Uploaded by Primrose Everdeen

Chapter 4 - Working Capital Managementt

“The Lord is my shepherd, I shall not be in want. He makes me
lie down in green pastures, he leads me beside quiet waters, he
restores my soul. He guides me in paths of righteousness for his
name’s sake. Even though I walk through the valley of the
shadow of death, I will fear no evil, for you are with me; your
rod and your staff, they comfort me.”
Psalm 23:1-4
After studying this chapter, you should be able to:
1. Explain the goal of working capital management.
2. Explain the tradeoff between the firm’s profitability and the related risk.
3. Explain the factors to be considered in managing working capital.
4. Explain the different techniques to be employed in cash and marketable
securities management.
5. Explain the different techniques to be employed in receivable management.
6. Explain the different techniques to be employed in inventory management.
7. Explain the different techniques to be employed in accounts payable
8. Explain the different techniques to be employed in short-term credit
Working capital management is an important yardstick to measure a company’s
operational and financial efficiency. This aspect must form part of the company's
strategic and operational thinking. Efforts should constantly be made to improve
the working capital position. This will yield greater efficiencies and improve
customer satisfaction.
The firm’s balance sheet provides information about the structure of the firm’s
investments on one hand and the structure of its financing sources on the other
hand. The structures chosen should consistently lead to the maximization of the
value of the owner’s investment in the firm. Important components of the firm’s
financial structure include the level of investment in current assets and the extent
of current liability financing.
The goal of working capital management is to manage each of the firm’s current
assets (inventory, accounts receivable, cash and marketable securities) and current
liabilities (accounts payable, accruals, and notes payable) to achieve a balance
between profitability and risk that contributes positively to the firm’s value.
A tradeoff exists between a firm’s profitability and its risk. Profitability is the
relationship between revenues and costs generated by using the firm’s assets-both
current and fixed in productive activities. A firm’s profits can be increased by (1)
increasing revenues and (2) decreasing costs. Risk is the probability that a firm will
be unable to pay its bills as they come due. It is generally assumed that the greater
the firm’s net working capital, the lower its risk. In other words, the more net
working capital, the more liquid the firm and therefore the lower its risk of
becoming technically insolvent.
Working capital management refers to the management of current or short-term
assets and short-term liabilities. Components of short-term assets include
inventories, loans and advances, debtors, investments and cash and bank balances.
Short-term liabilities include creditors, trade advances, borrowings and provisions.
The major emphasis is, however, on short-term assets, since short-term liabilities
arise in the context of short-term assets. It is important that companies minimize
risk by prudent working capital management.
 APPROPRIATE LEVEL – This refers to adequacy of working capital. Consider
the nature of business and length of operating cycle.
 STRUCTURAL HEALTH – This refers to composition of working capital.
Consider the need for cash, accounts receivable and other current assets.
 LIQUIDITY – This refers to the relative transformation (and its rate) of
current assets into more liquid current assets (ex. Cash and marketable
In general, sound working capital policy requires:
 Managing cash and its temporary investment efficiently. (Cash/Marketable
Securities Management)
 Ensuring efficient manufacturing operations and sound material procurement.
(Inventory Management)
 Drafting and implementing effective credit and collection policies. (Receivable
 Seeking favorable terms from suppliers and other temporary creditors. (Shortterm Credit Financing)
Cash Management involves the maintenance of the appropriate level of cash to
meet the firm’s cash requirements and to maximize income on idle funds. On the
other hand, MS Management involves the process of planning and controlling
investment in marketable securities to meet the firm’s cash requirements and to
maximize income on idle funds.
The main objective of Cash and MS Management is to minimize the amount of cash
on hand while retaining sufficient liquidity to satisfy business requirements (ex.
Take advantage of cash discounts, maintain credit rating, and meet unexpected
1. Transaction Motive (Liquidity Motive)
- Cash is held to facilitate normal transactions of the business.
2. Precautionary Motive (Contingent Motive)
- Cash is held beyond the normal operating requirement level to provide
for buffer against contingencies, such as slow-down in accounts receivable
collection, possibilities of strikes, etc.
3. Speculative Motive
- Cash is held to avail of business incentives (ex. Discounts) and investment
4. Contractual Motive (Compensating Balance Requirements)
- A company is required by a bank to maintain a certain compensating
balance in its demand deposit account as a condition of a loan extended to
Refers to the average length of time a peso is tied up in current assets. It runs from
the date the company makes payment of raw materials to the date company
receives cash inflows thru collection of accounts receivable. In other words, cash
conversion cycle is simply the company’s operating cycle less the payment period.
The formula for cash conversion cycle is as follows:
Cash Conversion Cycle = Ave. Age of Inventory + Ave. Collection Period – Ave.
