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MODULE 8
Working capital management
Given the strategic choices surveyed in Modules 4 through 7, the financial executive must also attend to shorter-term
operating decisions. This includes the day-to-day, week to-week, and month-to-month management of working capital and
liquidity. In this module, you look at the management of overall working capital and its various components. You review the
major categories of current assets (cash and marketable securities, accounts receivable, and inventories) and the
management of accounts payable as a major source of short-term funding. Module 1 covered bank and other short-term
loans, which represent the other major category of current liabilities.
Comments on the required reading
● Before reviewing the Module Notes, read the text readings, in the following sequence:
r Chapter 4*
r Chapter 24 (pages 930 – 944 and 949 – 950); omit subsections “Bank Loans,” “Factor Arrangements,” and
“Money Market Instruments” (pages 944 – 949)
r Chapter 23
● For Examples 24-1 to 24-3 in Section 24.2, you should understand what components of net working capital would
change when trade credit terms are altered. The details of marginal analysis are not required.
* While Chapter 4 is not required reading for this module, it is required reading for Module 10. It is recommended
you review the sections on ratios, especially Section 4.5 (pages 116 – 120). This will assist you in your study of Topic
8.6.
Module topics and learning objectives
8.1 Net working capital (NWC) management Describe net working capital (NWC). (Level 2)
8.2 Objective of net working capital management Describe the objective of NWC management.
(Level 2)
8.3 Net working capital management procedure Describe the procedure for NWC management.
(Level 3)
8.4 Optimal levels for cash and marketable securities Describe the factors that determine the optimal
levels for cash and marketable securities. (Level 2)
8.5 Cash management techniques Explain cash management techniques. (Level 1)
8.6 Optimal levels for accounts receivable Describe the factors that determine the optimal
levels for accounts receivable, and use a
spreadsheet application to construct and analyze a
cash budget. (Level 1)
8.7 Optimal levels for inventory Describe the factors that determine the optimal
levels for inventory. (Level 2)
8.8 Managing accounts payable Explain the main issues relevant to managing
accounts payable; apply ethical reasoning in
resolving accounts payable management issues.
(Levels 1 and 2)
8.9 Securitization Describe the process of securitization. (Level 2)
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8.10 Cyclical patterns and cash flow planning Describe the important cyclical patterns in NWC,
and use a spreadsheet application to construct a
cash budget that allows planning for cash
shortfalls and surpluses. (Level 1)
8.11 International complications Describe international complications that arise
from multinational operations. (Level 3)
Module summary
Print this module
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8.1 Net working capital (NWC) management
Learning objective
● Describe net working capital (NWC). (Level 2)
Required reading
● Chapter 23, Section 23.1 (pages 902 – 905, excluding subsection “The Cash Budget”)
LEVEL 2
Net working capital (NWC) is defined as current assets minus current liabilities. For this course, this includes the following:
Current assets:
● Cash
● Marketable securities
● Accounts receivable
● Inventory
Current liabilities:
● Accounts payable
● Bank and other short-term loans
● Taxes payable
Changes in these accounts occur as a result of a firm’s normal day-to-day business activities as well as strategic decisions,
such as capital structure changes or major new investments (Modules 4 through 6).
NWC is necessary for the operation of the business enterprise. You can think of NWC as the oil that keeps the business
machine operating. Cash, for example, has no intrinsic benefit to the firm, but cash provides liquidity to facilitate transactions
with customers and suppliers. Similarly, accounts receivable may have no direct benefit to the firm but exists as a result of
the firm offering trade credit to its customers.
Thus, NWC appears to be an investment of capital that is necessary, but not profitable in its own right. In managing NWC,
the financial executive must decide whether the firm could earn more if funds did not have to be tied up in NWC.
This module focuses on the management of NWC and the major factors that determine the size of NWC. However, some of
the asset accounts are largely outside the control of the financial executive. The size of accounts receivable, for example, is a
function primarily of the level of credit sales, and will fluctuate closely with sales. The impact of the financial executive is
largely restricted to influencing the terms of trade credit. (Marketing will typically have a strong say in this also.)
Similarly, production and marketing departments largely set inventory levels. The financial executive’s role here is to ensure
that the cost of holding inventory is properly considered.
On the liabilities side, the activity level of the firm determines both taxes payable and accounts payable. As sales, production,
and earnings increase, so will accounts payable and taxes payable. The primary account on the liability side over which the
financial executive exercises control is the amount of bank and other short-term loans.
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8.2 Objective of net working capital management
Learning objective
● Describe the objective of NWC management. (Level 2)
No required reading
LEVEL 2
Given the short-term nature of the accounts, the management of them also has a short-term focus. Typically, the financial
executive is concerned with NWC this month, and not next year.
One reason for this short-term focus is the cyclicality of NWC. Many firms are subject to a seasonal pattern of changes in
NWC due primarily to seasonality in the firm's sales. It is important for the financial executive to manage NWC efficiently over
the cycle.
As NWC is the difference between current assets and current liabilities (where current assets typically exceed current
liabilities), it can be thought of as an asset, just like capital assets. The cost of any investment in NWC is the foregone return
from an alternative use of these funds. For example, funds tied up in finished goods inventory could be earning a return if
invested in capital projects or at least in interest-bearing financial assets.
It is much more difficult, however, to estimate the benefits of investments in NWC. Unlike capital projects, the investment in
NWC does not provide easily measurable and separable returns. In managing NWC, you want to maximize the net benefits
(total benefits minus total costs). Because of the short-term nature of the investment, you can ignore the time value of
money and, hence, discounting. Net benefits are maximized when marginal benefits equal marginal costs. Hence, managing
NWC essentially involves analyzing the marginal benefit of the last dollar of investment in NWC. The marginal benefit of a
dollar invested in NWC should equal the return being foregone on alternative investments. Identifying these marginal benefits
is one of the most challenging aspects of NWC management.
Because of this difficulty, an alternative operational objective of NWC management that is often chosen, and will be pursued
in this module, is to minimize the firm's investment in NWC, subject to having sufficient NWC to meet the firm's operational
needs, such as:
● sufficient cash to facilitate trade with customers and suppliers
● accounts receivable based on trade terms competitive with the firm's industry rivals
● inventory sufficient to not exceed a maximum allowable probability of running “out of stock” and thus losing potential
sales
The definitions of the factors that determine acceptable levels of various NWC accounts are covered in the following topics.
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8.3 Net working capital management procedure
Learning objective
● Describe the procedure for NWC management. (Level 3)
No required reading
LEVEL 3
For each relevant current asset account, the financial executive must determine the minimum acceptable account level that
satisfies the firm’s needs.
A key to this process is to understand how each account is linked to the firm’s activities. For example, accounts receivable are
obviously closely tied to sales. If sales are cyclical, accounts receivable will be cyclical. This cyclicality may lead to
variable short-term borrowing needs for the firm throughout the year. Also, incorporated into the determination of working
capital account levels is the impact of irregular, strategic decisions. Thus, the introduction of a new product may require
additional investments in inventory and accounts receivable.
A basic planning tool in the management of NWC is the cash budget. This provides detailed forecasts of cash flows for the
coming year, often on a monthly basis. You will construct a cash budget over the subsequent topics.
