CHAPTER 14

Working Capital Management

Learning Objectives
1 !e"ine net #orking capital$ %isc&ss t'e importance o" #orking capital management$
an% be able to comp&te a "irm(s net #orking capital
) !e"ine t'e operating an% cas' c*cles$ e+plain 'o# t'e* are &se%$ an% be able to
comp&te t'eir val&es "or a "irm
, !isc&ss t'e relative a%vantages an% %isa%vantages o" p&rs&ing -1. "le+ible an% -).
restrictive c&rrent asset investment strategies
4 E+plain 'o# acco&nts receivable are create% an% manage%$ an% be able to comp&te
t'e cost o" tra%e cre%it
/ E+plain t'e tra%e0o"" bet#een carr*ing costs an% reor%er costs$ an% be able to
comp&te t'e economic or%er 1&antit* "or a "irm(s inventor* or%ers
2 !e"ine cas' collection time$ %isc&ss 'o# a "irm can minimi3e t'is time$ an% be able
to comp&te t'e cas' collection costs an% bene"its o" a lockbo+
4 5%enti"* t'ree c&rrent asset "inancing strategies an% %isc&ss t'e main so&rces o"
s'ort0term "inancing
5 C'apter O&tline
141 Working Capital 6asics
Working capital management involves two key issues.
What is the appropriate amount and mix of current assets for the firm to
hold?
How should these current assets be financed?
Let us review some basic definitions related to working capital.
C&rrent assets are cash and other assets that the firm expects to convert
into cash in a year or less.
C&rrent liabilities (or short-term liabilities are obligations that the firm
expects to pay off in a year or less.
Working capital! also called gross working capital! is the funds invested
in a company"s cash account! account receivables! inventory! and other
current assets.
7et #orking capital -7WC. refers to the difference between current
assets and current liabilities.
o #W$ is important because it is a measure of li%uidity and
represents the net short-term investment the firm keeps in the
business.
Working capital management involves making decisions regarding the
use and sources of current assets
Working capital e""icienc* refers to the length of time between when a
working capital asset is ac%uired and when it is converted into cash.
Li1&i%it* is the ability of a company to convert assets&real or financial
&into cash %uickly without suffering a financial loss.
A. Working Capital Accounts and Trade-Offs
'he various working capital accounts are(
Cas'8 'his account includes cash and marketable securities like
'reasury securities.
o 'he higher the cash balance! the better the ability of the
firm to meet its short-term financial obligations.
Receivables( 'hese represent the amount owed by customers who
have taken advantage of the firm"s trade credit policy.
5nventor*( )irms maintain inventory of raw materials and work in
process and finished goods.
Pa*ables( 'he payables balance represents the amount owed to the
firm"s vendors and suppliers on materials purchased on credit.
o 'he accrual accounts are liabilities incurred but not yet
paid! such as accrued wages or taxes.
14) T'e Operating an% Cas' Conversion C*cles
'he cash conversion cycle begins when the firm invests cash to purchase the raw
materials that would be used to produce the goods that the firm manufactures and ends
not with the finished goods being sold to customers and the cash collected on the sales*
but when you take into account the time taken by the firm to pay for its purchases.
+ee ,xhibit -../ for a graphical representation of the cash conversion cycle.
When managing working capital accounts! financial managers want to do the following(
0elay paying accounts payable as long as possible without suffering any
penalties.
1aintain minimal raw material inventories without causing manufacturing
delays.
2se as little labor as possible to manufacture the product while producing
a %uality product.
1aintain minimal finished goods inventories without losing sales.
3ffer customers the most attractive credit terms possible on trade credit to
maximi4e sales while minimi4ing the risk of nonpayment.
$ollect cash payments on accounts receivable as fast as possible to close
the loop.
With the financial manager"s goal being to maximi4e the value of the firm! each of the
decisions above is intended to shorten the cash conversion cycle and improve the firm"s
li%uidity.
'wo tools to measure the working capital management efficiency are the operating cycle
and the cash conversion cycle.
A. Operating Cycle
'he operating c*cle begins when the firm receives the raw materials it purchased
and ends when the firm collects cash payments on its credit sales.
'wo measures&days" sales outstanding and days" sales in inventory&help
determine the operating cycle.
!a*s( sales in inventor* -!95. shows how long the firm keeps its
inventory before selling it.
o 5t is the ratio of the inventory balance to the daily cost of goods
sold.
o 'he %uicker a firm can move out its raw materials as finished
goods! the shorter the duration when the firm holds it inventory!
and the more efficient it is in managing its inventory.
!a*s( sales o&tstan%ing -!9O. estimates how long it takes on average
for the firm to collect its outstanding accounts receivable balance.
o 'his ratio is also called the average collection perio% -ACP..
o 6n efficient firm with good working capital management should
have a low average collection period compared to its industry.
'he operating cycle is calculated by summing the days" sales outstanding and the
days" sales in inventory.
Operating Cycle DSO DSI = +
-141.
B. Cash Conversion Cycle
'he cas' conversion c*cle is related to the operating cycle! but it does not start
until the firm actually pays for its inventory.
'he cash conversion cycle is the length of time between the cash
outflow for materials and the cash inflow from sales.
'o measure the cash conversion cycle! we need another measure called the day"s
payables outstanding.
!a*s( pa*able o&tstan%ing -!PO. shows how long a firm takes to pay off its
suppliers for the cost of inventory.
'he cash conversion cycle is then calculated by summing the days" sales
outstanding and the days" sales in inventory and subtracting the days" payables
outstanding.
'he formula is shown in ,%uation -../(
CashConversionCycle DSO DSI DPO = +

14, Working Capital 5nvestment 9trategies
)inancial managers use two types of strategies for current assets investments( flexible and
restrictive.
A. Flexible Current Asset nvest!ent "trategy
'he flexible strategy has a high percent of current assets to sales! whereas a
restrictive policy has a low percent of current assets to sales.
'he "le+ible strateg* calls for management to invest large amounts in cash!
marketable securities! and inventory.
'he strategy also promotes a liberal trade credit policy for customers! which
results in high levels of accounts receivable.
'he flexible strategy is perceived be a low risk and low return course of action for
management to follow.
'he advantage of this policy is the large working capital balances the firm holds.
'he strategy"s downside is the high inventor*0carr*ing cost associated with
owning a high level of inventory and providing liberal credit terms for its
customers.
'he higher carrying costs result for two reasons
'he investment in the low return current assets deprives the higher returns
that management could earn on longer term assets like plant and
e%uipment.
Higher amounts of inventory results in higher warehousing and storage
costs.
B. #estrictive Current Asset nvest!ent "trategy
$urrent assets are kept to a minimum in the restrictive strateg*
'he firm barely invests in cash and inventory! and has tight terms of sale intended
to curb credit sales and accounts receivable.
'he restrictive strategy is a high-risk! high-return alternative to the flexible
strategy.
'he high risk comes in the form of s'ortage costs that can be either
financial or operating.
Financial shortage costs arise mainly from the illi%uidity shortage of cash
and a lack of marketable securities to sell for cash.
o 5f unpaid bills are due! the firm will be forced to use expensive
external emergency borrowing.
o 5f funding cannot be secured! default occurs on some current
liability and the firm runs the risk of being forced into bankruptcy
by creditors.
Operating shortage costs result from lost production and sales.
o 5f the firm does not hold enough raw materials in inventory! time
may be wasted by a halt in production.
o 5f the firm runs out of finished goods! sales may also be lost! and
customer dissatisfaction may arise.
o 7estrictive sale policies such as allowing no credit sales will also
result in lost sales.
o 3verall! operating shortage costs can be substantial! especially if
the product markets are competitive.
C. The Working Capital Trade-off
'he optimal current asset investment strategy will depend on the relative
magnitudes of carrying costs versus shortage costs. 'his conflict is often referred
to as the working capital trade-off.
)inancial managers need to balance shortage costs against carrying costs
to find an optimal strategy.
5f carrying costs are larger than shortage costs! then the firm will
maximi4e value by adopting a more restrictive strategy.
3n the other hand! if shortage costs dominate carrying costs! the firm will
need to move toward a more flexible policy.
3verall! management will try to find the level of current assets that
minimi4es the sum of the carrying costs and shortage costs.
144 Acco&nts Receivables
A. Ter!s of "ale
Whenever a firm sells a product! the seller spells out the terms and conditions of
the sale in a document called the terms of sale.
'he agreement specifies when the cash payment is due and the amount of any
discount if early payment is made.
'rade credit! which is short-term financing! is typically made with a discount for
early payment rather an explicit interest charge.
6n offer of 89:-;! net .;< means that the selling firm offers a 9 percent
discount if the buyer pays the full amount of the purchase in cash within
-; days of the invoice date.
o 3therwise! the buyer has .; days to pay the balance in full from
the date of delivery.
'o calculate the cost! we need to determine the interest rate the buyer is paying
and convert it to an e%uivalent annual rate.
'he formula for calculating the ,67 for a problem like this is shown below! in
,%uation -...!