Payment Period
The firm’s goal should be to shorten its cash conversion cycle without hurting
operations. The longer is the cash conversion cycle, the greater the need for
external financing; hence, the more cost of financing.
1. Permanent Funding Requirement
This happens when the firm’s sales are constant which means its investment in
operating assets should also be constant.
2. Seasonal Funding Requirement
This happens when the firm’s sales are cyclic that results in an investment in
operating assets that vary over time with its sales cycles. This is in addition to the
permanent funding required for its minimum investment in operating assets.
Seasonal funding requirements can either be aggressive or conservative. Under an
aggressive funding strategy, the firm funds its seasonal requirements with shortterm debt and its permanent requirements with long term debt. On the other hand,
in a conservative funding strategy, the firm funds both its seasonal and its
permanent requirements with long-tem debt. The difference between a
conservative and aggressive funding strategy are summarized below:
Level of current assets
Reliance on long-term financing
Liquidity risk
Profitability and returns
Working Capital Policy
A positive cash conversion cycle means that the firm must use negotiated liabilities
(such as bank loans) to support its operating assets. Negotiated liabilities carry an
explicit cost, so the firm benefits by minimizing their use in supporting operating
assets. Simply stated, the goal is to minimize the length of the cash conversion
cycle, which minimizes negotiated liabilities. This goal can be realized through the
application of the following strategies:
1. Turn over inventory as quickly as possible without stockouts that result in lost
2. Collect accounts receivable as quickly as possible without losing sales from highpressure collection techniques.
3. Manage mail, processing, and clearing time to reduce them when collecting
from customers and to increase them when paying suppliers.
4. Pay accounts payable as slowly as possible without damaging the firm’s credit
Float refers to funds that have been sent by the payer but are not yet usable funds
to the payee. Float is important in the cash conversion cycle because its presence
lengthens both the firms average collection period and its average payment period.
However, the goal of the firm should be to shorten its average collection period
and lengthen its average payment period. Both can be accomplished by managing
the float.
Types of float:
1. POSITIVE (Disbursement) Float – slowing down payment means increasing
payment float and therefore increasing the firm’s average payment period (ex.
Controlled disbursing).
2. NEGATIVE (Collection) Float – speeding up of collections reduces customer
collection float time and thus reduces the firm’s average collection period, which
reduces the investment the firm must make in its cash conversion cycle (ex.
Lockbox system). A lockbox system works as follows: Instead of mailing payments
to the company, customers mail payments to a post office box. The firm’s bank
empties the post office box regularly, processes each payment, and
deposits the payments in the firm’s account.
Component of a float:
1. Mail Float – refers to the time delay between when payment is placed in the
mail and when it is received.
2. Processing Float – is the time between receipt of payment and its deposit into
the firm’s account.
3. Clearing Float – refers to the time between deposit of the payment and when
spendable funds become available to the firm. This component of float is
attributable to the time required for a check to clear the banking system.
Another aspect of cash management is knowing the optimal cash balance. There
are a number of methods that try to determine the magical cash balance, which
should be targeted so that costs are minimized and yet adequate liquidity exists to
ensure bills are paid on time (hopefully with something left over for emergency
purposes). One of the first steps in managing the cash balance is measuring
liquidity. There are numerous ways to measure this, including: cash to total assets
ratio, current ratio (current assets divided by current liabilities), quick ratio (current
assets less inventory, divided by current liabilities), and the net liquid balance (cash
plus marketable securities less short-term notes payable, divided by total assets).
The higher the number generated by the liquidity measure, the greater the liquidity
and vice versa. There is a trade off, however, between liquidity and profitability
that discourages firms from having excessive liquidity.
To help manage cash on a day-to-day basis in actual dollars and cents, there are a
number of cash management models. These include the Baumol Model, Miller-Orr
Model, and the Stone Model. In this discussion we will discuss only Baumol Model.
The Baumol Model is similar to the Economic Order Quantity (EOQ) Model.
Mathematically it is:
Optimal Cash Balance = √ 2 (Annual Cash Requirement) (Cost per Transaction)
Opportunity Cost of Holding Cash
Total Costs of Cash Balance = Holding Costs + Transaction Costs
 Holding Costs = Average Cash Balance* x Opportunity Cost
 Transaction Costs = Number of Transactions** x Cost per Transaction
* Average cash balance = OCB ÷ 2
* Number of transactions = Annual Cash Requirement ÷ OCB
One shortcoming of this model is that it accommodates only a net cash outflow
situation as opposed to both inflows and outflows. Also, the cash outflow is at a
constant rate, with no variation.
