Chapter 17 - Answer

CHAPTER 17

ADDRESSING WORKING CAPITAL

POLICIES AND MANAGEMENT OF

SHORT-TERM ASSETS AND LIABILITIES

1. These are firms with relatively long inventory periods and/or relatively long receivables periods. Thus, such firms tend to keep inventory on hand, and they allow customers to purchase on credit and take a relatively long time to pay.

2. These are firms that have a relatively long time between the time purchased inventory is paid for and the time that inventory is sold and payment received. Thus, these are firms that have relatively short payables periods and/or relatively long receivable cycles.

3. Carrying costs will decrease because they are not holding goods in inventory. Shortage costs will probably increase depending on how close the suppliers are and how well they can estimate need. The operating cycle will decrease because the inventory period is decreased.

4. Since the cash cycle equals the operating cycle minus the accounts payable period, it is not possible for the cash cycle to be longer than the operating cycle if the accounts payable period is positive. Moreover, it is unlikely that the accounts payable period would ever be negative since that implies the firm pays its bills before they are incurred.

II. Multiple Choice Questions

1. C 6. A 11. C 2. C 7. B 12. B 3. B 8. D 13. D 4. C 9. C 14. B 5. D 10. B

III. Problems

Problem 1 (Cash Equation)

The total liabilities and equity of the company are the net book worth, or market value of equity, plus current liabilities and long-term debt, so:

Total liabilities and equity = 10,380 + 1,450 + 7,500 = 19,330 ₱ ₱

This is also equal to the total assets of the company. Since total assets are the sum of all assets, and cash is an asset, the cash account must be equal to total assets minus all other assets, so:

Cash = 19,330 – 15,190 – 2,105 = 2,035₱ ₱ We have NWC other than cash, so the total NWC is:

NWC = 2,105 + 2,035 = 4,140 ₱ ₱

We can find total current assets by using the NWC equation. NWC is equal to:

NWC = CA – CL 4,140 = CA – 1,450

₱ ₱

CA = 5,590₱

Problem 2 (Changes in the Operating Cycle)

a. Increase. If receivables go up, the time to collect the receivables would increase, which increases the operating cycle.

b. Increase. If credit repayment times are increased, customers will take longer to pay their bills, which will lead to an increase in the operating cycle.

c. Decrease. If the inventory turnover increases, the inventory period decreases.

d. No change. The accounts payable period is part of the cash cycle, not the operating cycle.

e. Decrease. If the receivables turnover increases, the receivables period decreases.

f. No change. Payments to suppliers affects the accounts payable period, which is part of the cash cycle, not the operating cycle.

Problem 3 (Changes in Cycles)

a. Increase; Increase. If the terms of the cash discount are made less favorable to customers, the accounts receivable period will lengthen. This will increase both the cash cycle and the operating cycle.

b. Increase; No change. This will shorten the accounts payable period, which will increase the cash cycle. It will have no effect on the operating cycle since the accounts payable period is not part of the operating cycle.

c. Decrease; Decrease. If more customers pay in cash, the accounts receivable period will decrease. This will decrease both the cash cycle and the operating cycle.

d. Decrease; Decrease. Assume the accounts payable period does not change. Fewer raw materials purchased will reduce the inventory period, which will decrease both the cash cycle and the operating cycle.

e. Decrease; No change. If more raw materials are purchased on credit, the accounts payable period will tend to increase, which would decrease the cash cycle. We should say that this may not be the case. The accounts payable period is a decision made by the company’s management. The company could increase the accounts payable account and still make the payments in the same number of days. This would leave the accounts payable period unchanged, which would leave the cash cycle unchanged. The change in credit purchases made on credit will not affect the inventory period or the accounts payable period, so the operating cycle will not change.

f. Increase; Increase. If more goods are produced for inventory, the inventory period will increase. This will increase both the cash cycle and operating cycle.