,ffective annual rate =
9>?:days credit
0iscount
-@ -
0iscounted price

'rade credit is a loan from the supplier and it can be a very costly form of credit.
B. Aging Accounts #eceivables
6 common tool that credit managers use is called an aging schedule.
'he aging schedule shows the breakdown of the firm"s accounts receivable by
their date of sale&how long has the account not been paid in days.
5ts purpose is to identify and then track delin%uent accounts and to see that they
are paid.
6ging schedules are also an important financial tool for analy4ing the %uality of a
company"s receivables.
'he aging schedule reveals patterns of delin%uency and shows where
collection efforts should be concentrated.
,xhibit -..> shows aging schedules for three different firms.
14/ 5nventor* Management
5nventory management is largely a function of operations management! not financial
management.
1anufacturing companies generally carry three types of inventory( raw materials! work
in process! and finished goods.
A. $cono!ic Order %uantity
'he economic order %uantity (,3A mathematically determines the minimum
total inventory cost! taking into account reorder costs and inventory-carrying
costs.
'he optimal order si4e strikes the balance between these two costs.
,%uation -..? shows how to calculate ,3A.
B. &ust-in-Ti!e nventory 'anage!ent
5n this system the exact day-by-day! or even hour-by-hour! raw material needs
are delivered by the suppliers! who deliver the goods 8Bust in time< for them to
be used on the production line.
6 big advantage of this system is that there are essentially no raw inventory
costs and no chance of obsolescence or loss to theft.
3n the other hand! if the supplier fails to make the needed deliveries! then
production shuts down.
5f the system works for a firm! it cuts down their investment in working capital
dramatically.
142 Cas' Management an% 6&%geting
A. #easons for (olding Cash
'wo reasons exist for holding a cash balance. )irst! it facilitates transactions
with suppliers! customers and employees.
'he second reason is simply that most banks re%uire firms to hold minimum cash
balances! or compensating balances$ in exchange for the services they provide.
B. Cash Collection
$ollection time! or "loat$ is the time between when a customer makes a payment
and when the cash becomes available to the firm.
$ollection time can be broken down into three components.
)irst is delivery time! or mailing time.
o When a customer mails payment! it may take several days before
that payment arrives.
+econd is processing delay.
o 3nce the payment is received! it must be opened! examined!
accounted for! and deposited at the firm"s bank.
)inally! there is a delay between the time of the deposit and the time when
the cash is available for withdrawal.
Cayments in cash at the point of sale reduce the collection time to 4ero.
o Cayment by check or credit card at the point of sale eliminates the
mail time but not the processing time.
6 lockbox system allows geographically dispersed customers to send their
payments to a post office box close to them.
With a concentration account! a post office box is replaced by a local branch!
which receives the mailings! processes the payments! and makes the deposits.
,ither approach will reduce the collection time to an extent! but there is a cost
associated with it.
6nother increasingly popular means of reducing cash collection time is through
the use of electronic funds transfers! which reduces cash collection times in
every phase.
)irst! mailing time is eliminated.
+econd! processing time is reduced or eliminated since no data entry is
necessary.
)inally! electronic funds transfers typically have little or no delay in funds
availability.
144 :inancing Working Capital
A. "trategies for Financing Working Capital
,xhibit -..D shows the three basic strategies that a firm can follow to finance its
working capital and fixed assets.
,ach of the three panels show( (- the total long-term financing needed!
which consists of long-term debt and e%uity! and (/ the seasonal needs for
working capital that fluctuates with the level of sales.
'he mat&rit* matc'ing strateg* is shown in )igure 6 of ,xhibit -..D.
6ll working capital is funded with short-term borrowing! and! as the level of
sales varies seasonally! short-term borrowing fluctuates between some
minimum and maximum level.
6ll fixed assets are funded with long-term financing.
'he 8matching of maturities< is one of the most basic techni%ues used by
financial managers to reduce risk when financing assets.
'he long0term "&n%ing strateg* is shown in )igure E in ,xhibit -..D.
'his strategy relies on long-term debt to finance both capital assets and
working capital.
'his strategy reduces the risk of funding current assets because there is no
need to worry about refinancing assets since all funding is long term.
)igure $ in ,xhibit -..D shows the s'ort0term "&n%ing strateg* whereby all
working capital and a portion of fixed assets are funded with short-term debt.
While this lowers the cost under some interest rate scenarios! it forces the
firm to continually refinance the funding of the long-term assets in a changing
interest rate environment.
B. Financing Working Capital in )ractice
1any financial managers try to match the maturities of assets and liabilities when
funding the firm.
'hat is! short-term assets are funded with short-term financing! and long-
term assets are funded with long-term financing.
1ost financial managers like to fund some of their currents assets with long-term
debt as shown in )igure 6 of ,xhibit -..D! so-called permanent #orking capital
5n recent years! a number of large! well-known firms of the highest credit
standing have been funding some of their long-term fixed assets with short-term
debt sold in the commercial paper market.
C. "ources of "hort-Ter! Financing
6ccounts payable (trade credit! bank loans! and commercial paper are common
sources of short-term financing.
Eetween -FF; and /;;9! acco&nts pa*able constituted 9D percent of total current
liabilities for all publicly traded manufacturing firms.
'he buyer needs to figure out whether it makes financial sense to pay early
and take advantage of the discount or to wait and pay in full when the account
is due.
Eetween -FF; and /;;9! s'ort0term bank loans accounted for -F percent of total
current liabilities for all publicly traded manufacturing firms.
6n in"ormal line o" cre%it is a verbal agreement between the firm and the
bank! allowing the firm to borrow up to an agreed-upon upper limit.
5n exchange for providing the line of credit! a bank may re%uire that the
firm holds a compensating balance with them.
6 "ormal line o" cre%it is also known as 8revolving credit!< whereby the
bank has a legal obligation to lend to the firm an amount of money up to a
preset limit.
o 'he firm pays a yearly fee! in addition to the interest expense on the
amount they borrow.
5f the firm backs the loan with an asset! the loan is defined as secured*
otherwise! the loan is unsecured.
+ecured loans allow the borrower to borrow at a lower interest rate! all
else being e%ual.
Commercial paper is a promissory note issued by large financially secure firms!
which have high credit ratings.
$ommercial paper is not 8secured!< which means that the issuer is not
pledging any assets to the lender in the event of default.
However! most commercial paper is backed by a credit line from a
commercial bank.
'herefore! the default rate on commercial paper is very low! resulting in
an interest rate that is usually lower than what a bank would charge on a
direct loan.
)or medium-si4e and small businesses! acco&nts receivable "inancing is an
important source of funds.
6 company can secure a bank loan by pledging the firm"s accounts
receivable as security.
6 second way for a business to finance itself with accounts receivables is
to sell the receivables to a factor at a discount.
'he firm that sold the receivables has no further legal obligation to the
factor.
55 9&ggeste% an% Alternative Approac'es to t'e Material
'his chapter focuses on short-term financial decisions that involve cash inflows and outflows
that will occur within a year or less. ,xamples include the purchase of raw materials! payment
for the purchases of raw materials! sale of finished inventory! and the collection of cash for sales
made on credit. 'his chapter focuses on these types of decisions! which are called working
capital management.
'he chapter begins by reviewing some basic definitions and concepts that are necessary
to further our study of working capital management. #ext! the authors examine the individual
working capital accounts and then learn how to construct and analy4e the operating and cash
conversion cycles. 'hen they examine how the different working capital accounts are managed(
the cash account! accounts receivables! and inventory. )inally! the different financing options
that financial managers consider! and the risks involved! are discussed.
5nstructors may choose to cover this chapter at any point in the semester. 'he material is
sufficiently independent of previous material to allow that. 5t is important to recogni4e that many
undergraduates are more likely to deal with working capital management issues on their first Bob
than with issues like capital budgeting decisions or capital structure decisions.
#one of the %uantitative material is likely to be overwhelming! and as in previous
chapters! the end-of-chapter problems emphasi4e repetition to allow instructors to work some
problems in class and assign others for the students to work on their own.
555 9&mmar* o" Learning Objectives
-. !e"ine net #orking capital$ %isc&ss t'e importance o" #orking capital
management$ an% be able comp&te a "irm(s net #orking capital
#et working capital is the difference between current assets and current liabilities. Working
capital management refers to the decisions made regarding the use of current assets and how
they are financed. 'he goal of working capital management is to ensure that the firm can
continue its day-to-day operations and pay its short-term debt obligations. 'he computation
of net working capital for 0ell $omputer is illustrated in +ection -..-
/. !isc&ss t'e operating an% cas' c*cles$ e+plain 'o# are t'e* &se%$ an% be able
to comp&te t'eir val&es "or a "irm
'he operating cycle can be defined as the period starting with the receipt of raw materials
and ending with the receipt of cash for finished goods made from those raw materials. 5t can
be broken into two components( (- days" sales in inventory! which shows how long a firm
keeps its inventory before selling it! and (/ days" sales outstanding! which indicates how
long it takes on average for the firm to collect its outstanding accounts receivable. 7elated to
the operating cycle is the cash conversion cycle! which is the length of time between the cash
outflow for materials and the cash inflow from sales. 6n additional measure! that of days"
payables outstanding! is re%uired to calculate the cash conversion cycle. Eoth cycles are
simple tools to help the financial manager measure working capital efficiency and control
li%uidity. 'he computations are illustrated in +ection -../.
9. !isc&ss t'e relative a%vantages an% %isa%vantages o" p&rs&ing -1. "le+ible an% -).
restrictive c&rrent asset investment strategies
6 flexible strategy involves maintaining relatively high levels of cash! marketable securities!
and inventory! while a restrictive strategy keeps the levels of current assets relatively low. 5n
general! a flexible strategy is thought to be low risk and low return* its downsides include
low returns on current assets! potentially high inventory-carrying costs! and the cost of the
money necessary to provide liberal credit terms. 'he restrictive strategy involves higher risk
and return! with higher potential financial and operating shortage costs as its maBor
drawbacks.
.. E+plain 'o# acco&nts receivable are create% an% manage%$ an% be able to
comp&te t'e cost o" tra%e cre%it
6ccounts receivable are promises of future payment from customers that buy goods or
services on credit. 'he details are defined in the terms of sale! which include the due date! the
interest rate charge! and any discounts for early payment. 'he terms of sale are affected by
the practice in the industry and the creditworthiness of the customer. 'o manage accounts
receivable! the financial manager should keep close track of both days" sales outstanding and
the aging schedule.

