WORKING CAPITAL MANAGEMENT

Working capital (gross working capital) – simple referred to as current assets

 Permanent (normal) working capital – constitutes the minimum current assets required to conduct the business regardless of
seasonal requirements
 Variable (seasonal) working capital – additional working capital needed by the enterprise during the more active business
seasons of the year
 Net working capital – excess of current assets over current liabilities
 Net operating working capital – defines as current assets minus non-interest bearing current liabilities. More specifically, it is
often expressed as cash and marketable securities, accounts receivable and inventories, less accounts payable and accrued
liabilities.
 Zero working capital – has its own definition of working capital: Inventories + Receivables – Payables. The rationale is that
inventories and receivables are the keys to making sales, and that inventories can be financed by suppliers through accounts
payable.
Working capital management – involves the determination of the level, quality and maturity of each major current
assets and current liability. It also refers to the administration and control of current assets and current liabilities to
insure that they are adequate and used effectively for business purposes. It involves both setting working capital
policy and carrying out that policy in day-to-day operations. It could be viewed collectively or individually,
understanding the components of the working capital would lead to cash management, short-term securities
management, receivables management, inventory management, and short-term financing management.
Sources of working capital
1) Income from current operations, adjusted for noncash expenses such as depreciation
2) Gain on sale of marketable securities
3) Proceeds from the sale of non-current assets
4) Proceeds from long-term borrowings
5) Investments from owners
Uses of working capital
1. Operations (deducted from sources)
2. Purchase of non-current assets
3. Retirement/ payment of long-term debt
4. Return of capital to owners through: (1) dividend payments; (2) retirement of capital stock and (3) withdrawals

Significance of working capital management

1) Working capital represents the margin of safety for short-term creditors
Current assets are likely to yield a higher percentage of their book value on liquidation than do fixed assets. Hence, short-
term creditors look to the current asset as a source of repayment of their claims. The working capital also indicates the amount
by which the value of current assets could drop from their book values and still cover the claims of short-term creditors without
loss
2) The amount of working capital represents the extent to which current assets are financed from long-term sources
Although current assets are turned over within relatively short periods, they always represent some percentage of sales. In
this sense, a portion of current assets must be owned by the firm permanently. Consequently, it is appropriate that a portion of
current assets be financed from permanent sources.

Factors affecting level of current assets:

a) General nature of the business and product – trading and manufacturing companies usually require higher proportions of current
assets than service and utility companies do.
b) Effect of sales pattern – working capital needs will be affected by the nature of the change in sales or business activity.
If sales are brought about by cyclical (seasonal) changes, periodic build-up of receivables and inventory is temporary
and financing need is considered short-term. This is because the conversion of these investments into cash will come in
the normal course of operation. If the change in sales is due to secular (permanent) changes, the incremental working
capital required is permanent and will require long-term financing
c) Length of manufacturing process – the longer the period of time required to manufacture the products of the company, the
higher the level of working capital requirement is
d) Industry practices – industry or line of business with greater proportion of assets readily convertible to cash can afford to have a
lower working capital investment and a higher level of current liabilities
e) Terms of purchases and sales – the longer the credit period granted by suppliers of merchandise is, the lower the requirement for
permanent working capital is. Meanwhile, the longer the credit period given to customer of the firm is, the higher the
requirement for working capital is

Advantages of having an adequate working capital Disadvantages of having an

1. Company can settle its debts promptly thereby enabling it to  INADEQUATE WORKING CAPITAL
maintain its good credit standing
2. Credit may be extended to customers thereby increasing the 1) Risk of business failure is increased
sales volume of the firm 2) Company may not be able to pursue its objectives
because of lack of funds

3. Inventories can be easily replenished  EXCESSIVE WORKING CAPITAL

4. Current operating expenses are paid promptly
5. Management and employee morale is enhanced 1) Management may become inefficient and complacent
6. Profitable opportunities can be taken advantage of 2) Management may be tempted to speculate
3) Unnecessary expense and extravagance may result
4) Resources are not optimally employed

The management of working capital as a cluster of assets is important because the overall profitability and liquidity risk of the firm is affected by the
total amounts, as well as the types of working capital utilized. The level of working capital can be varied relative to the productive output that affects
the risk of insolvency as well as the potential profitability of the firm.

Working capital policy – refers to the firm’s policy regarding (1) target levels for each category of current assets and
(2) how assets will be financed.