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8.4 Optimal levels for cash and marketable securities
Learning objective
● Describe the factors that determine the optimal levels for cash and marketable securities. (Level 2)
Required reading
● Chapter 24, Section 24.1 (pages 930 – 934)
LEVEL 2
Cash may be defined as currency held by the firm plus the firm’s demand deposits. Marketable securities are defined as short-
term, highly liquid, interest-bearing financial assets, such as Canada treasury bills or high-grade commercial paper.
Section 24.1 describes four motives for holding cash. The two most basic are:
● cash for transactions: Even if you could perfectly forecast the
daily cash flows, there will be days when cash outflows will exceed cash inflows. In these cases, you must have cash
balances at the start of the day to meet the shortfall.
● a cash buffer for unexpected cash
outflows: In reality, a firm cannot predict daily cash flows perfectly, and must hold some cash
just in case an unanticipated outflow occurs. Cash for this purpose might be partly provided by “instant credit”
agreements with the firm’s bank, allowing the firm to make daily loans for emergency cash needs.
Knowledge about a firm’s minimum cash needs normally comes from experience in conducting business and avoiding cash
shortages. The primary factors that determine the minimum cash balance are:
● the expected cash needs for the day
● the degree of uncertainty about the daily cash flow
● the cost of acquiring a new cash holding
You can think of cash as a “good” that must be held in inventory. How much is held in inventory is determined by trading off
the costs and benefits. The major benefit of holding cash is that it facilitates transactions; the major cost of holding cash is
the foregone earnings from possible alternative investments. When reading about inventory management (text Section 24.3),
remember that cash could be the item in inventory.
Because of cyclical cash flows, the firm may at times hold “extra” cash, that is, cash over and above the minimum amount
required. This money should be invested in short-term interest-bearing securities. Typical investments used by corporate
treasurers include
● Canada treasury bills (T-bills)
● corporate commercial paper and bankers’ acceptances (BAs)
● bank certificates of deposit
However, there will be transaction costs involved in buying and selling these securities, and the firm must ensure that the
interest income from holding marketable securities more than covers the transaction costs involved.
The cash budget will help you determine when the firm should hold marketable securities. More will be said about this in
Topic 8.10.
One important technique for reducing the required cash holding is to reduce float. Float is cash that has been released to
the firm, but not yet received. Since it has not yet received the cash, the firm cannot use the cash (for example, put in an
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interest-bearing account). Float and various techniques for reducing float, such as lockbox systems, are explained in Section
24.1 and illustrated in Example 8.4-1.
Example 8.4-1: Reducing float
Magnatec Co. has 34 retail outlets across Canada that sell and service personal computers. Each outlet has substantial daily
cash flow. At present, some outlets maintain their own bank accounts and have their own borrowing agreements with a local
bank, while other outlets mail daily cash receipts to the head office in Regina.
Magnatec’s head office has noticed that at times several outlets are borrowing money (at rates from 5% to 7%) while other
outlets have excess cash balances (earning only 2%).
Also, head office has calculated that it takes, on average, six working days (mailing plus cheque clearing time) from the time
a customer pays at an outlet with no local bank until the money is credited to the head office bank account in Regina.
To solve these problems, head office hires a cash management consultant with the aim of improving the efficiency of
Magnatec’s cash management. Most of the chartered banks, for example, offer such cash management advice and services.
The consultant initiates two programs. First, a computer-based system allows head office to monitor the daily cash balances
at all its outlets. At the close of the day, outlets with excess cash can wire money, on instructions from head office, to outlets
that have cash shortages; this action results in reduced interest expense on borrowing.
Second, for those outlets without local banking services, a lockbox system is established. Customers deposit payments with a
collection representative who immediately wires head office’s bank in Regina; the payment is deposited to Magnatec’s
account that same day. This system reduces the time that cash is “lost” in the system from six days to one day. Additional
interest is earned on the newly available funds.
Clearly, this cash management service entails costs. Magnatec’s savings from the increased efficiency of cash management
must exceed these costs to make the service worthwhile.
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8.5 Cash management techniques
Learning objective
● Explain cash management techniques. (Level 1)
Required reading
● Chapter 24, Section 24.1, subsection “Cash Management Techniques” (pages 932 – 934)
LEVEL 1
As you learned in Topic 8.4, financial managers attempt to hold cash balances at a minimum level while still ensuring that
there is enough cash to meet upcoming obligations.
The objectives of cash management are:
● Reduce the opportunity cost of holding idle cash.
● Ensure that all obligations are paid on time.
● Collect money owed as soon as it becomes due.
Short-term temporary highly-liquid investments are used as a liquidity buffer. Idle cash is put into temporary investments
where it can be readily accessed when needed. Cash and chequing accounts do not earn interest for the most part. What the
funds will earn in a temporary investment is considered the opportunity cost of holding cash and funds in chequing accounts.
However, there is a timing lag between the issuing of cheques to suppliers and the deduction of cheques from the bank's
chequing account. The bank balance must be maintained in a positive position, yet the financial manager wants to minimize
the opportunity cost of holding a positive balance in a noninterest-bearing account.
As mentioned in Topic 8.4, the time difference between a cheque being issued and being cleared from the chequing account
is called the float. There is a payor's float called disbursement float that represents this time lag for the payor. This float is
also called a positive float because the payor's bank balance shows more cash than the amount the company actually
owns. On the other side of the transaction, there is a collection float (also known as a negative float) that results in the
bank's balance showing less cash than the amount the company actually owns.
The importance of the float will depend on the length of time involved and the size of the cheque. Financial managers work
to minimize the length of time involved. To do this, they divide float into three types:
● Mail float is the time required to transport a cheque from the payor to the payee.
● Processing float is the length of time it takes the payee to process the cheque and to deposit it in the bank for
collection.
● Clearing float is the time it takes the payee to receive cash after presenting a cheque to the bank. The Canadian
clearing system is one of the fastest in the world. If a bank receives a deposit before 5 p.m. local time, the funds are
credited to the depositor's account the same day.
Financial managers are concerned with the net float, or the difference between the disbursement and collection float.
Effective financial managers will speed cash collection and control cash disbursements.
Speeding cash collections
In Topic 8.4, a number of methods were listed for improving cash collection. With the advent of e-commerce, banks and
companies are collaborating to create safe and efficient methods of making payments. Although incomplete, the following
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paragraphs list some of the more common methods of improving cash collection.
Pre-authorized cheque arrangements
improve cash collection by allowing a customer to sign a series of post-dated cheques and submit them in advance to the
payee. This method eliminates mail float and reduces processing float. This method is suitable to a situation where the payor
is required to make recurring payments, such as a mortgage or lease.
Pre-authorized electronic debit
arrangements are much the same as pre-authorized cheque arrangements. With pre-
authorized electronic debits, the payor pre-authorizes the bank to debit an account and to send the funds to the payee's
bank. This method also eliminates mail float and cheque handling, and is suitable for recurring payments. However, banks
assess a per transaction fee.
The previous two methods are very similar. With pre-authorized cheques, there is more paperwork for the payor. Therefore,
when deciding between the two methods, the organization must assess whether it can process the paperwork for the pre-
authorized cheques at a lower unit cost than the bank transaction fee.
The point-of-sale system used in retail. This system allows retailers to use a
customer's debit card to transfer funds from the customer's account to the retailer's account. This method completely
eliminates float and processing costs. Banks incur only those administrative costs that come with processing regular cheques.
However, there is a large fixed cost in setting up the point-of-sale system that justifies the bank's per transaction fee.
