Chapter 12 Managing Working Capital
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1 Managing Working Capital Solutions to Even-Numbered Problems and Cases 12.2 Alton, West Industries, Niagara Supplies Alton West Industries Niagara Supplies Quantity of tools sold each year 5,000 12,000 7,500 Annual unit holding cost $7.50 $4.50 $6.75 Cost of placing an order $ $ $ EOQ 816 1, Number of orders per year (rounded up) Your company Days Discount Current payment period 60 Option % Option % Approximate interest rate Option % 50 Option % 30 (b) Exact interest rate Option 1 {[(1 + 3/97) 365/(60 10)] 1} 100% 24.90% Option 2 {[(1 + 2/98) 365/(60 30)] 1} 100% 27.86% (c) Yes, take the discount. It is better to choose Option 2 because the forgone interest is higher than in Option 1. Copyright 2009 Pearson Education Canada 1
2 12.6 Hercules Wholesalers Ltd (b) The liquidity ratios of the business seem low. The current ratio is only 1.1 (i.e., $306,000/$285,000) and its acid test ratio is 0.6 (i.e., $163,000/$285,000). The business may have insufficient liquid assets to pay its short-term obligations. A cash flow projection for the next period would provide better insight into the liquidity position of the business. The bank overdraft seems high and it would be useful to know whether the bank is pressing for a reduction, and what overdraft limit has been established for the business. The operating cash cycle can be calculated as follows: Average inventory turnover period: [(Opening inventory + Closing inventory)/2] 360 [( ) / 2] 360 Cost of goods sold 323 Number of Days 149 Add: Average collection period for receivables: Accounts receivable 360 Credit sales Less: Average payment period for payables: 279 Accounts payable Credit purchases 341 (153) OCC 126 (c) The business can reduce the operating cash cycle in a number of ways. The average inventory holding period seems quite long: at present, average inventory held represents almost five months sales revenue. This period can be reduced by reducing the level of inventory held. Similarly, the average collection period for receivables seems long at more than four months sales revenue. This may be reduced by imposing tighter credit control, offering discounts, and charging interest on overdue accounts. However, any policy decisions concerning inventory and business must take account of current receivables conditions. The operating cash cycle would also be reduced by extending the period of credit taken to pay suppliers. However, for the reasons mentioned in the chapter, this option must be given careful consideration because the credit period is already very long, at over five months. Copyright 2009 Pearson Education Canada 2
3 12.8 Sparkrite Average inventory turnover period ( ) / days 1, 080 ( ) / days 1,125 Average collection period for receivables * , days , days * Year-end receivables figures were used because opening figures were not available in both years. (b) Ways in which the business can exercise control over inventory levels include: Use of sales forecasting methods to assess demand for inventory. Use of inventory management models to determine the economic order quantity. Proper authorization procedures for ordering inventory. Establishing an accurate inventory-recording system. Use of the just-in-time method improving supplier lead times and to minimize inventory holding. Regular physical inventory checks to ensure accuracy of records and to identify slow-moving and obsolete inventory. Ensuring levels of inventory monitoring and security are appropriate to the value of the inventory held. Ways in which the business can exercise control over receivables levels include: Establishing creditworthiness checks on potential customers. Establishing credit limits. Offering discounts for prompt payment. Charging interest on late payments. Calculating average collection periods and preparing aging schedules of outstanding receivables. Invoicing customers promptly and sending reminders and statements at appropriate points. Checking to see where credit limits have been breached. Establishing a policy for dealing with late payers. Factoring (that is, allowing a finance institution to manage the receivables and obtaining financing on the strength of the receivables) where appropriate. Copyright 2009 Pearson Education Canada 3
4 12.10 Mayo Computers Ltd New proposals from credit control department ($000) ($000) Current level of investment in receivables ($20 million (60/365)) 3,288 Proposed level of investment in receivables [($20 million 60%) (30/365)] (986) [($20 million 40%) (50/365)] (1,096) (2,082) Reduction in level of investment 1,206 The reduction in overdraft interest as a result of the reduction in the level of investment in receivables will be $1,206,000 14% $169,000 (to the nearest thousand dollars). ($000) ($000) Cost of cash discounts offered ($20 million 60% 2.5%) 300 Additional cost of credit administration 20 Total additional costs 320 Bad debt savings (100) Interest charge savings (see above) (169) Total additional savings (269) Net cost of policy each year 51 These calculations show that the business would incur additional annual costs if it implemented this proposal. It would therefore be cheaper to stay with the existing credit policy. Copyright 2009 Pearson Education Canada 4
5 12.12 Delphi The accounts receivable aging schedule is: 1 month or less Number of months outstanding 1 to 2 months 2 to 3 months Total receivables $000 % $000 % $000 % $000 % February TV and hi-fi Music Retail March TV and hi-fi Music Retail April TV and hi-fi Music Retail May TV and hi-fi Music Retail We can see that the receivables will increase substantially in the first four months. The retail chains will account for about 60 per cent of the total receivables outstanding by May, as this group has the fastest rate of growth. There is also a significant decline in the proportion of total receivables outstanding from TV and hi-fi shops over this period. (b) In answering this part of the question, you should refer to the five Cs of credit that were discussed in detail in the chapter. Copyright 2009 Pearson Education Canada 5
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