ALTERNATIVE CURRENT ASSET INVESTMENT POLICIES

1
1. Conservative (relaxed) current asset investment policy (“fat cat”) – a policy under which relative large amounts of cash,
marketable securities and inventories are carried and under which sales are stimulated by a liberal credit policy, resulting in a
high level of receivables. This policy generally provides the lowest expected return on investment because capital tied up in
current assets either does not earn any substantial income at all or a minimal income if any, but it entails the lowest risk
2. Restricted (aggressive) current asset investment policy (“lean and mean”) – a policy under which holding of cash,
securities, inventories and receivables are minimized. In this policy, the firm has fewer liquid assets with which to prevent a
possible financial failure. Holdings in cash, securities, investors and receivables are minimized. While risk of financial failure is
high because of the small amount of total capital requirement, the profitability rate measured by the rate of return as total
assets however is higher.
3. Moderate current asset investment policy – a policy that is between relaxed and restricted policy.

Capital
Relaxed current asset policy

Moderate current asst policy

Restricted current asset policy

 Permanent current assets – current assets that a firm must carry even at the trough of its cycles
 Temporary current assets – current assets that fluctuate with seasonal (cyclical) variations in sales

ALTERNATIVE CURRENT ASSET FINANCING POLICIES

1) Maturity matching (self-liquidating) approach – a moderate approach to current asset financing involves matching to the extent
possible the maturities of assets and liabilities, so that temporary current assets are financed with are financed with short-term
nonspontaneous debt and permanent current assets and fixed assets are financed with long-term debt or equity, plus
spontaneous debt. It is a financing policy that matches asset and liability maturities.

This policy is also known as hedging policy call for the use of permanent financing (long-term debt and equity) to finance
permanent assets (fixed assets and permanent working capital) and then use of short-term financing to cover seasonal and/ or
cyclical temporary assets. This strategy minimizes the risk that the firm ill be unable to pay off its maturing obligations.

2) Aggressive approach – in this approach, a firm finances all of its fixed assets with long-term capital but part of its permanent
current assets is financed with short-term nonspontaneous credit. This happens because to acquire long-term funds, the firm
must generally go to the capital markets with a stock or bonds offering or muse negotiate long-term obligations with insurance
companies and so on. Many small businesses do not have access to such long-term capital. It is in this approach wherein some
permanent current assets, and perhaps even some fixed assets are financed with short-term debt.

A relatively high aggressive firm would be very much subject to dangers from using interest rates as well as loan renewal
problems. Although short-term debt is often cheaper than long-term debt, some firms are willing to sacrifice safety for the
chance of higher profits.

3) Conservative approach – this approach uses permanent or long-term financing source to finance all permanent assets and also
part of the temporary current assets and then hold temporary surplus of funds as marketable securities at the trough of the
cycle. Here, the amount of permanent, or long term capital exceeds the level of permanent assets. Conservative approach would
be to use long-term capital to finance all permanent assets and some temporary current assets.

Trade of between risk and return

Conservative Aggressive
Level of working capital High Low
Level of long-term financing High Low
Liquidity risk Low High
Profitability returns Low High

Notes:
 High level of current asset = LOW LIQUIDITY RISK
 More reliance on long-term financing = LOW RETURNS
 Substantial level of working capital entails high reliance on long-term financing, which would lead to greater liquidity but
lower returns (profit) because of higher explicit costs
 Liquidity of current assets will affect the terms and availability of short-term credit. Short term credit, in turn, affects the
amount of cash balance held by the firm
 Holding more current than long term assets results into reduced liquidity risk. However, the rate of return will be less than
with the current assets than with long term assets. This is because long-term assets generally earn greater than current
assets.

OBJECTIVE OF CURRENT ASSET MANAGEMENT

1. The total amount of liquidity necessary to avoid the risk of insolvency
2. The amount of cash versus near-cash (marketable securities) to have in the liquidity mix for transaction purposes

Cash conversion cycle – the average length of time involved – from the payment of raw materials to the collections of accounts
receivable.
Formula:
Cash Conversion Cycle = Inventory conversion period + Receivable collection period – Payable deferral period

Inventory conversion period = Inventory / Sales per day

Receivables collection period = Receivables / (sales / # of days in a year)
Payables deferral period = Payables / Purchases per day

2
CASH MANAGEMENT
Cash is a commodity it is not an investment. It has to be invested to produce wealth. Theoretically, cash represents an idle
resource. However, cash balance is maintained to meet loan conditions, contractual requirements, deposit arrangements or petty
cash contingencies. Managing cash is a treasurer’s domain. Cash balance should be at its optimum and cash flows ( inflows and
outflows) should be synchronized.
Cash management involves the maintenance of a cash and marketable securities investment level which will enable the
company to meet its cash requirements and at the same time optimize the income on idle funds.