?. E+plain t'e terms inventory-carrying costs an% reorder costs* an% be able to
comp&te t'e economic or%er 1&antit* "or a "irm(s inventor* or%ers
'he trade-off between carrying costs and reorder costs exists because as the si4e of a firm"s
orders for materials increases! the number of orders and total reorder costs decline. 6t the
same time! larger order si4e increases the average inventory si4e! and! therefore! average
inventory-carrying costs. 'he economic order %uantity (,3A is a tool for mathematically
finding the combination of the two costs that minimi4es the firm"s total inventory cost.
Learning by 0oing 6pplication -..9 offers practice in computing a firm"s ,3A.
>. !e"ine cas' collection time* %isc&ss 'o# a "irm can minimi3e t'is time$ an%
be able to comp&te t'e economic costs or bene"its o" a lockbo+
$ash collection time is the time between when a customer makes a payment and when the
cash becomes available to the firm. 5t has three components( (- delivery or mailing time! (/
processing delay! and (9 delay between deposit time and availability. Cossible methods a
firm can use to minimi4e this time include lockboxes! concentration accounts! and electronic
funds transfers. Work through Learn by 0oing 6pplication -... to decide whether a lockbox
is worth keeping.
D. 5%enti"* t'ree c&rrent asset "inancing strategies an% %isc&ss t'e main so&rces
o" s'ort0term "inancing
'here are three main current asset financing strategies( (- the matching maturity strategy!
which matches the maturities of assets with the maturities of liabilities* (/ the long-term
funding strategy! which finances both working capital and long-term assets with long-term
debt* and (9 the aggressive funding strategy! which uses short-term debt for both working
capital and long-term assets. +ources of short-term financing include accounts payable! short-
term bank loans! lines of credit! and commercial paper.
5; 9&mmar* o" <e* E1&ations
E1&ation !escription :orm&la
141
3perating cycle
3perating cycle = 0+3 @ 0+5
14)
$ash conversion cycle $ash conversion cycle =0+3 @ 0+5 G 0C3
14, $ash conversion cycle $ash conversion cycle = 3perating cycle G 0C3
144
,ffective annual rate (,67 ,67 =
9>?:dayscredit
0iscount
-@ -
0iscounted price

14/
,conomic order %uantity (,3A ,3A =
/ H 7eorder costs H +ales per period
$arryingcosts
; 6e"ore =o& >o On ?&estions an% Ans#ers
9ection 141
-. How do you calculate net working capital! and why is it important?
#et working capital is calculated as the difference between the current assets and current
liabilities. 5t is important for a firm to keep a positive net working capital balance! as
these funds are used to cover the day-to-day expenses and short-term liabilities as they
come due.
/. What are some of the trade-offs re%uired in the management of working capital accounts?
When managing working capital accounts! a financial manager is looking to delay paying
accounts payable as long as possible without suffering any penalties! maintain minimal
finished goods inventories without losing sales! and collect cash payments on accounts
receivable as fast as possible to close the loop! among other things.
9ection 14)
-. What is the operating cycle! and how is it related to the cash conversion cycle?
'he operating c*cle starts with the receipt of raw materials and ends with the collection
of cash from customers for the sale of finished goods. 'he operating cycle can be
described in terms of two components( days" sales in inventory and days" sales
outstanding. 'he cash conversion cycle is the length of time between the actual cash
outflow for materials and the actual cash inflow from sales. 'o calculate it! we need all of
the information used to calculate the operating cycle plus one additional measure( days"
payables outstanding.
9ection 14,
-. What are the two general current asset investment strategies discussed in this section! and
how do they differ?
'ypically! the two main current asset investment strategies are flexible and restrictive
strategies. 'he flexible strategy prompts management to keep large balances of cash!
marketable securities! and inventory. 'his strategy is perceived to be a relatively low-risk
and low-return course of action for management to follow. 'he restrictive strategy! on the
other hand! prompts management to keep the usage of current assets to a minimum and is
perceived to be high risk and high return.
/. What are the types of costs associated with each of these strategies?
'he flexible strategy is associated with a high level of carrying costs because of a firm"s
high levels of inventory and providing liberal credit for customers. 'he restrictive
strategy is associated with shortage costs! which can be either financial or operating in
nature.
9ection 144
-. What does 8.:-?! net 9;< mean?
5f a company declares a 8.:-?! net 9;< means of sale! it signifies that it will grant the
customer a . percent discount if the customer pays the full amount within -? days of the
invoice date. 3therwise the customer has 9; days to pay the balance in full from the date
of the delivery.
/. What is an aging schedule! and what is its purpose?
'he aging schedule for a firm lists the accounts receivable broken down by the number of
days until they are due or past due. )irms use aging schedules to keep track of their
accounts receivables and to assess how effective they are collecting on these accounts.
9ection 14/
-. What is the economic order %uantity model?
'he economic order %uantity model is an inventory management tool that mathematically
determines the minimum total inventory cost! taking into account reorder costs and
inventory-carrying costs. 'he main obBective of the model is to find the trade-off between
the two costs.
/. Why is an investment in inventory considered to be costly?
5nvestment in inventory is considered costly! because inventory must be stored! which
results in rental and maintenance costs. )urthermore! inventory on hand is subBect to loss
and theft! and faces the possibility of becoming obsolete. )inally! investment in inventory
provides no return unlike an investment in financial or real assets would.
9ection 142
-. What is float?
'he collection time! which is the time between when a customer makes a payment and
the time the cash becomes available is to the firm! is also referred to as float.
/. ,xplain how lockboxes are used.
Lockboxes are post office boxes set up by the firm for its customers to deliver their
payments to these boxes instead of the firm"s business address. 'he post office then
collects these payments and delivers them to the bank. 'he main purpose of lockboxes is
to minimi4e collection time for firms through cutting down on postal time and through
processing the payments directly at the bank.
9ection 144
-. List and briefly describe the three main short-term financing strategies.
'he three main short-term financing strategies are (- self-li%uidating strategy! in which
the maturity of the liabilities is matched with that of assets* (/ conservative strategy!
which relies more heavily on long-term financing* and (9 restrictive strategy! which
relies primarily on short-term financing.
/. What are the advantages and disadvantages of short-term financing?
+hort-term financing offers companies greater flexibility and usually a lower cost of
capital. 3n the other hand! short-term financing often comes with some illi%uidity
problems as well as uncertainty due to increased exposure to interest rate fluctuations.
9. Iive examples of sources of short-term financing.
,xamples of short-term financing include accounts payable! short-term bank loans!
informal lines of credit! formal lines of credit! or commercial paper. 'he two main
current asset investment strategies are (- flexible strategy! which encourages
management to keep large balances of current assets! and (/ restrictive strategy! which
keeps the usage of current assets to a minimum.
;5 9el" 9t&%* Problems
141 Jou are provided the following working capital information for the Elue 7idge
$ompany(
Acco&nt 6eginning 6alance En%ing 6alance
5nventory K /!>;; K/!LF;
6ccounts receivable 9!/// /!L;;
6ccounts payable /!?;; /!>D;
#et sales /.!?LF
$ost of goods sold -F!>9;
5f all sales are on credit! what are the firm"s operating and cash conversion cycles?
9ol&tion8
We calculate the operating and cash conversion cycles for Elue 7idge as follows(
5nventory = K/!LF;
6ccounts receivable = K/!L;;
6ccounts payable = K/!>D;
#et sales = K/.!?LF
$ost of goods sold = K-F!>9;
6ccounts receivable K/!L;;
0+3 = = = .-.> days
$redit sales 9>? K/.!?LF 9>?
days D . ?9
9>? >9; ! -F K
LF; ! / K
9>? $3I+
5nventory
0+5 = = =
6ccounts payable K/! >D;
0C3 = = = .F.> days
$3I+ 9>? K-F! >9; 9>?
%a*s @/, =
+ =
+ =
D . ?9 > . .-
0+5 0+3 cycle 3perating
%a*s 4/4 =
+ =
+ =
> . .F D . ?9 > . .-
0C3 0+5 0+3 cycle conversion $ash
14) 1errifield $osmetics calculates that its operating cycle for last year was D> days. 'he
company had K/9;!;;; in its accounts receivable account and had sales of K-.F/ million.
What can you say about 1errifield"s inventory management?
9ol&tion8
'he following information describes 1errifield"s inventory management(
3perating cycle = D> days
6ccounts receivables = K/9;!;;;
#et sales = K-!F/;!;;;
days D . .9
9>? ;;; ! F/; ! - K
;;; ! /9; K
9>? sales $redit
s receivable 6ccounts
0+3 = = =
%a*s ,), =
+ =
+ =
0+5
0+5 D . .9 D>
0+5 0+3 cycle 3perating
1errifield $osmetics takes 9/.9 days to move the inventory through as finished products.
14, Eelow is a partial aging of accounts receivable for Eitar 7oofing +ervices. )ill in the rest
of the information and determine its days" sales outstanding. How does it compare to the
industry average of .; days?
Age o" Acco&nts -in %a*s. ;al&e o" Acco&nt -A. B o" Total Acco&nt
;--; K/--!;;;
---9; -/;!9>;
9--.? -;9!//;
.>->; D/!L;;
3ver >; /9!D.;
Total K?9-!-/;
9ol&tion8
'he missing information for Eitar 7oofing is as follows(
Age o" Acco&nts -in %a*s. ;al&e o" Acco&nt -A. B o" Total Acco&nt
;--; K/--!;;; 9F.DM
---9; -/;!9>; //.D
9--.? -;9!//; -F..
.>->; D/!L;; -9.D
3ver >; /9!D.; ..?
'otal K?9-!-/; -;;M
%a*s 44) =
+ + + + =
+ + + + =
.9 . -> // . L D9 . L L- . > FD . 9
9>? (;.;.? >; (;.-9D .? (;.-F. 9; (;.//D -; (;.9FD 0+3 ,ffective
Eitar takes about . days more than the industry average of .; to collect on its receivables.
'he firm should focus collection efforts on all credit sales that take >; days or more to
collect.
144 Ey obtaining a lockbox! #i4am"s 1anufacturing was able to reduce its total cash
collection time by two days. 'he firm has annual sales of K?D;!;;; and can earn ..D?
percent annual interest. 6ssuming that the lockbox costs K?; per year! calculate the
savings that can be attributed to the lockbox.
9ol&tion8
'he following information applies to #i4am"s lockbox(
6nnual sales = K?D;!;;;
6nnual interest rate = ..D?M
6nnual cost of lockbox = K?;
$ollection time saved = / days
A@C,2 = =
= =
?; K / ;.D? . ; >. . ?>- ! - K
>. . ?>- ! - K
9>?
K?D;!;;;
sales daily
Savings
verage