Financial managers must look at the savings from the reduced administrative, processing, and float costs, and compare this
to the bank transaction fee.
Often the cost/benefit analysis is not the only assessment made. Competitive pressures may force a collection method
decision. A company may be required to use one collection method over another because of industry trends.
The acceptance of credit cards such as Visa and MasterCard by retailers and wholesalers is widespread. One reason for this
is that businesses that do not accept credit cards are at a competitive disadvantage to those that do. Another benefit to
accepting credit cards for payment is that it either eliminates float or substantially reduces it to perhaps one day. The
drawback is the cost, which can be substantial. While arrangements vary considerably, the merchant may be faced with
various sundry fees; a fixed cost per transaction; and a variable fee per transaction calculated as a fixed percentage fee of
the transaction size. These fees are determined by considerations such as credit card volume, average transaction size, and
competitive factors. For businesses with a high volume and high average transaction size, the variable fee can be as low as
1%, but this is very unusual. For small businesses it may be 4% or more.
Another innovation is money cards or electronic wallets. These are similar to credit cards in physical
appearance but operate like cash. A cardholder loads the money card with a balance up to a maximum amount (for example
$1,000) using a terminal similar to an automatic teller machine. This balance is automatically withdrawn from the
cardholder's account. Each time the card is used for a purchase from a retailer, the amount on the card is adjusted by
passing the card through a device when making the payment. The retailer's account is credited with the amount and the card
is debited. These cards are just like cash and can be used by anyone if lost or stolen.
Controlling cash disbursements
Controlling cash disbursement is the process of ensuring that payments are made at the latest possible date agreed to in the
transaction terms. The financial manager has little control over the amounts due in this area. Business changes would affect
the level of trade payables. In this section, you will look at various techniques used by the financial manager to manage
disbursements.
Paying exactly on time
Different suppliers will have different terms of payment. They will also have different methods of judging when a payment is
late. The postmark date on the envelope is one method of judging when a payment is made. This method allows the payor to
use the mail and processing float. Some unethical individuals will deliberately mail cheques from remote areas to delay
delivery.
Because of the time involved in using the mail, often the payee will specify that the date of receipt at the company's payment
centre is the payment date. This has obvious advantages for the payee but, with the uncertainty with the mail, it poses
difficulties for the payor. The payor company's financial manager will likely opt for pre-authorized cheques or pre-authorized
debit arrangements. This allows the financial manager to pay exactly on time, eliminating the float for both the payor and the
payee.
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Large firms with large numbers of small payments may find this process tedious and costly. In this case, they can make a
bank arrangement that guarantees that a single presentation of a group of cheques will be processed each day at a specified
time. This type of arrangement enables the financial manager to avoid overdrafts by transferring cash to the chequing
account immediately prior to the agreed-upon cheque processing time.
Centralized cash disbursements
Large firms often centrally control all cash accounts for the business in one location. This has the advantage of simplifying
cash management because only one central account has to be managed rather than several accounts. This saves
management costs. Concentrating cash in one account eases the process of using a cash surplus in one region to offset a
cash deficit in another. By concentrating all cash into one account, the surplus can be easily monitored and invested, thereby
reducing the opportunity costs.
A zero balance system is a system whereby branch accounts advise the central location daily of either their surplus or cash
needs. The central location will wire funds to locations with cash needs, and locations with a surplus will wire it to the central
location. The basic idea is that the branch locations should maintain a zero balance overnight.
Drafts can also be used to control disbursements centrally. A branch location will make payments only through drafts. The
bank will not make the payment unless the central office's financial manager has approved each draft separately. The payee
has to submit the draft to the payor's central controller, who signs it and returns it to the bank. The bank then makes the
payment.
Information services
Large banks have many services that assist financial managers in cash management. Banks will provide information on the
ledger balances, which indicates the float and the immediately available balance. Also provided are:
● the next day's available balance
● the balance available over the next few days in each of the company's bank accounts
● the previous and the current day's activity by account
The banks charge a fee for these services; therefore, a financial manager needs to assess the cost/benefit tradeoff.
Investment services
The automated balance transfer system provides a company with a simple investment service. Typically, the company will
have two accounts — a chequing account and an interest-bearing investment account. At a pre-arranged time each day, the
system verifies the client's chequing account balance. If there is more than a pre-arranged balance in the account, then the
overage is transferred into the interest-bearing account. These systems provide a convenient method that can save
substantial management costs. However, because the bank charges a fee for this service, the cost/benefits must be weighed.
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8.6 Optimal levels for accounts receivable
Learning objective
● Describe the factors that determine the optimal levels for accounts receivable, and use a spreadsheet application to
construct and analyze a cash budget. (Level 1)
Required reading
● Chapter 24, Section 24.2 (pages 934 – 941)
Note: For Examples 24-1 to 24-3 in Section 24.2, you should understand what components of net working capital
would change when trade credit terms are altered. The details of marginal analysis are not required.
LEVEL 1
Accounts receivable arise because the firm's customers do not immediately pay cash for the firm's product. The firm allows
the customer a period of time before the product must be paid for. This is called trade credit. For example, if trade credit
has terms of net 60, this means full payment of the bill is required within 60 days of the invoice date (other examples of
common credit terms are provided in Section 24.2).
Trade credit can be thought of as a loan from the firm to the customer, with no interest charge and a maturity equal to the
credit period (Section 24.2 defines “credit period” and possible discount periods). Customers view interest-free loans as
positive net present value investments, and so they take advantage of them. For example, given terms of net 60, customers
should pay on the 60th day, and not before. Just as firms try to speed up cash receipts, they try to slow down disbursements.
The terms of trade credit are marketing tools. They can be used to attract business. Cash discounts implicitly reduce product
price. This is illustrated in Example 8.6-1.
Example 8.6-1: Implications of changing credit terms
The Fogo Island Crab Trap Co. of Newfoundland (FICT) competes with NSJCT for crab trap sales along the east coast. Both
FICT and NSJCT offer trade credit of net 60. NSJCT is considering changing its trade credit terms to 2/10, net 30 in order to
attract business away from FICT.
Doug and Bob, NSJCT's managers, are studying the impact of this change on NSJCT. By changing trade credit terms from net
60 to 2/10, net 30, they determine the following changes will result:
1. NSJCT will take sales away from FICT; increased sales will result. This is positive, given favourable profit margins on
crab trap sales.
2. Most customers will pay for their crab traps within 10 days of the invoice, rather than the current 60 days (the reason
for this will be clear after reading Topic 8.7). By definition
AR = ACP × CSPD
where
AR = accounts receivable
ACP = average collection period (in days)
CSPD = credit sales per day
(If you are not familiar with these terms from your earlier accounting courses, review text Section 4.5, pages 116 –
120.)
Since the ACP will drop from about 60 days to 10 days, there will be a significant drop in accounts receivable. This is
positive.
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3. The increased sales will be mostly on credit, so that CSPD will increase. This will increase accounts receivable. As per
the above formula, this is a negative.
4. Most customers will pay within 10 days of invoice, and so will only pay 98% of the invoice amount (they take the 2%
discount). This will have a negative impact on NSJCT’s profit margin.
The decision to go to the new terms depends on whether the two positive factors (1 and 2 above) outweigh the negative
impacts (3 and 4 above). The amounts involved must be estimated and a marginal analysis carried out. (You need not work
through the details of this analysis; examples are given in Section 24.2.)