Objective of Cash Management:

1) To meet the cash disbursements needs
2) To minimize the funds committed to transactions and precautionary balances
3) To avoid misappropriation and handling losses in the normal course of business

Reasons of holding cash:

1. Transaction motive – cash is needed to facilitate the normal transactions of the business, that is, to carry out its purchases
and sales activities
2. Precautionary motive – cash may be held beyond its normal operating requirement level in order to provide for a buffer
against contingencies such as unexpected slow-down in accounts receivable collection, strike or increase in cash beyond
management’s original projections
3. Speculative motive – cash is held ready for profit-making or investment opportunities that may come up such as a block of
raw materials inventory offered at a discounted prices or a merger proposal
4. Contractual motive – a company may be required by a bank to maintain a certain compensating balance in its demand
deposit account as a condition of a loan extended to it.

MANAGING CASH FLOWS

Synchronized cash flows – a situation in which inflows coincide with outflows, thereby permitting a firm to hold low transactions
balances.

Determining the cash needs:

1) Cash budget – a schedule showing projected cash inflows and outflows over some period. It is used to predict cash surpluses
and deficits, and it is the primary cash management planning tool.
2) Cash breakeven chart – shows the relationship between the company’s cash needs and cash sources. It indicates the
minimum amount of cash that should be maintained to enable the company to meet its obligations.
3) Optimal cash balance model (Baumol Model) – in most medium or large-sized corporations, liquidity management has
assumed a greater role over the past decade. Since cash is needed for both transaction and precautionary needs in all
companies, it must be available in some form (cash, marketable securities, borrowing capacity) all of the time. The liquidity
managers must utilize some formal models or techniques to maintain the optimal amount at each moment in time because too
much liquidity brings down the rate of return on total assets employed and too little liquidity jeopardizes the very existence of
the firm itself. In managing the level of cash (currency plus demand deposits) for transaction purposes versus near cash
(marketable securities), the following costs must be considered: (1) Fixed and variable brokerage fees and (2) Opportunity costs
such as interest foregone by holding cash instead of near cash. This model balances the opportunity cost of holding cash against
the transaction costs associated with replenishing the cash account by selling off marketable securities or by borrowing.
Formula:
1) Total cost of cash balance = Holding costs + Transaction costs

Holding costs = Average cash balance x Opportunity cost

Transaction costs = Number of transactions x Cost per transaction

Total cash balance = (C/ 2) (K) + (T/C) (F)

Where:
C = amount of cash raised by selling marketable securities or by borrowing
C* = optimal amount of cash to be raised by selling marketable securities or by borrowing
C/2 = average cash balance
C*/2 = optimal average cash balance
F = fixed costs of making a securities trade or of obtaining a loan
T = total amount of net new cash needed for transactions during the period (usually a year)
k = opportunity cost of holding cash, net equal to the rate of return foregone on marketable securities or the cost of
borrowing to hold cash.
2) Optimal cash balance (C*)

2 (total amount of net new cash required) (fixed costs of trading securities or cost of borrowing)
Opportunity cost of holding cash

Note: The optimum cash balance computation resembles that of the economic order quantity

Techniques for lessening Cash needs:

1. Accelerating collections – any method that accelerates collection lessens the firm’s need for cash. This may be accomplished
through:
a) High standards on credit approval. Reliable collection pattern is greatly related to the quality of credit customers.
Customers who have shown their capability, ability and commitments to meet credit payments in the past are expected
to continue their paying practices in the coming periods.

b) Shorter trade discount and credit period. If the competitive environment suggests, granting trade credit facilities
on a shorter period is a more comfortable way of managing cash collections from customers
c) Efficient and effective billing system. Collections are also dependent on the efficiency of the organization’s billing
system. Accurate, prompt and service-oriented billing policies give a serious signal to customers that records are kept
completely and intact and commitments are expected to be met as they fall due.
Cost-effective collection systems such as:
1) Frequency of collection follow-up. Friendly, tactful and frequent notices of collections through calls, other electronic
means or personal visitation are tested practices in making an effective collection
2) Visibility of collection personnel. Maintaining an effective field collection personnel group is also a successful technique
most commonly applied by small and medium size distribution and financing companies
3) Use of specialized postal system (i.e. lockbox system). Collections through a postal system, either government-operated
or privately-owned postal company, are found to be cost-effective in other places.

3
 Lockbox plan – a procedure used to speed up collections and reduce floats through the use of post office boxes in
payer’s local areas.
4) Electronic fund transfer. The advent of electronic technology has already seeped its way to the banking sector where
transfers of funds are made anywhere and everywhere thereby scraping off several traditional bottlenecks in collections
such as the problem of distance, timing and costs.
5) Concentration banking. Collections could be facilitated by banks through a bank-to-bank transfer scheme. It is the
method of collections through banking facilities, where the depository bank of the seller is given authority to receive
transfer of funds from the buyer through its depository bank which has been authorized to transfer of funds.