'he firm can save KFL.9> each year by using the lockbox.
14/ 7ockville $orporation is looking to borrow K/?;!;;; at a stated L.? percent 6C7 from
its bank! which re%uires its customers to maintain a -; percent compensating balance.
What is the effective interest rate on this loan for 7ockville $orporation?
9ol&tion8
7ockville $orporation"s loan information is as follows(
6mount to be borrowed = K/?;!;;;
+tated annual interest rate = L.?M
$ompensating balance = -;M
6mount deposited as compensating balance = K/?;!;;; x ;.-; = K/?!;;;
,ffective borrowing amount e%ual to K/?;!;;; G K/?!;;; = K//?!;;;
5nterest expense = K/?;!;;; x ;.;L? = K/-!/?;
B @ .. .
K//?!;;;
K/-!/?;

amount borrowing ,ffective
expense 5nterest
rate interest ,ffective = = =
Ey setting aside a compensating balance of -; percent or K/?!;;; on the loan! the firm
increases its interest rate effectively to F... percent.
;55 Critical T'inking ?&estions
141 What factors must a financial manager consider when making decisions about account
receivables?
When dealing with accounts receivables! important decisions for the financial manager
include the amount of credit offered to various customers and the term of the credit. 'he
financial manager should keep close track of both the aging schedule and the effective
0+3. 5f either or both show consistent deterioration! it may be time to reconsider the
firm"s credit policy or the characteristics of its customers. 5n addition! in some industries!
sales vary by season. 6 firm must be aware of seasonal patterns and make the necessary
adBustments before drawing any conclusions about its accounts receivable.
14) List some of the working capital management characteristics you would expect a
computer manufacturing company following Bust-in-time delivery system! such as 0ell.
)irms like 0ell are likely to do an exceptional Bob of managing their inventory and
collecting on their receivables. 0ell employs a strategy similar to Bust-in-time
management where they maintain Bust sufficient inventory to meet the needs for a very
short time. 'his saves the firm a huge investment in inventory. 'hus their days sales in
inventory (0+5 will be very low compared to other industries. +imilar to 0ell! firms will
have a short collection period! and their operating cycle will be much lower than firms in
other industries. 5f other computer manufacturing firms follow the 0ell operating
philosophy! they will extend their days payables (0C3 to the point that tier cash
conversion cycle is negative. 5n other words! instead of having to invest in its working
capital! these firms will end up taking more time to pay their suppliers than the time taken
to produce! sell! and collect on the receivables.
14, What costs would a firm following a flexible current asset investment strategy worry
about! and why?
'he strategy"s downside is the high carrying cost associated with owning a high level of
inventory and providing liberal credit terms for customers. Ey investing in current assets!
management foregoes the higher rate of return it could have earned by investing in long-
term assets. 'herefore! there is an opportunity cost involved when investing in current
assets. +econd! large investments in some types of inventory can re%uire significant
warehousing and storage costs! which can be expensive.
144 How are customers and suppliers affected by a firm"s working capital management
decisions?
$ustomers like firms to maintain large finished goods inventories because when they go
to make a purchase! the item they want will likely be in stock. 5n general! large inventory
helps stimulate sales and increase customer satisfaction! but they can be a costly item on
a firm"s balance sheet. 1anagement"s decisions on the firm"s receivables policy is driven
by the industry type. $ompanies selling perishable products! such as food companies!
might ask for payment in full in less than -; days. 3n the other hand! if the firm is selling
durable goods! the terms of credit are likely to be more generous. 'he terms of sale are
also affected by the creditworthiness of the customer. 5f the firm is confident that it will
be paid! it is far more likely to extend credit than if there was some doubt about payment.
5f the customer is a particularly large firm or if there is a likelihood of repeat business!
then extending credit may be part of the marketing effect to secure the order. 'hus! when
the financial manager makes a decision to increase working capital! good things are likely
to happen to the firm&sales should increase! relationships with vendors and suppliers
should improve! and work or manufacturing stoppages should be less likely.
14/ 6 beverage bottling company in Nermont has days" sales outstanding of /9.D days. 5s this
good? ,xplain.
5n general! a lower 0+3 reflects the fact that the firm is managing its receivables very
well. However! it is not possible to decide whether a 0+3 of /9.D days is good or bad
unless you have a basis for comparison. 'hat basis of comparison could be a peer group!
historical data for the firm itself! or targets set by the management.
142 How do the following circumstances affect the cash conversion cycle( (a favorable credit
terms allow the firm to pay its accounts payable more slowly! (b inventory turnover
increases! and (c accounts receivable turnover decreases?
(a )avorable credit terms from suppliers allow the firm to use the suppliers" funds to
finance their working capital. 5t also reduces the firm"s cash conversion cycle.
(b 6n increase in the inventory turnover! that is! the 0+5 decreases! reduces both the
firm"s operating cycle and the cash conversion cycle.
(c 6s the accounts receivables turnover (0+3 decreases! the firm improves its
receivables management and reduces its operating cycle and hence! its cash
conversion cycle.
144 What are some industries in which the use of lockboxes would especially benefit
companies? ,xplain.
Lockboxes are a useful tool to speed up collection of receivables when the customer base
is dispersed across a large geographical area. #ormally! this would mean customer
payments would have to be mailed in! consolidated! and then deposited at the firm"s
bank. 'he alternative of setting up a lockbox system allows the firm to redirect customer
payments to regional locations for %uicker consolidation and cashing of payments. 'his is
typical in the retail industry where each store of a chain is located in a different city or
state.
14C +uppose you are a financial manager at a big firm and you expect the interest rates to
decline in the near future. What current asset investment strategy would you recommend
the company pursue?
6t a large firm! management would have access to the commercial paper market! which
can provide cheaper funding than short-term bank financing. 'o borrow in the
commercial paper market! a firm has to be financially strong. 5f interest rates are expected
to decline! such firms can plan on raising working capital by issuing commercial paper.
'hus! all or a portion of the working capital needs can be funded through short-term
funds that can be rolled over as long as interest rates are declining.
14@ Why is commercial paper only available to the most creditworthy customers?
$ommercial paper is available only to firms that are financially strong for two reasons.
)irst! there is no secondary market for investors to li%uidate prior to maturity.
$onse%uently! investors must hold it to maturity and have the confidence that the issuer
would pay them back at that time. +econd! this type of debt is not secured by any real
assets of the issuing firm. 'hus! firms that are the most creditworthy are able to raise
funds in this market at costs that are lower than bank loans.
141D ,xplain what a negative cash conversion cycle means.
7ecogni4e the cash conversion cycle is a function of a firm"s receivables turnover!
inventory turnover! and payables turnover. )irms that are highly efficient in managing
their inventory and receivables will have a short operating cycle and not need a large
investment in working capital. 6 large payables turnover implies that the firm is making
use of their suppliers" funds to fund their working capital needs. 'he difference between
the operating cycle and the payables turnover is the cash conversion cycle. 6 negative
cash conversion cycle means that the time taken by the firm to meet its payables exceeds
its operating cycle. 5n other words! the amount of time to manage their inventory and the
time taken to collect its receivables is less than the time taken to pay its suppliers.
;555 ?&estions an% Problems
6A95C
141 Cas' conversion c*cle8 Wolfgang"s 1asonry estimates that it takes the company /D
days on average to pay off its suppliers. 5t also knows that it has days" sales in inventory
of >. days and days sales" outstanding of 9/ days. How does Wolfgang"s cash conversion
cycle compare to that of an industry average of D? days?
9ol&tion8
0C3 = /D days
0+5 = >. days
0+3 = 9/ days
5ndustry average for cash conversion cycle = D? days.
Wolfgang"s cash conversion cycle =
%a*s 2@ =
+ =
+ =
/D >. 9/
0C3 0+5 0+3 cycle conversion $ash
+ince the firm"s cycle is less than the industry average of D? days! the firm is more
efficient than other firms in the industry in managing its working capital.
14) Cas' conversion c*cle8 #orthern 1anufacturing $ompany found that during the last
year! they took .D days to pay off its suppliers! while they took >9 days to collect their
receivables. 'he company"s days" sales in inventory was .F days. What is #orthern"s
cash conversion cycle?
9ol&tion8
0C3 = .D days
0+5 = .F days
0+3 = >9 days
#orthern"s cash conversion cycle =
%a*s 2/ =
+ =
+ =
.D .F >9
0C3 0+5 0+3 cycle conversion $ash
14, Cas' conversion c*cle8 0evon 6utomotive estimates that it takes the company about >/
days to collect cash from customers on finished goods from the day it receives raw
materials and about >? days to pay its suppliers. What is the company"s cash conversion
cycle? 5nterpret your answer.
9ol&tion8
0C3 = >? days
3perating cycle = >/ days
0evon"s cash conversion cycle =
$ash conversion cycle = 3perating cycle 0C3
= >/ O >?
= -9 days
'his firm has a negative cash conversion cycle. 'he amount of time to manage its
inventory and the time taken to collect its receivables is less than the time taken to pay its
suppliers.
144 Operating c*cle8 Lilly Eakery distributes its products to more than D? restaurants and
delis. 'he company"s collection period is /D days! and it keeps its inventory for four
days. What is Lilly"s operating cycle?
9ol&tion8
0+5 = . days
0+3 = /D days
Lilly"s operating cycle =
%a*s ,-
. /D
0+5 0+3 cycle 3perating
=
+ =
+ =
14/ Operating c*cle8 #et+peed 'echnologies is a telecom component manufacturer. 'he
firm typically has a collection period of .. days and days" sales in inventory of /F days.
What is the operating cycle for #et+peed?
9ol&tion8
0+5 = /F days
0+3 = .. days
#et+peed"s operating cycle =
%a*s 4, =
+ =
+ =
/F ..
0+5 0+3 cycle 3perating
142 Cost o" tra%e cre%it( +ybex $orp. sells its goods with terms of /:-; ,31! net 9;. What
is the implicit cost of the trade credit?
9ol&tion8
$redit terms = /:-; ,31! net 9;
,ffective annual rate = -
price 0iscounted
0iscount
-
credit days : 9>?

