontaneous short-term financing for a firm? Why
are the sources considered spontaneous, and how are they related to the firm's sales? Do
they normally have a stated cost?

The two key sources of spontaneous short-term financing (financing that arises from the
normal operating cycle) are accounts payable and accruals. Both of these sources are
spontaneous, since their levels increase and decrease directly with increases or decreases in
sales. If sales increase, the firm will purchase more new materials, resulting in higher accruals
of these items.

Review Question 2.

Is there a cost associated with taking a cash discount? Is there any cost associated with
forgoing cash discount? How is the decision to take a cash discount affected by the firm's
cost of borrowing short-term funds?

There is no cost – stated or unstated – associated with taking a cash discount; there is a cost of
giving up a cash discount. By giving up a cash discount, the purchaser pays the full price for
merchandise but can make the payment later. The unstated cost of giving up a cash discount is
the implied rate of interest paid to delay payments. This rate can be used to make decisions
 7

with respect to whether or not the discount should be taken. If the cost of giving up the cash
discount is greater than the cost of borrowing short-term funds, the firm should take the
discount. Cash discounts can be a source of additional profitability for a firm. However, some
firms, either due to lack of alternative funding sources or ignorance of the true cost, do not take
advantage of these discounts.

Review Question 8.

How are bills of exchange and promissory notes (commercial paper) used to raise short-
term funds?

Bills of exchange originated as a means of financing trade by providing for delayed payment
supported by a bank guarantee of payment. This bank guarantee enabled bill holders to sell
them for cash in advance of the stated settlement date.

In the late 1960s, the connection between trade and bills of exchange was broken when
companies began issuing bank-accepted bills as a means of acquiring short-term funding. In
the intervening period, the majority of bills issued have been for financing rather than trade
purposes. Promissory notes are a form of short-term financing instrument similar to a bill of
exchange, but which are issued by companies of good credit standing which do not need bank
backing for their issue and which do not need endorsement before being sold.

Bills and promissory notes are usually issued by companies in need of short-term finance.
Buyers of bills of exchange are banks, commercial and other investors looking to invest surplus
funds for short periods. Bills are sold in the money market, which is not a particular place but
consists of the buyers of bills, the sellers of bills and institutions acting as intermediaries or
brokers (such as merchant banks), trading with each other, often over the telephone.

Review Question 12.

Describe and compare the basic features of the following methods of using accounts
receivable to obtain short-term financing:

a) pledging accounts receivable

b) factoring accounts receivable.

A pledge of accounts receivable is the use of a firm’s receivables to secure a short-term loan.
The lender evaluates the quality of the accounts receivable, selects acceptable accounts and
files a lien on the collateral. After the selection of accounts, the lender determines the
percentage advanced against receivables. Typically ranging from 50 to 90 per cent of the face
value of the acceptable receivables, this amount becomes the principal on the loan. Pledging
receivables usually costs 2 to 5 per cent above the prime rate due to the nature of the borrower
and additional administrative costs. Commercial banks offer this type of financing.

Factoring accounts receivable is the outright sale to the factor or other financial institution.
The factor sets the conditions of the sale in a factoring agreement. Normally factoring is done
on a non-recourse basis (the factor accepts all credit risks), and the customer is usually notified
that the account receivable has been sold. Factoring can typically cost from 3 to 7 per cent
above the prime rate, including commissions and interest. This type of financing is handled by
specialised financial institutions called factors; some commercial banks and commercial
 8

finance companies factor receivables. While the cost is high, the advantages include immediate
conversion of receivables into cash and also the known pattern of cash flows.

Review Question 13.

Describe the basic features and compare each of the following methods of using inventory
as short-term loan collateral:

a) floating charge
b) floor plan loan.

A floating charge is a loan secured over a specific type of inventory, such as car tyres, where
the owner of the inventory is allowed to buy and sell from his inventory without recourse to
the finance provider, provided the total inventory stay within certain financial limits of the
finance advanced. On sale of inventory, the borrower keeps the money generated from sales
and makes periodic payments to the financier, as with other forms of fixed-term loans.

Under floor plan finance, ownership of specific items of inventory is transferred to the lender.
When a sale is affected, part of the proceeds is remitted to the financier to extinguish the lien
over the individual inventory item sold.