Accounts receivable management involves the determination of the amount and
terms of credit to extend to customers and monitoring receivables from credit
customers. The objective for managing accounts receivable is to collect accounts
receivable as quickly as possible without losing sales from high-pressure collection
techniques. Accomplishing this goal encompasses three topics: (1) credit selection
and standards, (2) credit terms, and (3) credit monitoring.
Credit selection involves the application of techniques for determining which
customers should receive credit. This process involves evaluating the customer’s
creditworthiness and comparing it to the firm’s credit standards, its minimum
requirements for extending credit to customers.
Factors to be considered in establishing credit standards – the Five C’s of Credit:
1. Character – the customers’ willingness to pay.
2. Capacity – the customers’ ability to generate cash flows.
3. Capital – the customers’ financial sources.
4. Conditions – the current general and industry-specific economic
conditions, and any unique conditions surrounding a specific transaction.
5. Collateral – the customers’ assets to secure debt.
The firm sometimes will contemplate changing its credit standards in an effort to
improve its returns and create greater value for its owners. This can be done
through relaxation of credit standards. The entity must consider that relaxing
credit standards may attract more customers thereby creating greater sales,
however it would entail more costs of AR such as collection, bad debts and interests
(opportunity costs).
Credit terms are the terms of sale for customers who have been extended credit
by the firm. Terms of net 30 mean the customer has 30 days from the beginning of
the credit period to pay the full invoice amount.
Including a cash discount in the terms is a popular way to achieve the goal of
speeding up collections without putting pressure on customers. The cash discount
provides an incentive for customers to pay sooner. By speeding collections, the
discount decreases the firm’s investment in accounts receivable, but also it
decreases the per-unit profit. Additionally, initiating a cash discount should reduce
bad debts because customers will pay sooner, and it should increase sales volume
because customers who take the discount pay a lower price for the product.
The final issue a firm should consider in its accounts receivable management is
credit monitoring. Credit monitoring is an ongoing review of the firm’s accounts
receivable to determine whether customers are paying according to the stated
credit terms.
Slow payments are costly to a firm because they lengthen the average collection
period and thus increase the firm’s investment in accounts receivable. Two
frequently used techniques for credit monitoring are (1) average collection period
and (2) aging of accounts receivable.
The average collection period is the number of days that credit sales are
outstanding. It has two components: (1) the time from sale until the customer
places the payment in the mail and (2) the time to receive, process, and collect the
payment once it has been mailed by the customer. The formula for finding the
average collection period is
Average collection period =
Accounts receivable
Average sales per day
Assuming receipt, processing, and collection time is constant, the average
collection period tells the firm, on average, when its customers pay their accounts.
Knowing its average collection period enables the firm to determine whether there
is general problem with accounts receivable.
An aging schedule breaks down accounts receivable into groups on the basis of
their time origin. The breakdown is typically made on a month-by-month basis. The
resulting schedule indicates the percentages of the total accounts receivable
balance that have been outstanding for specified periods of time. The purpose of
the aging schedule is to enable the firm to pinpoint problems.
Inventory Management refers to the process of formulation and administration of
plans and policies to efficiently and satisfactorily meet production and
merchandising requirements and minimizes costs relative to inventories. Its
objective is to maintain inventory at a level that best balances the estimates of
actual savings, the cost of carrying additional inventory, and the efficiency of
inventory control.
Numerous techniques are available for effectively managing the firm’s inventory.
The four commonly used techniques used are as follows:
A firm using ABC inventory system divides its inventory into three groups: A, B, and
C. The A group consists of the largest peso investment. Thus, requiring highest
possible control. The B group consists of items that account for the next largest
investment in inventory. They require normal control. The C group consists of a
large number of items that require a relatively small investment. They require the
simplest possible control.
The A group items are tracked on a perpetual inventory system that allows daily
verification of each item’s inventory level. B group items are frequently controlled
through periodic, perhaps weekly, checking of their levels. C group items are
monitored with unsophisticated techniques, such as the two bin method. With the
two bin method, the items are stored in two bins. As an item is needed, inventory
is removed from the first bin. When the bin is empty, an order is placed to refill the
first bin while inventory is drawn from the second bin. The second bin is used until
empty, and so on.
One of the most common techniques for determining the optimal order size for
inventory items is the EOQ model. The EOQ model considers various costs of
inventory and then determines what order size minimizes total inventory cost. The
EOQ assumes that the relevant costs of inventory can be divided into order costs
and carrying costs. Order costs include the fixed clerical costs of placing and
receiving orders. Carrying costs are the variable costs per unit of holding an item
of inventory for a specific period of time.
The EOQ model analyzes the tradeoff between order costs and carrying costs to
determine the order quantity that minimizes the total inventory cost.
