CHAPTER 6
WORKING CAPITAL MANAGEMENT
SOLUTIONS TO SELF-TEST EXERCISES
Exercise 1 – Measuring working capital efficiencies
a) Days of working capital
2006
Accounts receivable
Inventory
Sub-total
Accounts payable
Net
$ 35,000
50,000
85,000
17,000
$ 68,000
2007
$ 45,000
65,000
110,000
20,000
$ 90,000
For the year 2006
Accounts receivable + inventory – (accounts payable)
---------------------------------------------------------------Average daily sales
$ 68,000
= ----------- = 70.9 days
$ 959
For the year 2007
Accounts receivable + inventory – (accounts payable)
---------------------------------------------------------------Average daily sales
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$ 90,000
= ----------$1,151
= 78.2 days
Chapter 6 – Working Capital Management
b) Cash conversion efficiency ratio for the year 2007
2007
Net income
Amortization
Change in net working capital
$ 33,000
40,000
( 17,000)
Operating cash flow
$ 56,000
Accounts receivable
Inventory
Accounts payable
Notes payable
($10,000)
( 15,000)
3,000
5,000
Change un net working capital
($17,000)
Operating cash flow
------------------------Sales revenue
=
$ 56,000
-------------$ 420,000
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=
13.3%
Chapter 6 – Working Capital Management
Exercise 2 – The cash conversion cycle
The cash conversion cycle for the year 2006 is 104.6 and for the year 2007, 117.6. Here
are the calculations:
2006
2007
Accounts receivable conversion period
$35,000
---------- = 36.5
$959
$45,000
---------- = 39.1
$1,151
Inventory conversion period
$50,000
--------- = 103.1
$485
$65,000
---------- = 113.4
$573
Accounts payable deferral period
$ 17,000
---------- = 35.0
$485
$20,000
---------- = 34.9
$573
a) Accounts receivable conversion period
b) Inventory conversion period
c) Operating cycle
d) Accounts payable deferral period
e) Cash conversion cycle
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2006
2007
36.5
103.1
139.6
35.0
104.6
39.1
113.4
152.5
34.9
117.6
Chapter 6 – Working Capital Management
Exercise 3 – Earning interest on investments
CompuTech Inc. would earn $65.75 and is calculated as follows.
20 days
$ 10,000 x 12% x ----------365 days
=
$65.75
Exercise 4 – Establishing the minimum cash reserve
CompuTech’s minimum cash balance would be set at $9,333 and is calculated as follows.
Step 1: Average daily cash expenditures would be $933 ($28,000 ÷ 30).
Step 2: Cash reserve would be $9,333 ($933 x 10).
Exercise 5 – Trade discount policies
The company should adopt the 1/10, N/30 day credit policy. Here is the calculation.
10-day
payment
65-day
payment
Effective price
$ 247.50
$ 250.00
Cost of goods
Credit cost
Interest on money
- 110.00
.33
+ 4.11
- 110.00
- 2.15
--
Net income
$ 141.28
$ 137.85
Exercise 6 – Establishing a credit policy
Operating return on investment gives 15%. If the company wants to earn 20%, the Millers
should not change the credit terms.
Incremental operating income
------------------------------------------------------Incremental investment in accounts receivable
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=
$ 3,000
------------ = 15%
$20,000
Chapter 6 – Working Capital Management
Exercise 7 – Impact of revised credit policy on ROI
The expected increase is $ 975. The Millers should therefore change its credit policy.
Here is the calculation.
A. Incremental net income
Increase in sales
1,000 x $10.00 =
Marginal cost of
1,000 x $6.50 =
increased sales
Operating income before bad debts
Increase in bad debts before tax
Income from additional sales
Income tax @ 35%
Net income
$ 10,000
6,500
3,500
2,000
1,500
525
$ 975
B. Incremental investment in accounts receivable
Sales per month at old level = 4,000 x $10 x 1/12
=
$ 3,333
Sales per month at new level = 5,000 x $10 X 2/12 =
8,333
Increase in accounts receivable investment
$ 5,000
To achieve the annual after-tax return of 16% on this investment, annual net income
would have to be increased by $800 (16% X $5,000).
Exercise 8 – The economic ordering quantity
The company should order 180 units per order.
EOQ
=
2 X $1.50 X 2,500
=
$0.23
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180 units
Chapter 6 – Working Capital Management
Exercise 9 – Monthly inventory replenishment
CompuTech should place 1 order every six weeks (7.56 ÷ 12).
a) Economic ordering quantity
2 x $3.50 x 4,000
EOQ =
= 529 units
$0.10
b) Orders per month
4,000
-------- =
529
7.56 orders per year
or 1 order every six weeks (7.56 orders ÷ 12)
Exercise 10 – Slowing the disbursements to suppliers
If bills were paid at the 50-day limit, the accounts payable would increase to $27,600
($562 x 50 = $28,100). This would add an extra $8,100 in cash ($28,100 - $20,000) and
be considered as additional financing obtained from suppliers.
Average daily purchases
Average payment practices
=
=
$205,000
-------------365
=
$562
$20,000
----------$562
=
36 days
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