2. Slowing disbursements – any action on the part of the finance officer which shows the disbursement of funds lessens the use
for cash balance. This can be done by:
a) Use of checks and drafts. Disbursements must be made in checks or drafts unless it is impractical to do so. the use of
check signifies that the cash payment is authorized after all the accounting verification processes. The use of check
makes use of the “cash float”.
Play the float – involves taking advantage of the time it takes for the company’s check to clear the banking system.
 Float – the difference between the balance shown in the firm’s (or individual) checkbook and the balance on the
bank’s record.
 Cash float – number of days from the date of the check to the date the money is withdrawn.
 Disbursement float – value of the checks that were written but are still being processed and thus have not
been deducted from the account balance by the bank
 Collections float – amount of checks that we have received but have not yet been credited to our account
 Net float – difference between our checkbook balance and the balance shown on the bank’s account

Check clearing – the process of converting a check that has been written and mailed into cash in the payee’s
account.
For local checks to be cleared = takes two days
For regional checks to be cleared = takes normally five days
b) Voucher system. Transactions that need cash payments are recorded in a voucher register. Details of transactions are
entered to keep an accurate record of events and amounts. Additionally, liability due date and credit terms is readily
available for rightful management disposition. More importantly, before a check is prepared, a journal voucher is
processed and supported by documents showing the existence, accuracy, and verifiability of the debt to be paid.
c) The 3:00 o’ clock habit. For a maximized use of float, checks are to be issued at or after 3:00 o’ clock in the afternoon
after the bank clearing time is closed. This makes the check good for deposit in the following business day, at the
earliest. This practice stretches the deposit by a day.
d) Thank God it’s Friday (TGIF) syndrome. If the checks are issued on a Fridays, deposit could be made the incoming
Monday, thereby, increasing the cash float by two more days (that is Saturday and Sunday)
e) Centralized processing of payables. This permits the finance manager to evaluate the payments coming due for the
entire firm and to schedule the availability of funds to meet these needs on a company-wide basis. It also results to
more efficient monitoring of payables and float balances. Care, however, should be taken so as not to create ill will
among suppliers of goods and services or raise the company’s cost if bills are not paid on time.
f) Zero balance accounts (ZBA). These are special disbursement accounts having a zero peso balance on which checks are
written. As checks are presented to a ZBA for payment, funds are automatically transferred from a master account.
g) Delaying payment. If one is not going to take advantage of any offered trade discount for early payment, pay on the last
day of the credit period.
h) Less frequent payroll. Instead of paying the workers weekly, they may just be paid semi-monthly

Internal control for cash

1) The cash department should be under the supervision of the treasurer
2) The cash department should be separated from the accounting and other departments that keep records of transactions and
events
3) All cash transactions must be supported by available proof of accuracy. All cash receipts must be issued pre-numbered official
receipts. All official receipts must be multi-copied and preferably machine validated. All check issuances must be supported by
delivery receipts, sales invoices, receiving reports, board resolutions or official receipts
4) All cash receipts must be deposited intact in the designated depository on the day of collection or in the following business day
5) Bank deposit slips must always be on file, complete and available
6) Periodic reconciliation of bank and book records must be done
7) Cash count should always be done and with an element of surprise
8) All checks must be properly signed and approved by at least two signatories
9) Cash personnel must be properly selected and trained
10) Cashiers must be bonded
11) Cashiers should be rotated, periodically or surprisingly
12) A cashier’s manual must be made available
13) Use of mechanical or electronic equipment in issuing checks and official receipts
14) Preparation and verification of daily cash report

MARKETABLE SECURITIES MANAGEMENT

Marketable securities – securities that can be sold on short notice

Objective of marketable securities management

The firm may hold excess funds in anticipation of a cash outlay. When funds are being held for other than immediate
transaction purposes, they should be converted from cash into interest-bearing marketable securities. Marketable securities which
should be of highest investment grade usually consists of treasury bills, commercial paper, certification of time deposits from
commercial banks.
Realistically, management of cash and marketable securities cannot be separated. Management of one implies management
of the other.

Reasons for holding marketable securities

“Firms can reduce their cash balances by holding marketable securities, which can be sold on short notice at close on their
quoted prices. They serve both as a substitute for cash and as a temporary investment for funds that will be needed in the near
future.”

4
1. They serve as substitutes for cash balances. Many firms prefer to hold marketable securities as a substitute for transaction
balances, precautionary balances, for speculative balances or for all three. In most cases, however, the securities are held
primarily for precautionary purposes or as a guard against a possible shortage of bank credit
2. They are held as temporary investment where a return us earned while funds are temporary idle
3. They are built up to meet known financial requirements such as tax payments, maturity bond issue etc...