The formulas for the EOQ model are as follows:
EOQ = √ 2 x Annual Demand x Ordering Cost
Carrying Cost
Ordering Cost =
Annual Demand
Carrying Cost =
x Order cost per order
x Carrying cost per unit
Once the firm has determined its economic order quantity, its must determine
when to place an order. The reorder point reflects the firm’s daily usage of the
inventory item and the number of days needed to place and receive an order.
Assuming that the inventory is used at a constant rate, the formula for the reorder
point is
Reorder point = Days of lead time x daily usage
The JIT System is used to minimize inventory investment. The philosophy is that
materials should arrive at exactly the time they are needed for production. Ideally,
the firm would only have work-in-process inventory. Because its objective is to
minimize inventory investment, a JIT System uses no (or very little) safety stock.
The goal of the JIT System is manufacturing efficiency. It uses inventory as a tool
for attaining efficiency by emphasizing quality of the materials used and their
timely delivery. When JIT is working properly, it forces process inefficiencies to
Today a number of systems are available for controlling inventory and other
resources. Some of the basic techniques include the following:
A. Materials Requirement Planning (MRP) System
MRP is an inventory management technique that applies EOQ
concepts and computer to compare production needs to available
inventory balances and determine when orders should be placed for
various items on a product’s bill of materials.
B. Manufacturing Resource Planning II (MRP II)
MRP II is a sophisticated computerized system that integrates data
from numerous areas such as finance, accounting, marketing, engineering,
and manufacturing and generates production plans as well as numerous
financial and management reports.
C. Enterprise Resource Planning (ERP)
ERP is a computerized system that electronically integrates
external information about the firm’s suppliers and customers with the
firm’s departmental data so that information on all available resourceshuman and material-can be instantly obtained in a fashion that eliminates
production delays and controls costs.
Accounts payable are the major source of unsecured short-term financing for
business firms. They result from transactions in which merchandise is purchased
but no formal note is signed to show the purchaser’s liability to the seller.
Accounts payable management is the management by the firm of the time elapse
between its purchase of raw materials and its mailing payment to the supplier. The
firm’s goal is to pay as slowly as possible without damaging its credit rating. This
means that accounts should be paid on the last possible, given the supplier’s stated
credit terms.
The credit terms that a firm is offered by its suppliers enable it to delay payments
for its purchases. Because the supplier’s cost of having its money tied up in
merchandise after it is sold is probably reflected in the purchase price, the
purchaser is already indirectly paying for this benefit. The purchaser should
therefore carefully analyze credit terms to determine the best trade credit strategy.
If a firm extended credit terms that include a cash discount, it has two options - to
take the cash discount or give it up.
1. Taking the Cash Discount
If a firm intends to take a cash discount, it should pay on the last day of the discount
period. There is no cost associated with taking a cash discount.
2. Giving up the Cash Discount
If the firm chooses to give up the cash discount, it should pay on the final day of
the credit period. There is an implicit cost associated with giving up a cash discount.
The cost of giving up cash discount is the implied rate of interest paid to delay
payment of an accounts payable for an additional number of days. In other words,
the amount is the interest being paid by the firm to keep its money for a number
of days.
Cost of giving up
cash discount =
Annualized cost of
giving up CD =
Cash Discount
100% - CD
# of Working Days
# of days payment can be delayed
# of Working Days
# of days payment can be
A strategy that is often employed by a firm is stretching accounts payable – that is,
paying bills as late as possible without damaging its credit rating. Such a strategy
can reduce the cost of giving up a cash discount.
Assuming, Lawrence Industries was extended credit terms of 2/10 net 30 EOM. The
cost of giving up the cash discount, assuming on the last day of the credit period,
was found to be approximately 36.5% [2% x ( 365/20)]. If the firm were able to
stretch its accounts payable to 70 days without damaging its credit rating, the cost
of giving up the cash discount would be only 12.2% [2% x (365/60)]. Stretching
accounts payable reduces the implicit cost of giving up a cash discount.
Although stretching accounts payable may be financially attractive, it raises an
important ethical issue: It may cause the firm to violate the agreement it entered
into with its supplier when it purchased merchandise. Clearly, a supplier would not
look kindly on a customer who regularly and purposely postponed paying for
The cost of bank loan is actually the entity’s effective annual rate. The cost of
bank loan and commercial papers can be computed by using the following
1. Without Compensating Balance
a. If not discounted (cash proceeds normally equal face value).
Amount Received (Face)
b. If discounted (cash proceeds is net of interest – deducted in
Face Value – Interest
2. With Compensating Balance (CB)
a. If not discounted
Face Value - CB
Nominal %
100% - CB%
b. If discounted
Face Value – Interest
– CB
Nominal %
100% - Nominal%
- CB%
Interest + Issue Costs
Face Value – Interest – Issue Costs
360 days
Koyot Company, a producer of paper dinnerware, has annual sales of P10,000,000,
a cost of goods sold of 75% of sales, and purchases that are 65% of cost of goods
sold. Average inventory is P1,250,000, average receivables is P1,500,000 and
average accounts payable is P406,250.