How will FICT react? A price war may result!
As this example shows, the terms of the firm's trade credit are often set from a marketing perspective. One function for the
financial executive is to undertake the type of marginal analysis suggested in order to determine the economic desirability of
terms of trade credit.
Another function is to monitor accounts receivable and manage the collection process. Section 24.2 of the text describes this
process.
Beyond these activities, the financial executive must take the level of accounts receivable as being outside direct control.
In Computer illustration 8.6-1, you will construct a cash budget worksheet and use it to analyze several aspects of cash
budgeting, including the impact of trade credit terms, ending cash requirements, and accounts receivable collection.
Computer illustration 8.6-1: Cash budgeting — net cash flow determination
NSJCT sets a different required ending cash for each month, depending on the perceived need for a cash buffer to cover
unexpected cash outflows for the particular month. For this computer illustration, you will focus on deriving the net cash flow
for each month. In Computer illustration 8.10-1, you will learn how to set up a cash budget to plan for cash shortfalls and
cash surpluses.
NSJCT has a corporate tax rate of 25%. The firm pays its corporate taxes quarterly, at the end of each quarter. Cash receipts
from sales for any particular month are collected over a three-month period, with 30% in the same month as the sales, 40%
in the next month, and the balance in the third month. For the sake of simplicity, assume that NSJCT does not have any bad
debts. The material purchased for any particular month (t) is based on 40% of projected sales in the third month (t + 2). The
material purchases are paid one month after the purchase. Salaries for the sales staff for any particular month are 15% of
the current month's sales.
Using Excel file FN1M8P1, complete NSJCT’s 12-month cash budget.
Procedure
1. Open Excel file FN1M8P1 and click the worksheet tab for M8P1. Note the following:
r The input data area is in rows 8 to 21. Check that the data entries in column F conform to the problem
description. The assumptions are numbered (1) through (4). The lower part of the worksheet cross-
references these assumptions.
r Row 28 contains the sales figures for 12 months.
r Cells B31, B32, and C32 contain cash receipt figures. These amounts relate to sales for November and
December of the previous year and cannot be determined from the sales data provided.
r Cells L36 and M36 contain purchase figures that cannot be determined from the sales data provided.
r Cell B40 contains the accounts payable payment for January. February sales are $330, so that December's
purchases are 0.40 × $330 = $132. This amount is payable in January.
r Rows 42 to 47 contain amounts related to the following:
■ “Wages” and “Miscellaneous” are regular expenses.
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■ “Promotions” is a special product promotion expense.
■ “Retooling” is a major capital expenditure in August.
■ “Dividends” is a special preferred dividend payable in July.
■ “Taxes” are the estimated quarterly tax payments, calculated as 25% (cell F8) of the quarterly taxable
income (row 50).
2. Using assumption (1), complete the cash receipts schedule in rows 30 to 33.
3. Using assumption (2), complete row 36 — Purchases.
4. Using assumption (3), complete row 40 — Payments on accounts payable.
5. Using assumption (4), complete row 41 — Sales salaries.
6. Complete rows 48 and 52 to calculate the total disbursements and net cash flow for each month respectively.
Note that purchases, sales salaries, wages, promotions, and miscellaneous form the expenses for the month. Note
the difference between cash disbursements and expenses. Total disbursements in row 48 include accounts payable
disbursements, but exclude purchases for the month. However, the quarterly taxable income amounts (row 50)
exclude accounts payable disbursements, but include purchases.
7. Click the sheet tab for M8P1S. Compare your worksheet with the solution and resolve any differences. You may wish
to print the solution to assist you in reviewing the following commentary.
Commentary
To follow this commentary, use your solution printout or the solution worksheet M8P1S. Notice NSJCT's
cyclicality of net cash flow: February to June are the inflow months, and outflows begin in July
(see row 52).
Trade credit
The terms of trade credit have an important impact on the firm's cash budget. Assumption 1 (rows 11 to 13) states that the
NSJCT's trade credit policy results in customers paying 30% of the accounts receivable in the same month as the sales, 40%
in month 2 and 30% in month 3. Changing NSJCT's trade credit policy would alter this accounts receivable collection pattern
and directly impact the cash flow. For example, changing cells F11 and F12 to 0% and 20% shifts the cash flows by
approximately two months to the future. (Do not save this worksheet.)
Financial environment changes
Suppose the new provincial laws being considered would raise NSJCT's corporate tax rate to 55% (combined federal and
provincial), with the accounts receivable collection pattern at the original 30%, 40%, and 30%. What would this do to
NSJCT's cash flow pattern?
Use your completed worksheet or the solution worksheet M8P1S. Change cell F8 to 55%, and examine row 52. The firm will
now face net cash outflows in all of its tax-paying months (March, June, September, and December).
This is only one example of regulation affecting the firm's cash flows. Others include property and sales taxes, unemployment
insurance, and other factors that determine salaries (for example, cell F21).
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8.7 Optimal levels for inventory
Learning objective
● Describe the factors that determine the optimal levels for inventory. (Level 2)
Required reading
● Chapter 24, Section 24.3 (pages 941 – 942)
LEVEL 2
Inventories, including raw materials, work in process, and finished goods, are determined largely by production and
marketing factors. The major input of the financial executive is to determine the cost of holding inventory. This cost, as you
have repeatedly seen, is the opportunity cost of foregone return by being unable to deploy elsewhere the funds tied up in
inventory.
To extend the brief discussion in Section 24.3, there are four major determinants of the amount of inventory held:
● cost of restocking the inventory :
This cost could also entail fixed set-up costs for a new production run. The more expensive it is to restock inventory,
the more inventory you order each time; this reduces the number of orders you need to make over time. But, larger
inventory orders mean larger inventory levels, on average.
● rate of demand for the product : The more
units of inventory demanded per time period, the larger the inventory is, on average.
● cost of holding a unit of
inventory : This cost includes the opportunity cost of funds tied up in inventory. Suppose you
represent this cost by the firm's weighted average cost of capital (WACC). If physical storage costs (after tax) are $5
per unit of inventory, a unit stays in inventory for an average of three months, the firm's WACC is 12%, and the cost
of goods sold for a unit of inventory is $29, then the after-tax cost of holding a unit of inventory is
5 + [(1.12)1/4 – 1] × 29 = $5.83 per unit
● degree of uncertainty about
future demand for the product : The more
uncertainty, the larger a “buffer” inventory should be to avoid inventory shortages. Thus, more uncertainty about
demand leads to higher inventory levels, on average. In this context, the costs of a stockout are also important, with
higher stockout costs in higher inventory levels.
The cost of holding a unit of inventory is the major concern of the financial executive.
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8.8 Managing accounts payable
Learning objective
● Explain the main issues relevant to managing accounts payable (Level 1); apply ethical reasoning in resolving
accounts payable management issues. (Level 2)
Required reading
● Chapter 24, Section 24.4, up to “Bank Loans” (pages 943 – 944) (Level 1)
LEVEL 1
This topic will review the management of accounts payable. Bank and other short-term loans were covered in Module 1.
The firm buying goods on trade credit creates accounts payable. They are a mirror image of accounts receivable: what an
account payable is to a customer, an account receivable is to a supplier. Thus, the underlying management principles for
accounts payable and receivable are very similar. From Topic 8.5, if trade credit terms are net 60, the firm makes its payment
60 days from the invoice date, thus getting “free use” of that money for 60 days. Thus, the level of accounts payable is
essentially “automatic,” given a firm’s purchases and the terms of trade credit.