Factors Influencing the Choice of Marketable Securities

1) Risks
a) Default risk – risk that the issuer of the security cannot pay the principal or interest at due dates
b) Interest rate risk – risk of declines in market values of the security due to rising interest dates
c) Inflation risk – the risk that inflation will reduce the “real” value of the investment. In periods of rising prices, inflation risk is
lower on investments (e.g. common stocks) whose returns tend to rise inflation than on investments whose returns are fixed

2) Maturity. Marketable securities held should mature or can be sold at the same time cost is required
3) Yield (returns on securities). Generally, the higher a security’s risk, the higher its required return. Corporate investors, like
other investors must make a trade-off between risk and return when choosing marketable securities. Because these securities
are generally held either for a specific known need or for use in emergencies, the portfolio should consist of highly liquid short-
term securities issued by the government or very strong corporation. Treasurers should not sacrifice safety fir higher rates of
return.
4) Marketability (liquidity) risk. Refers to the risk that securities cannot be sold at close to the quoted market price and is
closely associated with liquidity risk.

RECEIVABLES MANAGEMENT

Objective of Receivable management

“To encourage sales and gain additional customers by extending credit.” It is therefore the responsibility of the
finance officer to evaluate the pertinent costs and benefits related to credit extension, to finance the firm’s investment in accounts
receivable, implement the firm’s chosen credit policy and to enforce collection.

Credit management – strategically defines the quality of accounts receivable collections.

Credit and collection have a direct relationship. If credit standards are high, the rate of collection is expected to
be high and vice-versa.
Credit management Credit policy Effects to
variables Collection Receivable Receivable Collection
balance turnover period
High Faster Decrease Increase Shorter
Discount rate Low Slower Increase Decrease Longer
Short/Strict Faster Decrease Increase Shorter
Discount time Long / lax Slower Increase Decrease Longer
Short/ strict Faster Decrease Increase Shorter
Credit period Long/ lax Slower Increase Decrease Longer
High / strict Faster Decrease Increase Shorter
Credit cap/ credit limit Long/ lax Slower Increase Decrease Longer
Low risk/ strict Faster Decrease Increase Shorter
Credit class High risk/ lax Slower Increase Decrease Longer

Credit policy – set of decisions that include a firm’s credit period, credit standards, collection procedures and discounts offered
Collection policy – procedures that a firm follows to collect accounts receivable.
Credit cap/ credit limit – the limitation of credit line in terms of amount set or imposed by the seller to a given customer depending
on his capability to meet trade payments.
Credit block – policy of non-delivery of merchandise to customers once their accounts become past due.
Credit class – pertains to group of customers to whom merchandise shall be delivered. Customers may be classified according to
their income level, place of residence, gender, age, geographical location, civil status, and other matters of social demographics.
Credit limits and other credit terms are determined for each credit class.

Factors in determining Accounts Receivable policy

1. Credit standards. Credit policy can have a significant influence upon sales. If credit policy is relaxed, while sales may increase,
the quality of accounts receivable may suffer. This may result into longer average collection period. An optimal credit policy
would involve extending trade credit more liberally until the marginal profitability on additional sales equals the required return
on the additional investment in receivables. Or it is a trade-off between the profits on sales that give rise to receivables on one
hand and the cost of carrying these receivables plus bad debt losses on the other. These are standards that stipulate the
required financial strength that an applicant must demonstrate to be granted credit.
2. Credit terms. It involves both the length of the credit period and the discount given. Although the customs of the industry
frequently dictate the terms given, the credit period if lengthened generally results to an increased product demand and vice
versa. It is a statement of the credit period and any discounts offered (e.g. 2/10, net 30)
Credit period – length of time for which credit is granted.

3. Collection period. Credit analysis is instrumental in determining the amount of credit risk to be accepted. In turn, the amount
of risk accepted affects the slowness of receivables and the resulting investment in receivables, as well as the amount of bad
debt losses. Collection procedures affect these factors. Within a reasonable range, the lower the proportion of bad debt losses
and the shorter the average collection period, all other things remaining the same
4. Delinquency and default. Whatever credit policies a business firm may adopt, there will be some customers who will delay and
others who will default entirely, thereby increasing the total accounts receivable costs. Again, the optimal credit policy that
should be adopted is the one that provides the greatest marginal benefit