+
= (- @ /:FL
9>?:/;
O -
= (-.;/;.
-L./?;;
O -
= -...?F O -
= ;...?F! or 44/@ percent
144 Cost o" tra%e cre%it( Puggs! 5nc.! sells its goods with terms of .:-; ,31! net >;. What is
the implicit cost of the trade credit?
9ol&tion8
,ffective annual rate = -
price 0iscounted
0iscount
-
credit days : 9>?

+
= (- @ .:F>
9>?:?;
O -
= (-.;.-D
D.9
O -
= -.9.D/ O -
= ;.9.D/! or ,44)B
14C Lockbo+8 7osenthal 0esign has daily sales of K?F!;;;. 'he financial management team
determined that a lockbox would reduce the collection time by -.> days. 6ssuming the
company can earn ?./ percent interest per year! what are the savings from the lockbox?
9ol&tion8
6ll sales are assumed to be credit sales.
6nnual interest rate = ?./M
$ollection time saved = -.> days
A4$@DCCD = =
=
> . - ;?/ . ; ;;; ! ?F K +avings
;;; ! ?F K sales daily 6verage

'he firm can save K.!F;L.L; due to the use of lockbox.
14@ Lockbo+8 Cacific 'raders has annual sales of K-!LF?!;;;. 'he firm"s financial manager
has determined that using a lockbox will reduce collection time by /.9 days. 5f the firm"s
opportunity cost on savings is ?./? percent! what are the savings from using the lockbox?
9ol&tion8
6nnual sales = K-!LF?!;;;
6nnual interest rate = ?./?M
$ollection time saved = /.9 days
A2)2@1 = =
= =
9 . / ;?/? . ; DL . -F- ! ? K +avings
DL . -F- ! ? K
9>?
K-!LF?!;;;
sales daily 6verage

'he firm can save K>/>.F- due to the use of lockbox.
141D E""ective interest rate8 'he Qellog Eank re%uires borrowers to keep an L percent
compensating balance. Iorman Pewels borrows K9.;!;;; at a D percent stated 6C7.
What is the effective interest rate on the loan?
9ol&tion8
6mount to be borrowed = K9.;!;;;
+tated annual interest rate = D.;M
$ompensating balance = LM
6mount deposited as compensating balance = K9.;!;;; H ;.;L = K/D!/;;
,ffective borrowing amount = K9.;!;;; G K/D!/;; = K9-/!L;;
5nterest expense = K9.;!;;; H ;.;D = K/9!L;;
421B = = =
K9-/!L;;
K/9!L;;

amount borrowing ,ffective
expense 5nterest
rate interest ,ffective
Ey setting aside a compensating balance of L percent or K/D!/;; on the loan! the firm
increases its interest rate effectively to D.>- percent.
1411 E""ective interest rate8 1organ $ontractors borrowed K-.D? million at an 6C7 of -;./
percent. 'he loan called for a compensating balance of -/ percent. What is the effective
interest rate on the loan?
9ol&tion8
6mount to be borrowed = K-!D?;!;;;
+tated annual interest rate = -;./M
$ompensating balance = -/M
6mount deposited as compensating balance = K-!D?;!;;; H ;.-;/ = K/-;!;;;
,ffective borrowing amount e%ual to K-!D?;!;;; G K/-;!;;; = K-!?.;!;;;
5nterest expense = K-!D?;!;;; x ;.-;./ = K-DL!?;;
112B = = =
K-!?.;!;;;
K-DL!?;;

amount borrowing ,ffective
expense 5nterest
rate interest ,ffective
Ey setting aside a compensating balance of -/ percent or K/-;!;;; on the loan! the firm
increases its interest rate effectively to --.> percent.
141) :ormal line o" cre%it8 Winegartner $osmetics is setting up a line of credit at its bank for
K? million for up to two years. 'he loan rate is ?.LD? percent and also calls for an annual
fee of .; basis points on any unused balance for the year. 5f the firm borrows K/ million
on the day the loan agreement was signed! what is the firm"s effective rate?
9ol&tion8
Line of credit limit = K?!;;;!;;;
Loan rate = ?.LD?M
6nnual fee on used balance = ;..M
6mount borrowed = K/!;;;!;;;
2nused balance = K9!;;;!;;;
6nnual fee = K9!;;;!;;; x ;.;;. = K-/!;;;
5nterest expense = K/!;;;!;;; x ;.;?LD? = K--D!?;;
24CB =
+
=
+
=
K/!;;;!;;;
K-/!;;; (K--D!?;;