Suppose the trade credit terms are 3/10, net 60. Should the firm pay in 10 days to get the discount or wait and pay the full
invoice amount in 60 days?
You can analyze the decision to take a discount by realizing that missing the discount and waiting until the 60th day to pay is
just like borrowing from your supplier, with the cost of the loan being the amount of the discount foregone. Consider the
cash flows under the two alternatives (the terms are 3/10, net 60) on an invoice of $100:
t = 10 t = 60
Pay at t = 60, no discount –100
Pay at t = 10, take discount –97
Difference 97 –100
Thus, the incremental cost of delaying payment until t = 60 has a cash flow that looks just like a loan: take in $97 now and
repay $100 in 50 (that is, 60 – 10) days. Missing the discount is like borrowing $97 today and repaying the $97 plus $3
“interest” in 50 days.
The annualized cost of the missed discount is
[1 ÷ (1 – d)]n – 1 Equation 8-1
where
d = percentage discount offered for early payment, D ÷ F
F = invoice face value
D = dollar discount offered for early payment
n = 365 divided by the number of days between the two payment dates
For terms 3/10 net 60:
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n = 365 ÷ 50 = 7.3
Cost of missed discount = (1 ÷ 0.97)7.3– 1
= 24.90%
Note that the formula for the cost of the missed discount is exactly the same as the formula for the yield to maturity on a
pure discount loan.
This implicit loan rate should be compared to the firm’s borrowing rate. In this example, if the firm can borrow money from
the bank at a rate less than 24.90%, it should borrow from the bank and take the discount on the trade credit, paying on day
10.
If the trade terms are 2/10, net 30, then the cost of missing the discount is
(1 ÷ .98)365/20 – 1 = 44.59%
Look back at point 4 in the Fogo Island example in Topic 8.6 (Example 8.6-1). The cost of missing a discount on trade credit
with terms of 2/10, net 30 is so high that all customers should pay on the 10th day after the invoice date.
While this example illustrates that the financial executive should have some input into the management of accounts payable,
you should again note that the overall level of accounts payable is not directly controllable by the financial executive, as it
varies with purchase, and hence, production levels.
Summary
In managing current assets, you must balance the benefits of holding high levels of cash, accounts receivable, or inventory
against the cost of these accounts. The primary cost of these accounts is the opportunity cost of tying up the enterprise’s
funds. In managing accounts payable, you compare any costs of such supplier credit to the costs of alternative short-term
loans.
LEVEL 2
Focus on ethics: Applying the screws
As Financial VP of Mega Cabinet Co., Al Wood is a shrewd manager of Mega’s finances. Mr. Wood has just completed a
review of the suppliers of raw materials to Mega, including their trade credit terms and their financial health. Mr. Wood learns
that ABC Screw Co., which provides Mega with all its screws, has recently lost most of its large accounts, for reasons
unrelated to the quality of the screws (still among the best that can be bought). ABC Screw currently offers Mega trade credit
terms of “net 30”; that is, ABC Screw is basically giving Mega 30-day interest-free loans. As is normal, Mega has been waiting
the full 30 days after each purchase to pay the bill.
There is a $35,000 bill due to be paid to ABC tomorrow. Mr. Wood calls ABC Screw and says, due to some “technical
problems,” Mega will be two weeks late in paying this bill. Not wanting to lose Mega’s business, ABC Screw immediately
agrees to the delay. Mr. Wood’s alertness has gotten Mega an intrest-free loan of $35,000 for another two weeks. Several
more ABC bills are due in the next few weeks. Should Mr. Wood “stretch” Mega’s payment time again?
Concerned parties: Mr. Wood, investors in Mega and ABC Screw, and
employees of ABC Screw.
Ethical issues: Having discovered ABC’s total reliance on Mega for revenues, Mr. Wood
has ABC at a disadvantage. ABC may get more customers in the future, but Mr. Wood could certainly take advantage over
the next few weeks. Should he?
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8.9 Securitization
Learning objective
● Describe the process of securitization. (Level 2)
Required reading
● Chapter 24, Section 24.4, subsection “Securitizations” (pages 949 – 950)
LEVEL 2
One way that many large corporations, including banks, manage their working capital and increase their borrowing capacity
is through the process of securitization. As set out in the text, the basic process is that the company that has provided
financing to its customers packages and sells off a bundle of these loans to the investing public.
Typically, the securitizing company will have borrowed short-term funds to provide long-term financing to their customers.
Securitization improves the company’s working capital position, as they are selling off a package of what is primarily a long-
term asset for a current one — cash. Similarly, the securitizing company’s debt capacity is increased as the cash raised is in
turn used to pay down short-term debt — allowing the securitizing company to re-borrow.
The text discusses how General Motors (through GMAC1) securitizes its loan portfolio. Banks and other financial institutions
also securitize their assets, for similar reasons. The maximum amount that banks can lend is restricted by regulation to a
multiple of their regulatory capital2. To increase their lending capacity, and to earn fee income, banks routinely securitize
many types of their loans, including VISA accounts and home mortgages.
Securitization is not without its risks. When you grant a loan that you know that you have to collect, you tend to be more
careful in your assessment of the borrower’s credit worthiness than if you give a loan that you sell to somebody else who
assumes the risk of default. Indeed, the sub-prime mortgage crisis that severely compromised the stability and profitablity of
the North American financial system is a direct result of securitization gone awry. Specifically, many banks and other
mortgage-granting institutions ignored prudent lending practices as they knew that they would be selling off the loans, so
that the collection of the loans would be someone else’s problem.
1GMAC (General Motors Acceptance Corporation) began as a wholly-owned subsidiary of General Motors (GM) to finance
dealer-provided car loans. In 2006, GM sold a 51% interest. In late 2008, GMAC became a bank holding company.
2 A full discussion of regulatory capital is beyond the scope of this course.
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8.10 Cyclical patterns and cash flow planning
Learning objective
● Describe the important cyclical patterns in NWC, and use a spreadsheet application to construct a cash budget that
allows planning for cash shortfalls and surpluses. (Level 1)
Required reading
● Chapter 23, Sections 23.1 (subsection “The Cash Budget”), 23.2 and 23.3 (pages 905 – 920)
LEVEL 1
As sales levels change and the production pattern does not perfectly match the sales pattern, there will be fluctuations in a
firm's current assets. Some current liabilities will also fluctuate, especially taxes payable and accounts payable.
The financial executive must be aware of this pattern to plan for a source of funds when there is a cash shortfall and to plan
for investments when there is excess cash. Such fluctuations in net working capital are illustrated in the following exhibit.
Exhibit 8.10-1: Financing of current assets
Suppose the firm's current assets less taxes and accounts payable has a pattern that looks like the curve CA in Exhibit 8.10-1.
The firm must finance the fluctuating net working capital “asset” with either short-term or long-term financing, or with some
mix of the two. Here are three alternative approaches to cash planning:
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Plan A
Use sufficient long-term financing (debt and equity) to cover the largest forecasted CA requirement.
When the CA curve in Exhibit 8.10-1 touches the dotted Plan A line, there is no excess liquidity in the system. At all other
points in time, the firm has more long-term financing than is necessary for covering CA, and so will hold marketable securities
in excess of the amount required in current assets almost all year.