Costs associated with accounts receivable

a) Credit analysis, accounting and collection costs. If the firm is extending credit in anticipation of attracting more business, it
incurs cost of hiring a credit manager plus assistants and bookkeepers within the finance department; of acquiring credit
information sources and of generally maintaining and operating a credit and collection department.
b) Capital costs. Once the firm extends credit, it must raise funds in order to finance it. The interest to be paid if the funds are
borrowed or the opportunity cost if equity capital will constitute the cost of funds that will be tied up in the receivables.
c) Delinquency costs. These are incurred when the customer is late in paying. This delay adds collection costs above those
associated with a normal collection. Delinquency also creates an opportunity cost for any additional time the funds are tied up
after the normal collection period

5
d) Default costs (Bad debts). The firm incurs default costs when a customer fails to pay at all. In addition to the collection costs,
capital costs and delinquency costs incurred up to this point, the firm loses the cost of goods sold not paid for. It has to write off
the entire sales once it decides the delinquent account has defaulted and is no longer collectible.

Summary of trade-offs in Credit and Collection policies

Trade offs
Benefits Costs
 Relaxation of credit standards  Increase in sales and total  Increase in:
contribution margin 1) Credit processing costs
2) Collection costs
 High default costs or bad debts
 Higher capital costs

 Lengthening of credit period  Increase in sales and total  Higher capital costs (opportunity cost
contribution margin of higher investment in receivables)

 Granting cash discounts  Increase in sales and total  Lesser profit

contribution margin
 Opportunity income on lower
investment in receivable

 Intensified collection efforts  Lower default costs or bad debts  Higher collection expenses
 Lower opportunity cost or capital  Lower sales
costs

MARGINAL/ INCREMENTAL ANALYSIS IF CREDIT POLICIES

IF: Change in credit policy?
 Incremental profit contribution > incremental cost Accept
 Incremental profit contribution = incremental cost Be indifferent
 Incremental profit contribution < incremental cost Reject

Trade discount/ Credit discounts - given to encourage credit customers to pay their accounts earlier.
This win-win situation between the seller and the buyer speaks of the benefits that could be derived by the buyer in terms of
reduction in the amount to be paid and the benefit on the part of the seller for the opportunity to use the money to generate
additional earnings. The bait is “the higher the discount rate, the more attractive it is for the buyer to pay at an earlier date”.
However, the cost-benefit trade off should be considered, that is, the cost of offering the discount rate should be compared with the
benefit of using the money.

Cash discounts –reduction in the price of goods given to encourage early payment.
Effective discount rate – discount rate adjusted on an annual basis.
Formula: Effective discount rate: (Days in a year / remaining credit time) x [Discount rate / (100% - discount rate)]
Effective discount rate: Discount time turnover x adjusted discount rate per discount time

SELLER BUYER
 EDR < ROI of money collected in advance Offer trade discount
 EDR > ROI if money is used Ignore trade discount
 EDR < cost of money (e.g. interest rate) Ignore trade discount
 EDR > ROI of money collected in advance Do not offer trade discount
 EDR < ROI if money is used Avail trade discount
 EDR > cost of money Avail trade discount

Seasonal dating – used to induce customers to buy early by not requiring payment until the purchaser’s selling season, regardless
of when the goods are shipped.

INVENTORY MANAGEMENT
Objective of inventory management
Inventory is the stockpile of the product the firm is offering for sale and the components that make up the product. It is the
responsibility of the financial officer to maintain a sufficient amount of inventory to insure the smooth operation of the firm’s
production and marketing functions and at the same time avoid tying up funds in excessive and slow-moving inventory.

Functions of inventories
1. Pipeline (transit) inventories. These are inventories which are being moved or transported from one location to another and
they fill the supply pipelines between stages of the entire production-distribution system
2. Organizational (decoupling) inventories. These are inventories that are maintained to provide each link in the production-
distribution chain a certain degree of independence from the others. These will also take care of random fluctuations in demand
and/or supply
3. Seasonal (anticipation) stock. These are built up in anticipation of the heavy selling season or in anticipation of price increase
or as part of promotional sales campaign
4. Batch (lot-size) inventories. These are inventories that are maintained whenever the user makes or buys material in larger
lots than are needed for his immediate purposes
5. Safety (buffer) stock. These inventories are maintained to protect the company from uncertainties such as unexpected
customer demand, delays in delivery goods ordered etc..

Inventory management – directly linked to the operating goal of giving the best service to customers.