amount Eorrowed
fee 6nnual expense 5nterest
rate interest ,ffective
'he effective borrowing rate for the firm is >..LM with the annual fee of .; basis points.
57TERME!5ATE
141, Cas' conversion c*cle8 Jour boss asks you to compute the company"s cash conversion
cycle. Looking at the financial statements! you see that the average inventory for the year
was K/>!9;;! accounts receivable were K-D!F;;! and accounts payable were at K-?!-;;.
Jou also see that the company had sales of K-?.!;;; and that cost of goods sold was
K-//!;;;. 5nterpret your firm"s cash conversion cycle.
9ol&tion8
6ll sales are assumed to be credit sales.
6ccounts receivables = K-D!F;;
6ccounts payables = K-?!-;;
+ales = K-?.!;;;
5nventory = K/>!9;;
$ost of goods sold = K-//!;;;
6ccounts receivable K-D! F;;
0+3 = = = ./.. days
$redit sales 9>? K-?.! ;;; 9>?
days D . DL
9>? ;;; ! -// K
9;; ! /> K
9>? $3I+
5nventory
0+5 = = =
6ccounts payable K-?!-;;
0C3 = = = .?./ days
$3I+ 9>? K-//! ;;; 9>?
%a*s 4/@ =
+ =
+ =
/ . .? D . DL . . ./
0C3 0+5 0+3 cycle conversion $ash
'he firm takes nearly D> days from the time it pays for its raw materials to the time it
reali4es cash from its credit sales. Ey taking a couple of more days to pay it suppliers
relative to the time it takes to collect on its receivables! it reduces the cash conversion
cycle.
1414 Cas' conversion c*cle8 Elackwell 6utomotive! 5nc.! reported the following information
for the last fiscal year.
6lack#ell A&tomotive$ 5nc
Assets As o" ,E,1E)DDC Liabilities an% E1&it*
$ash and marketable sec. K /9!;-? 6ccounts payable and accruals K->9!/?D
6ccounts receivable -.-!/?L #otes payable /-!--?
5nventories /-/!...
3ther current assets --!//9
'otal current assets K9LD!F.; 'otal current liabilities K-L.!9D/
#et sales F-/!99/
$ost of goods sold ?.D!.;;
$alculate the firm"s cash conversion cycle and operating cycles.
9ol&tion8
6ccounts receivables = K-.-!/?L
6ccounts payables = K->9!/?D
#et sales = KF-/!99/
5nventory = K/-/!...
$ost of goods sold = K?.D!.;;
6ccounts receivable K-.-! /?L
0+3 = = = ?>.? days
$redit sales 9>? KF-/! 99/ 9>?
days D . -.-
9>? .;; ! ?.D K
... ! /-/ K
9>? $3I+
5nventory
0+5 = = =
6ccounts payable K->9! /?D
0C3 = = =-;L.F days
$3I+ 9>? K?.D! .;; 9>?
%a*s 1@C) =
+ =
+ =
D . -.- ? . ?>
0+5 0+3 cycle 3perating
$ash conversion cycle = 0+3 @ 0+5 O 0C3
= ?>.? @ -.-.D O -;L.F
= C@, %a*s
141/ Cas' conversion c*cle8 ,lsee! 5nc.! has net sales of K-9 million with D? percent of it
being credit sales. 5ts cost of goods sold is >? percent of annual sales. 'he firm"s cash
conversion cycle is .-.9 days. 'he inventory for the firm is K-!L-D!9..! while its
accounts payable is K/!-D-!>F;. What is the firm"s accounts receivable balance?
9ol&tion8
#et sales = K-9!;;;!;;;
$redit sales = (;.D? H K-9!;;;!;;; = KF!D?;!;;;
6ccounts payable = K/!-D-!>F;
5nventory = K-!L-D!9..
$ost of goods sold = (;.>? H +ales = (;.>? H K-9!;;;!;;; = KL!.?;!;;;
$ash conversion cycle = .-.9 days
6ccounts payable K/!-D-! >F;
0C3 = = = F9.L days
$3I+ 9>? KL! .?;! ;;; 9>?
5nventory K-!L-D! 9..
0+5 = = = DL.? days
$3I+ 9>? KL! .?;! ;;; 9>?
%a*s /22 =
+ =
+ =
0+3
L . F9 ? . DL 0+3 9 . .-
0C3 0+5 0+3 cycle conversion $ash
2sing the 0+3 e%uation! we can solve for the accounts receivable.
6ccounts receivables
?> > days
$redit sales 9>? F D?; ;;; 9>?
6ccounts receivables ?>.> K/>!D-/.99
A#
+"O .
, * *
= = =
= =A1$ /11$ @14C1
'he firm has accounts receivables of A1$/11$@1C.
1412 Cas' conversion c*cle8 Poanna Handicrafts! 5nc.! has net sales of K../9 million with ?;
percent of it being credit sales. 5ts cost of goods sold is K/.?. million. 'he firm"s cash
conversion cycle is .D.F days. 'he firm"s operating cycle is L>.9 days. What is the firm"s
accounts payable?
9ol&tion8
#et sales = K.!/9;!;;;
$redit sales = (;.? x K.!/9;!;;; = K/!--?!;;;
$ash conversion cycle = .D.F days
3perating cycle = L>.9 days
$ost of goods sold = K/!?.;!;;;
%a*s ,C4 =
=
+ =
0C3
0C3 9 . L> F . .D
0C3 0+5 0+3 ( cycle conversion $ash
6ccounts payable 6ccounts payable
0C3 = = = 9L.. days
$3I+ 9>? K/! ?.;! ;;; 9>?
6ccounts payable = 9L..HK>! F?L.F; =A)24$ ))1@)
'he firm has accounts payable of A)24$))).
1414 Operating c*cle8 6viva 'echnology"s operating cycle is L- days. 5ts inventory level was
at K-9.!;;; last year! and the company had a K-.- million cost of goods sold. How long
does it take 6viva to collect on its receivables?
9ol&tion8
3perating cycle = L- days
5nventory = K-9.!;;;
$ost of goods sold = K-!-;;!;;;
days ? . ..
9>? ;;; ! -;; ! - K
;;; ! -9. K
9>? $3I+
5nventory
0+5 = = =
%a*s ,2/ =
+ =
+ =
0+3
? . .. 0+3 L-
0+5 0+3 cycle 3perating
5t takes 6viva 9>.? days to collect on its receivable.
141C Operating c*cle8 Cremier $orp. has sales of KL-/!9..! and its cost of goods sold is D;
percent of sales. 6ssume all sales are credit sales. 5f the firm"s accounts receivable total
K--9!F;/ and its operating cycle is L-.> days! how much inventory does the firm have?
9ol&tion8
$redit sales = KL-/!9..
3perating cycle = L-.> days
$ost of goods sold = (;.D x KL-/!9.. = K?>L!>.-
6ccounts receivable = K--9!F;/
6ccounts receivable K--9! F;/
0+3 = = = ?-./ days
$redit sales 9>? KL-/! 9.. 9>?
%a*s ,D4 =
+ =
+ =
0+5
0+5 / . ?- > . L-
0+5 0+3 cycle 3perating
A44$,2D4C =
= = =
5nventory
days . . 9;
9>? >.- ! ?>L K
5nventory
9>? $3I+
5nventory
0+5
'he firm has inventory of A44$,21.
141@ Economic or%er 1&antit*8 Longhorn 'raders is one of the largest 7N dealers in 6ustin
and sells about /!L;; recreational vehicles a year. 'he cost of placing an order with their
supplier is KL;;! and the inventory-carrying costs are K-?; for each 7N. 'he company
likes to maintain safety stock of -/ 7Ns. 1ost of their sales are either in spring or the fall
of each year. How many orders will the firm need to place this year?
9ol&tion8
6nnual sales = /!L;; units
$ost of placing an order = KL;;
5nventory-carrying cost per 7N = K-?;
+afety stock = -/ 7Ns
L . -D/
-?; K
L;; ! / L;; K /
ts cos $arrying
period per +ales costs 7eorder /
,3A
=

=

=
,conomic order %uantity = -D9 7Ns
#o. of orders the firm needs to place = /!L;; : -D9 = 12
14)D E""ective interest rate8 'he $larkson 0esigner $ompany is looking for a loan of
KD?;!;;;.'he bank will provide the loan at an 6C7 of >.LD?. +ince the loan calls for a
compensating balance! the effective interest rate on the loan increased to F./? percent.
What is the compensating balance on this loan?
9ol&tion8
6mount to be borrowed = KD?;!;;;
+tated annual interest rate = >.LD?M
$ompensating balance = ?
,ffective interest rate = F./?M
5nterest expense = KD?;!;;; x ;.;>LD? = K?-!?>/.?;
.9 . .9/ ! ??D K
;F/? . ;
?; . ?>/ ! ?- K
amount borrowing ,ffective
amount borrowing ,ffective
K?-!?>/.?;
F./?M

amount borrowing ,ffective
expense 5nterest
rate interest ,ffective
= =
=
=
,ffective borrowing amount = KD?;!;;; G K$E = K??D!.9/..9
$ompensating balance deposit = KD?;!;;; - K??D!.9/..9 = K-F/!?>D.?D
$ompensating balance = K-F/!?>D.?D : KD?;!;;; = )/2B
Ey setting aside a compensating balance of /?.>M on the loan! the firm increases its
interest rate effectively from >.LD? to F./? percent.
14)1 E""ective interest rate8 'he $olonial Window 'reatments $ompany is borrowing
K-!?;;!;;;. 'he loan re%uires a -; percent compensating balance! and the effective
interest rate on the loan is F.D? percent. What is the stated 6C7 on this loan?
9ol&tion8
6mount to be borrowed = K-!?;;!;;;
+tated annual interest rate = ?
$ompensating balance = -;M
,ffective interest rate = F.D?M
$ompensating balance = (;.-; x K-!?;;!;;; = K-?;!;;;
,ffective borrowing amount = K-!?;;!;;; G K-?;!;;; = K-!9?;!;;;
>/? ! -9- K ;;; ! 9?; ! - K ;FD? . ; expense nterest 5
amount borrowing ,ffective
expense 5nterest
F.D?M