Problem 4 (The Operating and Cash Cycles)

We first need the turnover ratios. Note that we use the average values for all balance sheet items and that we base the inventory and payables turnover measures on cost of goods sold:

Inventory turnover = 11,375/ [( 1,273 + 1,401)/2] = 8.51 times₱ ₱ ₱ Receivables turnover = 14,750/ [( 3,782 + 3,368)/2] = 4.13 times₱ ₱ ₱ Payables turnover = 11,375/ [( 1,795 + 2,025)/2] = 5.96 times₱ ₱ ₱ We can now calculate the various periods:

Inventory period = 365 days/8.51 times = 42.89 days Receivables period = 365 days/4.13 times = 88.38 days Payables period = 365 days/5.96 times = 61.24 days

So the time it takes to acquire inventory and sell it is about 43 days. Collection takes another 88 days, and the operating cycle is thus 43 + 88 = 131 days. The cash cycle is thus 131 days less the payables period: 131 – 61 = 70 days.

Problem 5 (Working Capital) a. Working Capital = 400,000₱

Net Working Capital = 400,000 − 200,000 = ₱ ₱ ₱200,000 Current Ratio = 400,000/ 200,000 = ₱ ₱ 2 times

b. Five Star’s return on equity is 12.5 percent ( 62,700/ 500,000).₱ ₱ Five Star Manufacturing Company

Income Statement

For the Year Ended December 31, 2011

Net sales ₱800,000

EBIT (20% of sales) 160,000 Less: Interest expense

Long-term debt (15%) 45,000 Earnings before taxes 95,000 Less: Income taxes (34%) 32,300

Net income ₱62,700

c. The net working capital and current ratios for each strategy are shown below:

Strategies

Current Assets as a Percent of Sales 30% 50% 70% Current assets (CA) ₱300,000 ₱ 500,000 ₱ 700,000 Fixed assets 600,000 600,000 600,000 Total assets ₱900,000 ₱1,100,000 ₱1,300,000 Current liabilities (CL)* ₱180,000 ₱ 200,000 ₱ 260,000 Long-term liabilities 270,000 330,000 390,000 Total liabilities ₱450,000 ₱ 550,000 ₱ 650,000 Stockholders’ equity (SE) 450,000 550,000 650,000 Total liabilities and equity ₱900,000 ₱1,100,000 ₱1,300,000 Net working capital (CA – CL) ₱120,000 ₱ 300,000 ₱ 440,000 Current ratio (CA/CL) 1.7 times 2.5 times 2.7 times *Assume that all current liabilities are in the form of short-term debt. d. The firm’s liquidity position, as measured by the amount of net working

capital and current ratio, improves when current assets are a higher percentage of sales.

e. The rate of return on equity for each strategy is shown below: Strategies

Current Assets as a Percent of Sales 30% 50% 70% Net sales ₱1,000,000 ₱1,000,000 ₱1,000,000 EBIT (18% of sales) 180,000 180,000 180,000 Interest expense Short-term debt (10%) 18,000 20,000 26,000 Long-term debt (15%) 40,500 49,500 58,500 Earnings before taxes (EBT) 121,500 110,500 95,500 Income taxes (34%) 41,310 37,570 32,470

Net income ₱ 80,190 ₱ 72,930 ₱ 63,030 Return on equity (NI/SE) 17.8% 13.0% 9.7% f. Five Star’s profitability decreases as liquidity increases. For example, the firm’s liquidity (current ratio = 2.7 times) is the highest but profitability (ROE = 9.7 percent) is the lowest when current assets are 70 percent of sales.

g. The return on equity, net working capital and current ratio for each strategy are shown below:

Financing- Mix Strategies Restricted Compromise Flexible EBIT ₱180,000 ₱180,000 ₱180,000 Interest expenses

Short-term (10%) 10,000 30,000 45,000 Long-term (15%) 52,500 22,500 0 Earnings before taxes (EBT) 117,500 127,500 135,000 Income taxes (34%) 39,950 43,350 45,900 Net income ₱77,550 ₱84,150 ₱89,100 Return on equity (NI/SE) 17.2% 18.7% 19.8% Net working capital (CA – CL) ₱200,000 0 ( 150,000)₱ Current ratio (CA/CL) 3.0 times 1.0 times 0.7 times