1. Compute for the Receivable Turnover.
2. Compute for the Inventory Turnover.
3. Compute for the Payable Turnover.
4. Compute for the Average Collection Period, Age of Inventory,
and Payment Period.
5. Compute for Operating Cycle.
6. Compute for Cash Conversion Cycle.
Arius Company holds, on average, P50,000 in cash and marketable securities,
P1,250,000 in inventory, and P750,000 in accounts receivable. Arius’ business is
stable over time, so its operating assets can be viewed as permanent. In addition,
Arius’ accounts payable of P425,000 are stable over time.
In contrast, Julien Isabel Company, which produces bicycle pumps, has seasonal
funding needs. Julien has seasonal sales, with its peak sales being driven by the
summertime purchases of bicycle pumps. Julien holds at minimum, P25,000 in cash
and marketable securities, P100,000 in inventory, and P60,000 in accounts
receivable. At peak times, Julien’s inventory increases to P750,000 and its accounts
receivable increases to P400,000. To capture production efficiencies, Julien
produces pumps at a constant rate throughout the year. Thus, accounts payable
remain at P50,000 throughout the year.
1. Compute for Arius Company’s permanent funding requirement.
2. Compute for Julien Isabel Company’s permanent funding requirement.
3. Compute for Julien Isabel Company’s peak seasonal funding requirement.
Matinik Corporation is expecting to have total payments of P1,800,000 for one
year, cost per transaction amounted to P25 and the interest rate of marketable
securities is 10%.
1. What is the company’s optimal initial cash balance that minimizes total cost?
2. What is the total number of transactions (cash conversions) that will be required
per year?
3. What will be the average cash balances for the period?
4. What is the total cost of maintaining cash balances?
(Adapted: Principles of Managerial Finance by Lawrence J. Gitman)
It typically takes Matinik Corporation 8 calendar days to receive and deposit
customer remittances. Matinik is considering adopting a lockbox system and
anticipates that the system will reduce the float time to 5 days. Average daily cash
receipts are P220,000. The rate of return is 10 percent.
1. How much is the reduction of float in cash balances associated with
implementing the system?
2. What is the amount of return associated with the earlier receipt of the funds?
3. If the lockbox costs P7,500 per month to implement, should the system be
(Adapted: Financial Management Principles and Applications by Keown, et. al.)
SPSBL Corp., a manufacturer of tools is currently selling a product for P10 per unit.
Sales (all on credit) for last year were 60,000 units. The variable cost per unit is P6.
The firm’s total fixed costs are P120,000.
The firm is currently contemplating a relaxation of credit standards that is expected
to result in the following: a 5% increase in unit sales to 63,000 units; an increase in
the average collection period from 30 days to 45 days; an increase in bad-debt
expenses from 1% of sales to 2%. The firm’s required return no equal-risk
investments, which is the opportunity cost of tying up funds in accounts receivable,
is 15%.
1. Should the proposed relaxation in credit standards be implemented?
X Company has an average collection period of 40 days. In accordance with the
firm’s credit terms of net 30, this period is divided into 32 days until the customers
place their payments in the mail and 8 days to receive, process, and collect
payment once they are mailed. X Company is considering initiating a cash discount
by changing its credit terms from net 30 to 2/10 net 30. The firm expects this
change to reduce the amount of time until the payments are placed in the mail,
resulting in an average collection period of 25 days. X has raw materials with
current annual usage of 1,100 units. Each finished product produced requires 1 unit
of this raw material at a variable cost of P1,500 per unit, incurs another P800 of
variable cost in the production process, and sells for P3,000 on terms net 30. X
Company estimates that 80% of its customers will take the 2% discount and that
offering the discount will increase sales of the finished product by 50 units per year
but will not alter its bad-debt percentage. X opportunity cost of funds invested in
accounts receivable is 14%.
1. Should X offer the proposed cash discount?
Jems Company presents the following information:
Annual credit sales: P25,200,000
Rate of return: 18%
Collection period: 3 months
Terms: n/30
The company considers to offer a 4/10, n/30 credit term. It anticipates that 30%
of its customers will take advantage of the discount while sales would remain
constant. The collection period is expected to decrease to two months.
1. What is the net advantage (disadvantage) of implementing the proposed
discount policy?