amount borrowing ,ffective
expense 5nterest
rate interest ,ffective
= =
=
=
+tated interest rate = K-9-!>/? : K-!?;;!;;; = C44/B
14)) :ormal line o" cre%it8 Iruppa! 5nc.! has Bust set up a formal line of credit of K-; million
with )irst $ommunity $ommercial Eank. 'he line of credit is good for up to five years.
'he bank will be charging them an interest rate of >./? percent on the loan! and in
addition the firm will pay an annual fee of >; basis points on the unused balance. 'he
firm borrowed KD.? million on the first day the credit line became available. What is the
firm"s effective interest rate on this line of credit?
9ol&tion8
Line of credit limit = K-;!;;;!;;;
Loan rate = >./?M
6nnual fee on used balance = ;.>M
6mount borrowed = KD!?;;!;;;
2nused balance = K9!;;;!;;;
6nnual fee = K/!?;;!;;; x ;.;;> = K-?!;;;
5nterest expense = KD!?;;!;;; x ;.;>/? = K.>L!D?;
24/B =
+
=
+
=
KD!?;;!;;;
K-?!;;; (K.>L!D?;

amount Eorrowed
fee 6nnual expense 5nterest
rate interest ,ffective
14), :ormal line o" cre%it8 Lansdowne ,lectronics has a formal line of credit of K- million
up to three years with H#0 Eank. 'he interest rate on the loan is ?.9 percent! and under
the agreement! Lansdowne has to pay ?; basis points on the unused amount as the annual
fee. +uppose the firm borrows K>D?!;;; the first day of the agreement. What is the fee
the company must pay? What is the effective interest rate?
9ol&tion8
Line of credit limit = K-!;;;!;;;
Loan rate = ?.9M
6nnual fee on used balance = ;.?M
6mount borrowed = K>D?!;;;
2nused balance = K9/?!;;;
6nnual fee = K9/?!;;; x ;.;;? = A1$2)/
5nterest expense = K>D?!;;; x ;.;?9 = K9?!DD?
//4B =
+
=
+
=
K>D?!;;;
K-!>/? (K9?!DD?

amount Eorrowed
fee 6nnual expense 5nterest
rate interest ,ffective
14)4 Lockbo+8 Pennifer ,lectricals is evaluating whether a lockbox they are currently using is
worth keeping. 1anagement estimates that the lockbox reduces the mail float by -.L days
and the processing by half a day. 'he remittances average K?;!;;; a day for Pennifer
,lectricals! with the average check K?;;. 'he bank charges K;.9. per processed check.
6ssume that there are /D; business days in a year and the firm"s opportunity cost of those
funds is > percent. What will the firm"s savings be from using the lockbox?
9ol&tion8
6verage daily sales = K?;!;;;
#o. of business days = /D;
3pportunity cost of funds = >M
6verage check amount = K?;;
#o. of checks processed per day = K?;!;;; : K?;; = -;;
$ollection time saved = -.L days
Crocessing time saved = ;.? days
Cer-check processing fee = K;.9.
'he cost of a lockbox = -;; checks K;.9. per check /D; days = KF!-L;
+avings from mail float = -.L days K?;!;;; = KF;!;;;
+avings from processing float = ;.? days K?;!;;; = K/?!;;;
'otal savings = (+avings from mail float @ +avings from processing float
= KF;!;;; @ K/?!;;; = K--?!;;;
+avings from lockbox = K--?!;;; H ;.;>= A2$@DD
+ince the savings from the lockbox is less than the cost of the lockbox! it is not worth
keeping the lockbox for Pennifer ,lectricals.
14)/ Lockbo+8 Ha4el $orp. has Bust signed up for a lockbox. 1anagement expects the
lockbox to reduce the mail float by /.- days. Ha4el $orp."s remittances average K9D!;;;
a day for Ha4el! with the average check being K-/?. 'he bank charges K;.9D per
processed check. 6ssume that there are /D; business days in a year. What will the firm"s
savings be from using the lockbox if the opportunity cost of those funds is -/ percent?
9ol&tion8
6verage daily sales = K9D!;;;
#o. of business days = /D;
6verage check amount = K-/?
#o. of checks processed per day = K9D!;;; : K-/? = /F>
$ollection time saved = /.- days
Cer check processing fee = K;.9D
'he cost of a lockbox = /F> checks K;.9D per check /D; days = K/F!?D;..;
+avings from mail float = /.- days K9D!;;; = KDD!D;;
3pportunity cost of funds = -/M
+avings from lockbox = KDD!D;; H ;.-/= A@$,)4
+ince the savings from the lockbox is less than the cost of the lockbox! it is not worth
keeping the lockbox for Ha4el $orp.
14)2 Aging sc'e%&le8 Iinseng $ompany collects ?; percent of its receivables in -; days or
fewer! 9- percent in -- to 9; days! D percent in 9- to .? days! D percent in .> to >; days!
and ? percent in more than >; days. 'he company has K-!/-9!;;; in accounts receivable.
Crepare an aging schedule for Iinseng $ompany.
9ol&tion8
6ccounts receivables = K-!/-9!;;;
Age o" Acco&nts -in %a*s. ;al&e o" Acco&nt -A. B o" Total Acco&nt
;--; K >;>!?;; ?;.;M
---9; 9D>!;9; 9-.;
9--.? L.!F-; D.;
.>->; L.!F-; D.;
3ver >; >;!>?; ?.;
Total K-!/-9!;;; -;;.;M
14)4 Aging sc'e%&le8 6 partial aging of accounts receivable for Lincoln $leaning +ervices is
given in the following table. What percent of receivables are in the .?-day range?
0etermine the firm"s effective days" sales outstanding. How does it compare to the
industry average of 9? days?
Age o" Acco&nts
-in %a*s. ;al&e o" Acco&nt -A. B o" Total Acco&nt
-; K/D-!;;;
9; -.?!//;
.?
>; ?9!FL;
D? 9-!/.?
Total K?LF!/-L -;;.;M
9ol&tion8
6ccounts receivables = K?LF!/-L
Age o" Acco&nts
-in %a*s. ;al&e o" Acco&nt -A. B o" Total Acco&nt
-; K/D-!;;; .>.;M
9; -.?!//; /..>
.? C4$44, 14@
>; ?9!FL; F./
D? 9-!/.? ?.9
Total K?LF!/-L -;;.;M
,ffective 0+3= 6ge of the account category Cercent of 67 for the account category
= (-; x ;..> @ 9; x ;./.> @ .? x ;.-.F @ >; x ;.;F/ @ D? x ;.;?9
= /L./ days
'he firm is more efficient than other firms in the industry as its effective 0+3 is lower.
14)C Aging sc'e%&le8 Qeswick )encing $ompany collects .? percent of its receivables in -;
days or fewer! 9. percent in -; to 9; days! -/ percent in 9- to .? days! ? percent in .> to
>; days! and . percent in more than >; days. 'he company has KF9D!;;; in its accounts
receivable account. Crepare an aging schedule for Qeswick )encing.
9ol&tion8
6ccounts receivables = KF9D!;;;
Age o" Acco&nts
-in %a*s. ;al&e o" Acco&nt -A. B o" Total Acco&nt
;--; K./-!>?; .?.;M
---9; 9-L!?L; 9..;
9--.? --/!..; -/.;
.>->; .>!L?; ?.;
3ver >; 9D!.L; ..;
Total KF9D!;;; -;;.;M
14)@ :actoring( Renex! 5nc.! sells K/?;!;;; of its accounts receivable to factors at 9 percent
discount. 'he firm"s average collection period is F; days. What is the dollar cost of the
factoring service? What is the simple annual interest cost of the factors loan?
9ol&tion8
6ccounts receivables sold = K/?;!;;;
)actor discount = 9M
6verage collection period = F; days
0ollar cost of factoring per month = K/?;!;;; x ;.;9 = A4$/DD
0ollar cost over F; days = KD!?;; x 9 = K//!?;;
+imple monthly interest cost of factoring = 9:FD = ;.;9;F9
+imple interest cost of factoring = ;.;9;F9 x -/ = ,41B
14,D :actoring( 6 firm sells K-;;!;;; of its accounts receivable to factors at / percent
discount. 'he firm"s average collection period is one month. What is the dollar cost of the
factoring service?
9ol&tion8
6ccounts receivables sold = K-;;!;;;
)actor discount = /M
6verage collection period = 9; days
0ollar cost of factoring per month = K-;;!;;; x ;.;/ = A)$DDD
A!;A7CE!
14,1 What impact would the following actions have on the operating and cash conversion
cycles? Would the cycles increase! decrease! or remain the unchanged?
a 1ore raw material than usual is purchased.
b 'he company enters into an off season! and inventory builds up.
c Eetter terms of payment are negotiated with suppliers.
% 'he cash discounts offered to customers are decreased.
e 6ll else remaining the same! an improvement in manufacturing techni%ue decreases
the cost of goods sold.
9ol&tion8
9it&ation Operating c*cle
Cas' conversion
c*cle
a. 1ore raw material than usual is
purchased.
ncrease ncrease
b. 'he company enters into an off
season! and inventory builds up.
ncrease ncrease
c. Eetter terms of payment are
negotiated with suppliers.
-o change +ecrease
d. 'he cash discounts offered to
customers are decreased.
ncrease ncrease
e. 6ll else remaining the same! an
improvement in manufacturing
techni%ue decreases the cost of goods
sold.
ncrease .nchanged
14,) What impact would the following actions have on the operating and cash conversion
cycles? Would the cycles increase! decrease! or remain the unchanged?
a Less raw material than usual is purchased.
b 'he company encounters unseasonable demand! and inventory declines rapidly.
c 'ighter terms of payment are demanded by suppliers.
% 'he cash discounts offered to customers are increased.
e 6ll else remaining the same! due to labor turnover and poor efficiency! the cost of
goods sold increases.
9ol&tion8
9it&ation Operating c*cle
Cas' conversion
c*cle
a. Less raw material than usual is
purchased.
+ecrease +ecrease
b. 'he company encounters unseasonable
demand! and inventory declines rapidly.
+ecrease +ecrease
c. 'ighter terms of payment are demanded
by suppliers.
-o change ncrease
d. 'he cash discounts offered to customers
are increased.
+ecrease +ecrease
e. 6ll else remaining the same! due to
labor turnover and poor efficiency! the
cost of goods sold increases.
+ecrease .nchanged
14,, 1organ +ports $ompany Bust reported the following financial figures.
Morgan 9ports E1&ipment Compan*
Assets Liabilities an% E1&it*
$ash and marketable sec. K >DD!./9 6ccounts payable K-!D/-!>>F
6ccounts receivable -!L.?!--9 #otes payable /!--9!9.?
5nventories -!9-/!.DL
'otal current assets K9!L9?!;-. 'otal current liabilities K9!L9?!;-.
#et sales F!F-/!/9/
$ost of goods sold ?!F.D!9FF
a $alculate the firm"s days" sales outstanding.
b What is the firm"s days" sales in inventory?
c What is the firm"s days" payable outstanding?
% What is the firm"s operating cycle? How does it compare to the industry average
of D/ days?
e What is the firm"s cash conversion cycle? How does it compare to the industry
average of ./ days?
9ol&tion8
a
6ccounts receivable K-!L.?!--9
0+3 = = = >
$redit sales 9>? KF! F-/!99/ 9>?
4@ %a*s
b.
%a*s CD2 = = =
9>? 9FF ! F.D ! ? K
.DL ! 9-/ ! - K
9>? $3I+
5nventory
0+5
c.
6ccounts Cayable K-! D/-! >>F
0C3 = =
$3I+ 9>? K?! F.D! 9FF 9>?
= 1D/4 %a*s
d.
%a*s 14C/ =
+ =
+ =
> . L; F . >D
0+5 0+3 cycle 3perating
'he firm is very inefficient in managing its receivable and inventory as its
operating cycle exceeds the industry average of D/ days by about DD days.
e.
%a*s 4)C =
+ =
+ =
D . -;? > . L; F . >D (
0C3 0+5 0+3 cycle conversion $ash
'he firm"s cash conversion cycle is on a par with the industry average of ./ days
thanks to its suppliers" very generous credit policy.
14,4 Packson ,lectricals is one of the largest dealers of generators in Choenix and sells about
/!;;; of them a year. 'he cost of placing an order with their supplier is KD?;!! and the
inventory-carrying costs are K-D; for each generator. 'hey like to maintain safety stock
of -? at all times.
a What is the firm"s ,3A?
b. How many orders will the firm need to place this year?
c What is the average inventory for the season?
9ol&tion8
6nnual sales = /!;;; units
$ost of placing an order = KD?;
5nventory-carrying cost per generator = K-D;
+afety stock = -? generators
a.
L . -9/
-D; K
;;; ! / D?; K /
ts cos $arrying
period per +ales costs 7eorder /
,3A
=