Plan B
Use long-term financing sources only for the minimum CA requirement over time. At all points in Exhibit 8.10-1 where the CA
curve is above the Plan B line, short-term borrowing will be necessary to cover the shortage of long-term financing. Plan B
involves almost constant use of short-term debt.
Plan C
This compromise plan uses “permanent” (long-term) financing for part of the CA requirements. For those parts of the cycle
where the CA curve is above the Plan C line, short-term borrowing is used; when the CA curve is below the Plan C line,
excess cash is invested in marketable securities.
Most firms use a plan similar to Plan C.
The cash budget is a planning document. It requires the financial executive to look into the future and anticipate future cash
flows and needs. To be of optimal use, the cash budget should be based on sufficiently fine basic time intervals to fully
portray seasonal and/or cyclical variations, which can average out over longer time periods. By anticipating these patterns,
the financial executive can plan for short-term borrowing and optimal investment in marketable securities. Monthly cash
budgets are typical.
The cash budget is also important for forecasting the impact of potential changes in the firm, brought on either by
management actions or by changes in the firm's operating or financial environment. Computer illustration 8.10-1 provides an
example.
Computer illustration 8.10-1: Cash budgeting — determining borrowing needs
In Computer illustration 8.6-1, you constructed a cash budget worksheet for NSJCT. In this illustration, you will extend this
cash budget to include the financing activities of NSJCT and plan for cash shortfalls and cash surpluses. Borrowing covers any
cash shortfall. Excess cash is applied to repayment of loans. Any cash excess after repayment of loans is invested in
marketable securities.
Procedure
1. Open Excel file FN1M8P2 and click the worksheet tab M8P2. It contains the cash budget from Computer illustration
8.6-1 with an added Summary Cash Flow table in rows 55 to 64. Cells B62 and B64 contain pre-entered formulas. Do
not assume that you can copy these formulas to the rest of the cells in the row.
2. Complete row 58 — Beginning cash. Cell B58 is pre-entered. The amounts for the required ending cash (row 59) are
also pre-entered. Each of these amounts represents the cash buffer that NSJCT may need to cover unexpected cash
outflows for each month. Set the beginning cash for month t to the required ending cash for month t – 1.
3. Complete row 60 — Total cash flow. This row represents the net cash flow and is equal to net cash flow less any
increase in the required cash balance from the start of the month. A negative cash flow, such as in January, requires
a source of financing to meet the shortfall. A positive amount, as in February, means excess cash is available in that
month.
4. In row 62, calculate the cumulative borrowing balance. Note the use of the ABS (absolute) function in the formula in
cell B62. (The absolute value of a number is the number without its sign). Your formulas in the remaining cells in this
row will reference three amounts:
a. total cash flow for the current month
b. cumulative marketable securities as of the previous month
c. cumulative borrowing balance as of the previous month
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If the sum of (a) and (b) is less than (c), then calculate the cumulative borrowing amount for the month, taking into
account more borrowing or repayment of the loan. If the sum of (a) and (b) is equal to, or greater than (c), there is a
net cash surplus, and the cumulative borrowing amount is zero. For simplicity, ignore the accounting for interest
payments on the bank loan.
5. In row 64, calculate the cumulative market securities investment. If the sum of (a) and (b) from step 4 is greater
than (c), then calculate the cumulative marketable securities amount, taking into account more investment, or
repayment of the loan. If the sum of (a) and (b) is equal to or less than (c), there is a net cash shortfall, and the
cumulative marketable securities amount is zero. For simplicity, ignore the accounting for earnings from the
marketable securities.
6. Click the sheet tab for M8P2S. Compare your worksheet with the solution and resolve any differences. You may wish
to print the solution to assist you in reviewing the following commentary.
Commentary
To follow this commentary, use your completed worksheet or the solution worksheet M8P2S.
Cash buffer
“Required ending cash” (that is, the cash buffer) in row 59 is the amount of cash NSJCT has decided it must have on hand to
begin the next month. For example, the $50,000 in cell B59 (for January) is the required cash balance at the start of
February; the February beginning cash (cell C58) reflects this fact.
It is clear that the required ending cash balance impacts the cash budget of the firm. The total cash flow (row 60) is the
beginning cash (row 58) plus the net cash flow (row 57) less required ending cash (row 59). Since the total cash flow affects
the amounts NSJCT must borrow (row 62) or can invest in marketable securities (row 64), the required ending cash balance
thus has a direct impact on the financial activities of the firm. For example, NSJCT has a net cash flow in April of $99,000
(cell E57), but an extra $10,000 is needed in cash in April (cell E59 minus cell E58), so that only $99,000 – $10,000 =
$89,000 is available (E60).
Financing activities
NSJCT meets its cash shortfall by short-term borrowing from its line of credit at the bank. For example, the January shortfall
of $98,000 is met by borrowing, and the amount borrowed is recorded under “Cumulative borrowing” (row 62). By April, the
firm has reached a position where it pays off all cumulative borrowing and is able to invest $84,000 in marketable securities.
NSJCT must decide how to invest the excess cash. The cash budget indicates that cash shortages will begin again in July, but
some marketable securities will be held until the end of September. NSJCT can use these facts to select maturities for the
marketable securities to coincide with expected cash shortfalls. For example, all $84,000 cash excess at the end of April could
be invested in five-month commercial paper to mature at the end of September, just in time for the cash shortage in
October. Excess cash inflows from May and June will be put into shorter-term maturity investments.
The cyclical nature of NSJCT's cash flow is obvious. Short-term borrowing begins in October and continues through March to
meet the need for large current assets; that is, the CA curve is above the Plan C line described in Topic 8.10.
What-if analysis in cash budgeting
Suppose that, due to increased competition, NSJCT expects a 10% decrease in sales in all months. In worksheet M8P2S,
change the entries in row 28 (Sales) to amounts that are 10% smaller than the current sales amounts. For example, the
sales amounts for January, February, and March should be $414,000, $297,000 and $387,000 respectively. Print a copy of
the modified worksheet and compare the new cash budget with the first one. Observe the impact on cash flow and the
financing activities. For example, the amount of marketable securities invested at the end of April is now $42,000.
Further suppose that the drop in sales affects the payment pattern of NSJCT's customers. Suppose that NSJCT is able to keep
its better customers, and that more customers will pay in the month of purchase, resulting in an accounts receivable
collection of 60% in the current month, 30% in the next month, and the balance in the third month. Change cells F11 and
F12 to reflect these changes. Examine the summary cash flow area. Note that these two changes (drop in sales and
improved accounts receivable collection) significantly reduce the need for short-term financing, with borrowing only from
October to December. This allows for larger marketable security holdings and for longer periods of time.
Through the two computer illustrations in this module, you learned how to use a worksheet to assist in the preparation of a
cash budget. You also observed that the work involved in constructing a cash budget worksheet is more than compensated
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8.11 International complications
Learning objective
● Describe international complications that arise from multinational operations. (Level 3)
No required reading
LEVEL 3
There are three problems for firms with multinational operations:
● Increased uncertainty about future cash flows is introduced with unknown future exchange rates. The increased
uncertainty may require larger cash “buffers” and more bank lines of credit to meet unanticipated cash outflows.