The Leaf Corporation reports the following information:
Selling price per unit
Variable cost per unit
Total fixed costs
Annual credit sales
240,000 units
Collection period
3 months
Rate of return
The Leaf Corporation, which has enough idle capacity, considers relaxing its credit
standards (i.e., more liberal extension of credit). The following is expected to
result: sales will increase by 25%; collection period will increase to 4 months; bad
debt losses are expected to be 5% on the incremental sales; and collection costs
will increase by P40,000.
1. Should the proposed relaxation in credit standards be implemented?
S Company has an A group inventory item that is vital to the production process.
This item costs P1,500 and S uses 1,100 units of the item per year. The cost per
order is P150 per order while the carrying cost per unit per year is P200. S wants
to determine its optimal order strategy for the item. S operates 250 days per
year. Its lead time is 2 days and S wants to maintain a safety stock of 4 units.
1. Compute for the Economic Order Quantity.
2. Compute for the reorder point.
Hurkin Manufacturing Company pays accounts payable on the tenth day after
purchase. The average collection period is 30 days, and the average age of
inventory is 40 days. The firm currently has annual sales of about P18 Million. The
firm is considering a plan that would stretch its accounts payable by 20 days. It
the firm pays 12% per year for its resource investment, what annual savings can it
realize by this plan?
Thompson Paint Company uses 60,000 gallons of pigment per year. The cost of
ordering pigment is P200 per order, and the cost of carrying the pigment in
inventory is P1 per gallon per year. The firm uses pigment at a constant rate every
day throughout the year.
1. Calculate the EOQ.
2. Assuming that it takes 20 days to receive an order it has been placed,
determine the reorder point in terms of gallons of pigment.
Regency Rug Repair Company is trying to decide whether it should relax its credit
standards. The firm repairs 72,000 rugs per year at an average price of P32 each.
Bad debt expenses are 1% of sales, the average collection period is 40 days, and
the variable cost per unit is P28. Regency expects that if it does relax its credit
standards, the average collection period will increase to 48 days and that bad
debt expense will increase to 1and 1/2% of sales. Sales will increase by 4,000
repairs per year. The firm has a required rate of return on equal-risk investments
of 14%.
1. Should the company relax its credit standards?
Law Industries, operator of a small chain video stores, purchased P1,000 worth of
merchandise on February 27 from a supplier extending terms of 2/10 net 30
EOM. If Law gives up the cash discount, payment can be made on March 30. To
keep its money for an extra 20 days, it will cost the firm P20 to delay payment for
20 days.
1. Should the company take or give up the cash discount?
Mason Products, a large building-supply company, has four possible suppliers,
each offering different credit terms. The information for the four suppliers are as
Credit Terms
2/10 net 30
1/10 net 55
3/20 net 70
4/10 net 60
If the firm needs short term funds, it can borrow from its bank at an interest rate
of 13%.
1. Which of the following suppliers discount should be taken up and which is to be
given up?
ABC Trading Co. was granted a P200,000 bank loan with 12% stated interest.
Required: The effective annual rate under the following cases:
1. ABC receives the entire amount of P200,000.
2. ABC was granted a discounted loan.
3. ABC is required to maintain a compensating balance of P10,000 under the nondiscounted loan.
4. ABC is required to maintain a compensating balance of 10% under a discounted
ABC Co. plans to sell P100,000,000 in 180-day maturity paper, which it expects to
pay discounted interest at an annual rate of 12%. Due to this commercial paper,
ABC expects to incur P100,000 in dealer placement fees and paper issuance costs.
Required: The effective cost of ABC’s credit.
(Sources: CMA/CIA/RPCPA/AICPA/Various test banks)
1. Wales Company has P8,000,000 in current assets, P3,500,000 of which are
considered permanent current assets. In addition, the firm has P6,000,000
invested in fixed assets. Wales Company wishes to finance all fixed assets
and permanent current assets plus half of its temporary current assets with
long-term financing costing 15 percent. Short-term financing currently costs
10 percent. Wales Company’s earnings before interest and taxes are
P2,200,000. Income tax rate is 40 percent.
How much would Wales Company’s earnings after taxes under this financing
A. P212,500
C. P225,000
B. P127,500
D. P 85,000
2. Luminous Co. has total fixed assets of P100,000 and no current liabilities. The
table below displays its wide variation in current asset components.
1st Qtr
2nd Qtr
3rd Qtr
4th Qtr
P 20,000
P 10,000
P 15,000
P 20,000
Accts receivable
If Luminous’ policy is to finance all fixed assets and half the permanent
current assets with long-term financing and rest with short-term financing,
what is the level of long-term financing?
A. P 68,000
C. P150,000
B. P100,000
D. P155,625
3. Holding all other variables constant, which of the following would increase a
firm's external funding requirements in the planning period?