Basic comparison between traditional and modern management models

Criteria Traditional Inventory management Modern Inventory management
 Objective Deliver sales on time at the lowest possible cost Delivers sales on time at the most reasonable price

 Primary strategy Maintain adequate inventory holdings of Efficient scheduling of production process (i.e.
materials and finished goods input, throughput and output) through the use of
technology and linkages to suppliers

 Business environment  Production is labor-intensive  Production is technology-oriented

 Use of mechanical equipment and  Use of electronic and mechanical equipment
machineries and machineries
6
  Product-oriented; functional in nature  Process-oriented
 Emphasis on company-customer relations  Emphasis on suppliers-company-customer
 Less investment in capital expenditures relations
 Generally, lesser cost of production in the  Heavy investments in capital expenditures
short-run  Generally, lower cost of doing business in the
long-run

 Inventory models  Economic order quantity model  Just-in-time (JIT)

 Reorder point  Flexible manufacturing system
 Order cycling method  Computer integrated manufacturing
 Two-bin system  Materials requirements planning (MRP)
 Min-max model  Manufacturing resource planning (MRP-II)
 ABC classification  Enterprise resource planning

INVENTORY MANAGEMENT TECHNIQUES

1) Inventory planning. It involves the determination of what inventory quality, quantity, timing and location should be in order to
meet future business requirements.
a. Economic order quantity (EOQ) – refers to the units of materials that should be purchased to minimize total relevant
inventory costs.
Formula:
Economic Order Quantity:
In units:
__________________________________________________________
√ (2 x Annual demand x Cost per order) / Carrying cost per unit
In pesos:
________________________________________________________________
√ (2 x Annual demand in pesos x Cost per order) / Carrying cost ratio

Total relevant inventory costs – sum of ordering costs and carrying costs
Formula: Total ordering costs + Total carrying costs

Note: At Economic Order Quantity (EOQ), total ordering cost is EQUAL to total carrying cost.

Ordering costs – include those spent in placing an order, waiting for an order, inspection and receiving costs, setup costs
and quantity discounts lost. Its total cost is taken from the historical records of the organization.
Formula:
 Total ordering costs: Cost per order x number of orders
 Cost per order: Total ordering costs / number of orders
 Number of orders: Annual demand / Order size

Carrying costs – those spent in holding, maintaining or warehousing inventories such as warehousing and storage costs,
handling and clerical costs, property taxes and insurance, deterioration and shrinkage of stocks, obsolescence of stocks,
interest and return on investment (e.g. lost return on investment tied up in inventory).
Formula:
 Carrying cost per unit: Total carrying cost / Average inventory
or Unit cost x Carrying cost ratio
 Carrying cost ratio: carrying cost per unit / Unit cost
 Average inventory: Order (lot) size / 2
 Total carrying costs: Carrying cost per unit x Average inventory

Relationship between order size, ordering costs and carrying costs

Order size Ordering costs Carrying costs
Increase Decrease Increase
Decrease Increase Decrease

b. Economic Production Run (economic production quantity; optimum production run; optimum lot size). It refers to the size of
production where the total cost of materials will be at minimum. The EOQ formula can be used in determining the optimum
production run. This is the economic order quantity model for manufacturing firms, particularly in terms of producing
products.

Formula:
Economic Production Run
_______________________________________________
√ (2 x Annual demand x Set up cost) / Carrying cost per unit

c. Economic Order Quantity with “back orders”.

Back orders – sale made when the item is not in stock.
Formula:
Economic order quantity with back orders:
___________________________________________________________________
√ (2 x annual demand x cost per order)
[carrying cost per unit x (Cost of back orders / (Cost of back orders – Carrying cost per unit)]

d. Reorder point (ROP). It refers to the inventory level where a purchase order should be placed. It is the sum of lead time
quantity and safety stock quantity.
Formula:
Reorder point: Lead time quantity + Safety stock quantity
 Lead time. Refers to the waiting time from the date the order is placed until the date the delivery is received.
Lead time quantity. It represents the normal usage during the lead time period.
Formula: Lead time quantity: Normal usage x Normal lead time
Normal usage. It means the average usage of inventory during a period (i.e. annual demand / working days in a year)
Safety stock. It is set to serve as a margin in case of variations in normal usage and normal lead time. Hence, it is a
safety stock for variations in usage and a safety stock for variations in time.
Formulas:
Safety stock: Safety stock (usage) + Safety stock (time)
Safety stock (usage): (Maximum usage – Normal usage) x Normal lead time
7
 Safety stock (time): (Maximum lead time – Normal lead time) x Normal usage
Maximum inventory level. It is the sum of the safety stock quantity and order size. The minimum quantity is the safety
stock quantity.
Formula: Safety stock quantity + Order size