The floor plan method of finance is, in effect, a prepaid form of sale, with the borrower acting
as a commission agent trading inventory he or she does not own. The floating charge loan is
more typical of finance arrangements where the inventory is used as collateral for the loan, but
title remains with the borrower.

Problem 3.

Lyman Nurseries purchased seeds costing $25 000 with terms 3/15 net 30 EOM on 12 January.
How much will the firm pay if it takes the cash discount? What is approximate cost of giving
up the cash discount, using the simplified formula?

Payment required if taking the cash discount = $25,000 × 0.97 = $24,250

Cost of giving up the cash discount ≈ 3% × (365  15) ≈ 73%

Problem 13.

Data Back-up Systems has obtained a $10000, 90-day bank loan at an annual interest rate of
15%, payable at maturity.

a) How much interest (in dollars) will the firm pay on the 90-day loan?

90
Interest  10,000  0.15   $369.86
365

b) Find the effective cost of the loan for the 90 days.

$369.86
Effective cost of loan for 90 days =  3.70%
$10,000
 9

c) Annualise your finding in part b to find the effective annual rate of interest for this
loan, assuming it is rolled over each 90 days throughout the year under the same terms
and circumstances.

Effective annual rate = (1 + 0.037)4 – 1 = 15.64%

Problem 15.

The Darwin Bank advanced Gundagai Glass (GG) $100 000 on a 90-day note at 2.5% over the
annual prime rate. The day the loan was made the prime rate was 8%. It went to 9% on day 30,
10% on day 60 and 11% on day 90.

a) What amount of interest would GG pay if this was a fixed-rate loan?

If this was a fixed-rate loan, the interest rate would be set on the day of the loan.
Annual interest rate = Prime + 2.5% = 10.5%
Interest due = (10.5%) x (90/365) x $100 000 = $2 589

b) What amount of interest would GG pay if this was a floating-rate loan?

With a floating-rate loan, the interest rate changes each time the prime rate changes. Here,
there are three 30-day periods to consider:

Period 1: Interest = 2.5% + 8.0% = 10.5%

Period 2: Interest = 2.5% + 9.0% = 11.5%
Period 3: Interest = 2.5% + 10.0% = 12.5%

Interest due = (10.5%) x (30/365) x ($100 000)

+ (11.5%) x (30/365) x ($100 000)

+ (12.5%) x (30/365) x ($100 000)

= $863.01 + $945.20 + $1027.39

= $2835.60

c) Discuss the difference between the two loans.

With the floating-rate loan, interest is higher by $246. Floating-rate loans protect the financial
institutions during periods of rising interest rates.

Problem 16.

Calculate the annual percentage interest cost on a $150 000, six-month loan with a stated
interest rate of 12% if:

a) interest is paid at maturity

 10

If interest is paid at maturity, the stated rate and the effective annual percentage cost are
equal. The annual interest cost would be 12 per cent.

b) interest is paid in advance.

If interest is paid in advance, the amount for the six months would be:
½ year x 0.12 x $150,000 = $9,000

The firm would therefore receive the use of:

$150,000 - $9,000 = $141,000

The annual interest cost would therefore be:

($9,000 ÷ $141,000) x 2 = 0.0638 x 2 = 12.76%

The calculation uses ‘2’ to translate six months’ interest into yearly terms. This problem
illustrates that interest paid in advance increases the effective interest rate.

Problem 26.

Horizon Telecom sold $300 000 worth of 120-day commercial paper for $298 000. What is
the dollar amount of interest paid on the commercial paper? What is the effective 120-
day rate on the paper?

Interest = $300,000 – $298,000 = $2,000

Interest $2,000
Effective 120-day rate  =  0.67%
Amount received $298,000

Problem 27.

If a commercial bill maturing to a value of $500 000 in 90 days can be sold for $480 000, what
annual interest (per cent) is paid on this issue?

Interest 365 $20,000 365

Effective annual rate   =   16.22%
Amount received N $500,000 90

Problem 28.

Specific Dynamics Limited has just sold an issue of 90-day promissory notes (assume a 365-
day year) with a face value of $30 000 000. The firm has just received $29 550 000. What is
the effective annual interest rate of promissory notes (assume a 365-day year)?

Interest 365 450,000 365

    0.0152  4.056  6.17%
Amount borrowed N 29,550,000 90