A. An increase in assets
C. An increase in dividends paid
B. A decrease in accruals
D. All of the above
4. Common sources of short-term financing include:
A. Stretching payables
C. Reducing inventory
B. Issuing bonds
D. All of the above
5. The type of company most likely to need short-term financing is one that
A. has no seasonality and no growth in sales from year to year
B. sells only for cash
C. has a high degree of seasonality
D. has lower total fixed costs than total variable costs
6. The goal of managing working capital, such as inventory, should be to minimize
A. costs of carrying inventory
B. opportunity cost of capital
C. aggregate of carrying and shortage costs
D. amount of spoilage or pilferage
7. Zap Company follows an aggressive financing policy in its working capital
management while Zing Corporation follows a conservative financing policy.
Which one of the following statements is correct?
A. Zap has low ratio of short-term debt to total debt while Zing has a high
ratio of short-term debt to total debt.
B. Zap has a low current ratio while Zing has a high current ratio.
C. Zap has less liquidity risk while Zing has more liquidity risk.
D. Zap finances short-term assets with long-term debt while Zing finances
short-term assets with short-term debt.
8. Short-term financing plans with high liquidity have:
A. high return and high risk
B. moderate return and moderate risk
C. low profit and low risk
D. none of the above
9. Temporary working capital supports
A. the cash needs of the company.
B. payment of long term debt.
C. acquisition of capital equipment.
D. seasonal peaks.
10. As a firm's cash conversion cycle increases, the firm:
A. becomes less profitable
B. increases its investment in working capital
C. reduces its accounts payable period
D. incurs more shortage costs
11. The average length of time a peso is tied up in current asset is called the:
A. net working capital.
C. receivables conversion period.
B. inventory conversion period.
D. cash conversion period.
12. All of these factors are used in credit policy administration except:
A. credit standards
C. peso amount of receivables
B. terms of trade
D. collection policy
13. Which of the following statements is most correct? If a company lowers its
DSO, but no changes occur in sales or operating costs, then:
the company might well end up with a higher debt ratio.
the company might well end up with a lower debt ratio.
the company would probably end up with a higher ROE.
the company's total asset turnover ratio would probably decline.
14. All but which of the following is considered in determining credit policy?
A. Credit standards
C. Accounts
B. Credit limits
D. Collection efforts
15. When a specified level of safety stock is carried for an item in inventory, the
average inventory level for that item
decreases by the amount of the safety stock.
is one-half the level of the safety stock.
Increases by one-half the amount of the safety stock.
Increases by the number of units of the safety stock.
16. Which of the following statements is correct for a firm that currently has total
costs of carrying and ordering inventory that are 50% higher than total carrying
A. Current order size is greater than optimal
B. Current order size is less than optimal
C. Per unit carrying costs are too high
D. The optimal order size is currently being used
17. The Spades Company has an inventory conversion period of 75 days, a
receivables conversion period of 38 days, and a payable payment period of 30
days. What is the length of the firm’s cash conversion cycle?
A. 83 days
B. 113 days
C. 67 days
D. 45 days
18. Samaritan Supplies, Inc. has P5 million in inventory and P2 million in accounts
receivable. Its average daily sales are P100,000. The company has P1.5 million
in accounts payable. Its average daily purchases are P50,000. What is the
length of the company’s cash conversion period?
A. 50 days
C. 30 days
B. 20 days
D. 40 days
19. Samaritan Supplies, Inc. has P5 million in inventory and P2 million in accounts
receivable. Its average daily sales are P100,000. The company has P1.5 million
in accounts payable. Its average daily purchases are P50,000. What is the
length of the company’s inventory conversion period?
A. 50 days
C. 120 days
B. 90 days
D. 40 days
20. Simile Inc. has a total annual cash requirement of P9,075,000 which are to be
paid uniformly. Simile has the opportunity to invest the money at 24% per
annum. The company spends, on the average, P40 for every cash conversion
to marketable securities.
What is the optimal cash conversion size?
A. P60,000
C. P45,000
B. P55,000
D. P72,500
21. Hyperbole Corporation estimates its total annual cash disbursements of
P3,251,250 which are to be paid uniformly. Hyperbole has the opportunity to
invest the money at 9% per annum. The company spends, on the average,
P25 for every cash conversion to marketable securities and vice versa.
What is the opportunity cost of keeping cash in the bank account?
A. P3,825.00
C. P4,190.00
B. P1,912.50
D. P 188.55
22. What are the expected annual savings from a lock-box system that collects 150
checks per day averaging P500 each, and reduces mailing and processing times
by 2.5 and 1.5 days respectively, if the annual interest rate is 7%?