=

=
,conomic order %uantity = 1,, generators
b. #o. of orders the firm needs to place = /!;;; : -99 = 1/ or%ers
c. 6verage inventory = ((-99 O ;:/ @ -? = C) generators
14,/ 'an4ani%e! 5nc.! sells K/;;!;;; of its accounts receivable to factors at ? percent discount.
'he firm"s average collection period is F; days.
a What is the dollar cost of the factoring service?
b What is the simple annual interest cost of the factors loan?
c What is the effective annual interest cost of the loan?
9ol&tion8
6ccounts receivables sold = K/;;!;;;
)actor discount = ?M
6verage collection period = F; days
a. 0ollar cost of factoring per month = K/;;!;;; x ;.;? = A1D$DDD
0ollar cost over F; days = K-;!;;; x 9 = K9;!;;;
b. +imple monthly interest cost of factoring = ?:F? = ;.;?/>
+imple interest cost of factoring = ;.;?/> x -/ = 2,)B
c
C/D2B = =
+ =

+ =
L?;> . ;
- ;?/> . ; - (
-
rate Auoted
- ,67
-/
m
m
CFA )roble!s
-..9>. 6 company increasing its credit terms for customers from -:-;! net 9; to -:-;! net >; will
likely experience
6. an increase in cash on hand.
E. an increase in the average collection period.
$. higher net income.
0. a higher level of uncollectible accounts.
9ol&tion8
E is correct.
-..9D. +uppose a company uses trade credit with the terms of /:-;! net ?;. 5f the company pays
their account on the ?;th day! the effective borrowing cost of skipping the discount on
day -; is closest to
6. -..>M
E. -..FM
$. -?.;M
0. /;./M
9ol&tion8
0 is correct.
9>?: .;
;.;/
$ost = -@ - /;./. percent
;.FL



=
-..9L. Which of the companies has the lowest accounts receivable turnover in the year /;S/?
6. $ompany 6
E. $ompany E
$. $ompany $
0. $ompany 0
9ol&tion8
E is correct.
$ompany 6( K>.; million:K-./ million = ?.;;
$ompany E( K..; million:K-.? million = /.>D
$ompany $( K9.; million:K-.; million = 9.;;
$ompany 0( K;.> million:K;./ million = 9.;;
-..9F. 'he industry average receivables collection period
6. increased from /;S- to /;S/
E. decreased from /;S- to /;S/
$. did not change from /;S- to /;S/
0. increased along with the increase in the industry accounts receivable turnover.
9ol&tion8
E is correct.
/;S-( D9 days
/;S/( D;.9F9
#ote( 5f the number of days decreased from /;S- to /;S/! the receivable
turnover increased.
-...;. Which of the companies reduced the average time it took to collect on accounts
receivable from /;S- to /;S/?
6. $ompany 6
E. $ompany E
$. $ompany $
0. $ompany 0
9ol&tion8
E is correct.
$ompany E increased its accounts receivable (6:7 turnover and reduced
its number of days of receivables between /;S- and /;S/.
/;S- /;S/
$ompany 6:7 #umber 67 #umber
turnover of days of turnover of days of
receivables receivables
6 ?.;;; D9.;;; ?.;;; D9.;;;
E /.?;; -.>.;;; /.>>D -9>.LD?
$ 9.-/? -->.L;; 9.;;; -/-.>>D
0 ?.;;; D9.;;; 9.;;; -/-.>>D

9ample Test Problems
141 5f your firm"s 0+3 is .D.9 days and the days" sales in inventory is 9F.> days! what is the
firm"s operating cycle?
9ol&tion8
%a*s C2@ =
+ =
+ =
> . 9F 9 . .D
0+5 0+3 cycle 3perating
14) 5f $halet $orp. has an operating cycle of F9.. days and days" payables outstanding of
.L./ days! what is the firm"s cash conversion cycle?
9ol&tion8
%a*s 4/) =
=
+ =
/ . .L . . F9
0C3 0+5 0+3 cycle conversion $ash
14, 7anger $leaning $ompany has borrowed KF;!;;; at a stated 6C7 of L.? percent. 'he
loan calls for a compensating balance of L percent. What is the effective interest rate for
this company?
9ol&tion8
6mount to be borrowed = KF;!;;;
+tated annual interest rate = L.?M
$ompensating balance = LM
6mount deposited as compensating balance = KF;!;;; x ;.;L = KD!/;;
,ffective borrowing amount = KF;!;;; G KD!/;; = KL/!L;;
5nterest expense = KF;!;;; x ;.;L? = KD!>?;
@)4B = = =
KL/!L;;
KD!>?;

amount borrowing ,ffective
expense 5nterest
rate interest ,ffective
144 7osemary $orp. has daily sales of K-9F!;;;. 'he financial manager determined that a
lockbox would reduce the collection time by /./ days. 6ssuming the company can earn
?.? percent interest per year! what are the savings from the lockbox?
9ol&tion8
6verage daily sales = K-9F!;;;
$ollection time saved = /./ days
+avings from mail float = /./ days K-9F!;;; = K9;?!L;;
+avings if invested = K9;?!L;; x (;.;?? = A12$C1@
14/ $hoi ,xports is setting up a line of credit at its bank for KD.? million for up to three years.
'he loan rate is D.LD? percent and also calls for an annual fee of ?; basis points on any
unused balance for the year. 5f the firm borrows K? million on the day the loan agreement
was signed! what is the firm"s effective rate?
9ol&tion8
Line of credit limit = KD!?;;!;;;
Loan rate = D.LD?M
6nnual fee on used balance = ;.?M
6mount borrowed = K?!;;;!;;;
2nused balance = K/!?;;!;;;
6nnual fee = K/!?;;!;;; x ;.;;? = A1)$/DD
5nterest expense = K?!;;;!;;; x ;.;DLD? = K9F9!D?;
CD4B =
+
=
+
=
KD!?;;!;;;
K-/!?;; (K?F;!>/?

amount Eorrowed
fee 6nnual expense 5nterest
rate interest ,ffective