● Bureaucratic government interference can increase the uncertainty of cash flows. For example, special government
approval for trade (such as, foreign imports) may be required, with variable time lags. Also, foreign transfers of
funds, in particular repatriations of earnings, may be subject to restrictions and special approvals.
● Information, such as credit checking facilities, may be inadequate or nonexistent in foreign markets. This, of course,
increases the uncertainty of possible cash flows.
Example 8.11-1 explores these issues in the context of NSJCT.
Example 8.11-1: Financing and foreign exchange
Suppose NSJCT opens a plant in Sri Lanka (this international capital budgeting example was introduced in Topic 4.5). Sales
this year are estimated at 2 million rupees (R2,000,000). At the current exchange rate of R1 = C$0.0483, that will convert to
C$96,600.
However, over the coming year, the exchange rate could be as high as C$0.0550 or as low as C$0.0410 per rupee. Based on
sales of R2 million, this converts to revenues of between C$110,000 and C$82,000, a swing of C$28,000. This could
significantly affect NSJCT’s cash position.
One solution is to hedge foreign exchange exposure, for example, through forward contracts. Another possibility is to borrow
in the foreign country with outstanding receivables.
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Module 8 summary: Working capital management
Describe net working capital (NWC).
● Net working capital (NWC) = current assets – current liabilities
● Some components of NWC are not discretionary (accounts receivable, inventory, and taxes).
Describe the objective of NWC management.
● The theoretical objective of NWC management is marginal benefit of NWC = marginal cost of NWC. However, the
marginal benefits of NWC are very difficult to identify or quantify.
● The operational objective is to minimize the firm’s investment in NWC (and thereby the cost of holding NWC) subject
to its operational needs.
Describe the procedure for NWC management.
● Each account in NWC is dependent on the firm’s activities (for example, accounts receivable depends on the firm’s
sales).
● The cash budget is the major planning tool in managing NWC.
Describe the factors that determine the optimal levels for cash and marketable
securities.
● The minimum required level of cash is equal to an amount for transactions plus extra for unexpected cash outflows.
● Factors affecting the minimum level of cash include:
r the expected daily cash flow
r uncertainty about daily cash flow
r the cost of acquiring new cash
● The minimum level of cash is affected by the float, which is the amount of cash released to the firm but not yet
received.
Explain cash management techniques.
● The objectives of cash management are:
r Reduce the opportunity cost of holding idle cash.
r Ensure that all obligations are paid on time.
r Collect money owed as soon as it becomes due.
● Short-term temporary highly liquid investments are used as a liquidity buffer.
● Float is the time difference between a cheque being issued and being cleared from the chequing account.
● For the payor, this time lag is the disbursement float. For the payee, this time lag is the collection float.
● Float can be controlled through techniques that speed cash collection, including:
r lock boxes
r pre-authorized cheque arrangements
r pre-authorized debit arrangements
r point-of-sale systems
r credit cards
r money cards
● Cash disbursements can be controlled through:
r paying exactly on time
r centralized cash disbursements
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r using a bank’s information service
r using a bank’s investment service
Describe the factors that determine the optimal levels for accounts receivable, and use a
spreadsheet application to construct and analyze a cash budget.
● The terms of trade credit affect the level of accounts receivable.
● A marginal analysis determines whether the expected benefits from the change in the terms of credit, such as
increased sales, outweigh the increased costs.
● A cash budget worksheet is used to analyze several aspects of cash budgeting, including the impact of trade credit
terms, ending cash requirements, and accounts receivable collection.
● A cash budgeting worksheet consists of:
r input data area for key assumptions such as the tax rate, cash flow pattern from sales, purchases, accounts
payable schedule, and sales salaries as a percent of sales
r monthly cash receipts section
r monthly purchases section
r monthly cash disbursements area for regular cash expenses as well as dividend and tax payments
r monthly net cash flow
Describe the factors that determine the optimal levels for inventory.
● The amount of inventory held depends on:
r the cost of re-stocking the inventory
r the demand for the product
r the cost of holding a unit of inventory
r the degree of uncertainty about future demand for the product
Explain the main issues relevant to managing accounts payable; apply ethical reasoning
in resolving accounts payable management issues.
● The overall level of accounts payable depends on the level of production and the terms of its trade credit.
● A firm should take sales discounts if the cost of foregoing the discounts exceeds the firm’s cost of borrowing.
● The cost of the missed discount is calculated as [1 ÷ (1 – d)]n – 1
● Ethical concerns can arise with respect to accounts payable.
Describe the process of securitization.
● Securitization is the process of packaging portfolios of short or long-tem receivables and selling them to investors.
● The benefits to the securitizing firm include improving its working capital position and increasing its debt capacity.
● Securitization has its risks if the firm selling the portfolio ignores prudent lending practices.
Describe the important cyclical patterns in NWC, and use a spreadsheet application to
construct a cash budget that allows planning for cash shortfalls and surpluses.
● Seasonal fluctuations in sales and production require planning for a source of funds when there is a shortfall, and for
investments when there is an excess of funds.
● A firm may adopt one of three strategies for dealing with fluctuating cash flow patterns:
r Use sufficient long-term financing to cover the largest possible current asset requirement.
r Use sufficient long-term financing to cover the minimum possible current asset requirement.
r Use a compromise that has enough long-term financing to cover a portion of current assets.
● The worksheet extends the cash budget to include:
r a monthly summary taking into account the beginning cash balance, projected net cash flow, and required
ending cash balance to arrive at a net projected cash flow amount for the month
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r a monthly cumulative borrowing/cumulative excess cash for marketable securities amount
Describe international complications that arise from multinational operations.
● Three additional problems leading to increased uncertainty over cash flows are:
r exchange rates
r government intervention, such as currency restrictions concerning repatriation of earnings
r lack of information such as credit-checking facilities
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Module 8 self-test
Question 1
Refer to Example 23-1 on pages 908 – 909 in the text.
Use the following estimates provided in the example:
The firm expects that 50% of its sales will be for cash, and that 80% of its credit sales will be collected one month after the
sale, with the remainder being collected in the following month. It also estimates that 50% of its purchases will be paid 30
days from the purchase date, while the remaining 50% will be paid in 60 days.
The firm's estimated sales, purchases and wages, and other expenses for the May to October period are:
Month Sales Purchases Wages & Misc.
May $10,000 $4,500 $3,000
June $9,000 $4,500 $4,000
July $9,000 $4,000 $3,000
August $8,000 $5,000 $3,000
September $10,000 $5,000 $3,000
October $10,000 $5,000 $3,000
The beginning cash balance is $7,950 and the firm wants to maintain at least $5,000 in its cash account at any time going
forward. It has a $50,000 credit line that is revolved in multiples of $5,000. To keep the calculations simple, ignore interest
costs on the revolving loan.
Finally, the firm will pay $5,000 in taxes at the end of June, and plans to pay dividends of $3,000 in each of June and
September.
Required
Complete the firm’s cash budget for the months May through October.