A. P 5,250
C. P 21,000
B. P 13,125
D. P300,000
23. The Camp Company has an inventory conversion period of 60 days, a
receivable conversion period of 30 days, and a payable payment period of 45
days. The Camp’s variable cost ratio is 60 percent and annual fixed costs of
P600,000. The current cost of capital for Camp is 12%.
If Camp’s annual sales are P3,375,000 and all sales are on credit, what is the
firm’s carrying cost on accounts receivable, using 360 days year?
A. P281,250
C. P 20,250
B. P168,750
D. P 56,250
24. Caja Company sells on terms 3/10, net 30. Total sales for the year are
P900,000. Forty percent of the customers pay on the tenth day and take
discounts; the other 60 percent pay, on average, 45 days after their
What is the average amount of receivables?
A. P70,000
C. P77,200
B. P77,500
D. P67,500
25. Currently, La Carlota Company has annual sales of P2,500,000. Its average
collection period is 45 days, and bad debts are 3 percent of sales. The credit
and collection manager is considering instituting a stricter collection policy,
whereby bad debts would be reduced to 1.5 percent of total sales, and the
average collection period would fall to 30 days. However, sales would also
fall by an estimated P300,000 annually. Variable costs are 75 percent of sales
and the cost of carrying receivables is 10 percent. Assume a tax rate of 40
percent and 360 days per year.
What would be the decrease in investment in receivables if the change were
A. P 9,688
C. P 96,875
B. P 12,988
D. P129,975
26. Marsman Co. has determined the following for a given year:
Economic order quantity (standard order size)
5,000 units
Total cost to place purchase orders for the year
Cost to place one purchase order
Cost to carry one unit for one year
What is Marsman’s estimated annual usage in units?
A. 1,000,000
C. 500,000
B. 2,000,000
D. 1,500,000
P 100
27. For Raw Material L12, a company maintains a safety stock of 5,000 pounds.
Its average inventory (taking into account the safety stock) is 12,000 pounds.
What is the apparent order quantity?
A. 18,000 lbs.
C. 14,000 lbs.
B. 6,000 lbs.
D. 24,000 lbs
28. Durable Furniture Company uses about 200,000 yards of a particular fabric
each year. The fabric costs P25 per yard. The current policy is to order the
fabric four times a year. Incremental ordering costs are about P200 per order,
and incremental carrying costs are about P0.75 per yard, much of which
represents the opportunity cost of the funds tied up in inventory.
How much total annual costs are associated with the current inventory
A. P19,550
C. P38,300
B. P18,750
D. P62,500
29. The cost of discounts missed on credit terms of 2/10, n/60 is
A. 2.0 percent
C. 12.4 percent
B. 14.9 percent
D. 21.2 percent
30. What is the effective rate of a 15% discounted loan for 90 days, P200,000,
with 10% compensating balance? Assume 360 days per year.
A. 20.0%
B. 15.0%
C. 17.4%
D. 22.2%
31. The Premiere Company obtained a short-term bank loan for P1,000,000 at
an annual interest rate 12%. As a condition of the loan, Premiere is
required to maintain a compensating balance of P300,000 in its checking
account. The checking account earns interest at an annual rate of 3%.
Premiere would otherwise maintain only P100,000 in its checking account
for transactional purposes. Premiere’s effective interest costs of the loan is
A. 12.00%
B. 14.25%
C. 16.30%
D. 15.86%
32. An invoice of a P100,000 purchase has credit terms of 1/10, n/40. A bank loan
for 8 percent can be arranged at any time. When should the customer pay the
A. Pay on the 1st.
C. Pay on the 40th
B. Pay on the 10th
D. Pay on the 60th
33. The Peninsula Commercial Bank and Island Corporation agreed to the following
loan proposal:
 Stated interest rate of 10% on a one-year discounted loan; and
 15% of the loan as compensating balance on zero-interest current
account to be maintained by Island Corporation with Peninsula
Commercial Bank.
The loan requires a net proceeds of P1.5 million. What is the principal amount
of loan applied for as part of the loan agreement?
A. P1,666,667
B. P2,000,000
C. P1,764,706
D. P1,125,000
34. Every 15 days a company receives P10,000 worth of raw materials from its
suppliers. The credit terms for these purchases are 2/10, net 30, and payment
is made on the 30th day after each delivery. Thus, the company is considering
a 1-year bank loan for P9,800 (98% of the invoice amount). If the effective
annual interest rate on this loan is 12%, what will be the net peso savings
over the year by borrowing and then taking the discount on the materials?
A. P3,624
C. P4,800
B. P1,176
D. P1,224
35. Perlas Company borrowed from a bank an amount of P1,000,000. The bank
charged a 12% stated rate in an add-on arrangement, payable in 12 equal
monthly installments.
A. 22.15%
C. 25.05%
B. 24.00%
D. 12.70%