Procedure
1. Open Excel file FN1M8Q1. This file contains one worksheet, M8Q1.
2. Review the worksheet. It contains data from the question (rows 9 to 24), the text solution on page 908, and pre-
entered formulas. Note the relationships among the pre-entered formulas:
r The input data area is in rows 9 to 24. Check that the data entries in column H conform to the problem
description.
r Rows 30 to 35 contain the cash inflows, including the sales figures and cash receipts.
r Rows 38 to 45 contain the cash outflows, including purchases, wages, taxes, and dividends. You will complete
the payments of accounts payable.
r Rows 63 and 64 calculate the loan amount needed for the month and the maximum amount available for
repayment respectively. The formulas for these two rows share similar logic; they are quite complicated and
are beyond the scope of this course. For reference purposes, review the “Commentary on worksheet
functions” at the end of this question
3. Complete row 41 to calculate payments of accounts payable.
4. Complete row 51 to calculate the opening cash balances. Remember that the opening cash balance of any month
must equal the closing cash balance of the preceding month. Ignore April as you are only interested in the months of
May to October.
5. Complete row 56 to calculate the accumulated cash flow amount for each month.
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6. Complete row 65 to calculate the actual amount of loan to be repaid. Remember that the firm is only required to
repay the amount of revolving loan outstanding. Any amount of cash available over and above the revolving loan
balance is used in the operation of the business — that is, the balance in the revolving loan amount can never be
negative. (Use the IF function.)
7. Complete row 66 to calculate the increase or decrease in the revolving loan balance for each month. In your formula,
you should take advantage of the fact that rows 63 and 64 are mutually exclusive. In other words, if the formula in
the cell in row 63 yields a value, the corresponding cell in row 64 would yield zero. Remember that the maximum line
of credit is $50,000. Therefore, if the cash shortage for the month requires the firm to exceed the maximum line of
credit of $50,000 (cell H21), the formula should yield an error indicator (use the error indicator function #VALUE!).
The amounts calculated in this row are carried to row 58 in the summary cash flow table.
8. Complete row 67 to calculate the balance of the revolving loan. Note that the firm has a revolving loan balance of
zero at April 30 (cell F67).
Commentary on worksheet techniques
Using the INT function
The calculations of the loan amount needed for a particular month (row 63) and the maximum amount of loan repayment for
the month (row 64) are constrained by the same two factors: the firm requires a minimum cash balance of $5,000, and the
increase or decrease in the revolving loan must be in $5,000 amounts at a time. These constraints are built into the formulas
for row 64 and are also incorporated into the formulas for row 63.
For example, cell H64 has the formula
=IF(H56<H22+H24,0,=INT((H56-H24) / H22)*H22)
The following explains this formula and its logical components:
IF(H56<H22+H24,0) tests whether the net cash flow for June (in cell H56) is less than $10,000 (H22+H24 yields $10,000,
since ending cash balance must be at least $5,000, and the least amount of repayment is $5,000). If it is, no cash is available
for repayment of loan and the formula returns a value of zero in the cell. If it is not , the formula calculates the
maximum amount of cash available for repayment, as explained next.
INT((H56-H24)/H22)*H22 calculates the maximum amount of cash available for repayment. The amount of cash
available for repayment equals the net cash balance (cell H56) in excess of the minimum cash balance of $5,000 (cell H24).
However, the repayment amount must be in multiples of $5,000 (cell H22) calculated by the formula INT((H56-H22)/
H22). The integer function INT yields the integer portion of the number in the argument. Multiplying this integer portion by
$5,000 (cell H22) then yields the maximum amount of cash available for repayment, in multiples of $5,000.
Solution
Question 2
Chapter 23, Question 11 (page 924)
Solution
Question 3
Chapter 24, Question 24 (page 954)
Solution
Question 4
Chapter 24, Question 28 (page 955)
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Solution
Question 5
Chapter 24, Question 19 (page 954)
Solution
Question 6
a. Based on the following data, estimate average collection period (ACP), average days sales in inventory (ADSI),
average days of sales in payable (ADSP), operating cycle (OC), and cash conversion cycle (CCC) for 2009.
Fiscal year ending: 12/31/2009
Net sales $3,771,304
Assets
Cash & marketable securities 209,615
Receivables 896,098
Inventories 442,577
Prepaid expenses 10,294
Other current assets 0
Total current assets 1,558,584
Liabilities
Accounts payable 454,858
Taxes payable 36,270
Dividends payable 8,906
Current portion long-term debt 35,670
Short-term debt 154,915
Other current liabilities 220,390
Total current liabilities 911,009
b. Assume that the short-term debt is an operating loan and the CCC represents 90 days of sales. How much of the CCC
in terms of days of sales is financed using short-term debt? How is the firm financing the remaining CCC?
c. Identify five components of good working capital management and comment briefly on how each component of an
effective cash management strategy contributes to a business’s success?
d. Briefly explain the significance of the cash conversion period.
Solution
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Self-test 8
Question 1 solution
Open Excel file FN1M8Q1S and compare your solution to the solution worksheet M8Q1S.
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Self-test 8
Question 2 solution
The characteristics of sound working capital management include:
● maintaining optimal cash balances
● investing any excess liquid funds in marketable securities that provide the best return possible
● considering any liquidity and/or default risk constraints
● managing accounts receivables
● an efficient inventory management system
● obtaining an appropriate level of short-term financing, in the least expensive and most flexible manner possible
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Self-test 8
Question 3 solution
Four inventory management approaches are:
● the ABC approach: inventory is divided into several categories: The higher the priority of the inventory item, the more
time and effort devoted to its management.
● the economic order quantity (EOQ) model: an optimal inventory level is assumed when total shortage costs =
carrying costs.
● materials requirement planning (MRP): a detailed computerized system that orders inventory in conjunction with
production schedules.
● just-in-time (JIT) inventory systems: These fine tune the receipt of raw materials so that they arrive exactly when
they are required in the production process.
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Self-test 8
Question 4 solution
Therefore, Supplier B has a lower effective annual cost.
Another way to solve this question is to follow the formula in Topic 8.8, and find the cost of the missed discount:
Cost of missed discount:
Either method yields the same results. Supplier B has a lower effective annual cost.
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Self-test 8
Question 5 solution
a.
b.
You should take advantage of credit terms of 3/15 net 50 in (a) and pay on day 15 to take advantage of the discount,
and finance your purchase by using loans at 10%.
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Self-test 8
Question 6 solution
a.
b. Short-term debt of $154,915 represents 154,915 ÷ (3,771,304 ÷ 365) = 14.99 days of sales.
The remaining 75.01 (90 – 14.99) days of the CCC are financed using long term financing.
c. The components of good working capital management include:
● ensuring the maintenance of optimal cash balances
● investing excess liquid funds in money market instruments
● properly managing accounts receivables
● maintaining an efficient inventory management system
● maintaining an appropriate level of short-term financing
These components contribute to the firm’s success as follows:
● Cash is an idle resource. Too much cash on hand means that you are foregoing investment revenue; too little
means that you run the risk of missing important payment deadlines and hamper your ability to take
advantage of time-limited opportunities.
● Investing excess cash in money market instruments earns revenue for the company that would otherwise be
foregone.
● Properly managing accounts receivables will help to ensure that credit losses are minimized and the average
collection period is shortened.
● Maintaining an efficient inventory system will help ensure that inventory levels are kept to an acceptable
minimum given the need to minimize stock-outs and to employing the economic order quantity model or
other inventory management approach.
● Maintaining an appropriate level of short-term financing reduces borrowing costs and provides for more
financial flexibility.
d. The cash conversion period represents the average period of time elapsing between the payment of a supplier and
the actual point that payment from sales is received. It shows how long the firm has to wait to receive cash from
sales after paying the obligations that produced these sales. During this period, the firm has to use cash from equity
or debt to finance the payment of these obligations.
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