e. Stock out costs. Inadequate inventory levels carried by a business have the following costs: (1) extra purchasing, handling
and transportation costs; (2) lost sales and of customer goodwill; (3) additional clerical costs due to keeping customer-back
order records; (4) inflation-oriented increases in prices when inventory purchases are deferred; (5) frequent stock-out costs
leading to disruptions of production schedules, overtime and extra set-up time; (6) higher price due to small quantities (e.g.
extra purchasing on transportation costs); (7) foregone suppliers’ discount. Stock out costs has two costs, the carrying costs
of safety stock and costs of the stockout occurrences.
Formula
 Total stockout costs: Cost of carrying costs of safety stock quantity + Cost of stockout occurrences
 Cost of carrying Safety stock quantity: Safety stock quantity x Carrying cost per unit
 Stockout cost per occurrence: Stockout cost per unit x Stockout units
 Cost of stockout occurrences:
Stockout cost per occurrence x Probability of occurrence x Number of occurrences
2) Inventory control systems
Inventory control – the regulation of inventory within predetermined limits
Effective inventory management should provide adequate stocks to meet the requirements of the business, while at the
same time keeping the required investment to a minimum.
a) Fixed order quantity system. It is a system wherein each time the inventory goes down to a predetermined level (known as
reorder point), an order for a fixed quantity is placed. It requires the use of perpetual inventory records or the continuous
monitoring of the inventory level.
 Min-max model – sets definable limits in inventory balances. Here the minimum inventory level serves as the
reorder point. It includes normal quantity to be used from the time an order is placed up to the time the materials
are received. The safety stock quantity to minimize the occurrence of stockout is also included. The maximum
inventory level is the sum of the stockout quantity and the order size.
 Two-bin system – reorder is placed when the contents of the first bin are used up. It is an inventory control
procedure in which an order is placed when one of two inventory-stocked items is empty
 Red-line method – an inventory control procedure in which a red line is drawn around the inside of an inventory
stocked bin to indicate the reorder point level.
 Computerized inventory control system – a system of inventory control in which a computer is used to determine
reorder points and to adjust inventory balances
b) Fixed reorder cycle system. It is also known as the periodic review or the replacement system where orders are made after a
review of inventory levels has been done at regular intervals. An order is placed if at the time of the review the inventory
level had gone down since the preceding review. The quantity ordered under this system is variable depending on usage or
demand during the review period.
Formula in getting the replenishment level:
M = B + D(R-L)
Where: M = replenishment level in units; B = buffer stock in units; D = average demand per day;
R = time interval in days, between reviews; L = lead time in days
c) Optional replenishment system. This represents a combination of the important control mechanisms of the other two
systems.
Formula in getting the replenishment level:
P = B + D(L + R/2)
Where: P = reorder point in units; B = buffer stock in units; D= average daily demand in units;
L = lead time in days; R = time between review in days
d) ABC Classification system (selective control model). Under this system, segregation of materials for selective control is
made. Inventories are classified into “A” (high value items), “ B” (medium cost items) and “C” (low cost items). Control may
be exercised on these items as follows:
1. A items – highest possible controls, including most complete, accurate records, regular review by top supervisor, blanket
orders with frequent deliveries from vendor, close follow-up through the factory deliveries from vendors; close follow-up
through the factory to reduce lead time, etc. Careful accurate determination of order quantities and order point with
frequent review to reduce, if possible
2. B items – normal controls involving good records and regular attention; good analysis for EOQ and order point but
reviewed quarterly only or when major changes occur
3. C items – simplest possible controls such as periodic review of physical inventory with no records or only the simplest
notations that replenishment stocks have been ordered; no EOQ or order point calculations

Inventory class
A B C
Money value High Middle Low
Quality control Very strict Not too strict Strict
Inventory movements Slow Relatively fast Fast
Level of safety stock Low Moderate High
Quality of personnel Best available Average Fair
Quality of records Error-free Highly reliable Reliable
Replacement time ASAP Normal Can be long
Inventory turnover Low Average high

SHORT TERM FINANCING

Two basic problems encountered in managing the firm’s use of short-term financing:
a) Determining the level of short-term financing the firm should use
b) Selecting the source of short-term financing

Advantages and disadvantages of short term financing

1) Speed. A short-term loan can be obtained much faster than long-term credit. Lenders will insist on a more thorough financial
examination before extending long-term credit, and the loan agreement will have to be spelled out in considerable detail
because a lot can happen during the life of a 10- to 20- year loan. Therefore, if funds are needed in a hurry, the firm should look
to the short-term markets.
2) Flexibility. If it needs for funds are seasonal or cyclical, a firm may not want to commit itself to long-term debt for three
reasons: (1) flotation costs are higher for long-term debt than for short-term debt; (2) although long-term debt can be repaid
early, provided the loan agreement includes a prepayment provision, prepayment penalties can be expensive. According if a firm
thinks its need for funds will diminish in the near future, it should choose short-term debt; (3) long term loan agreements always

8
 contain provisions (or covenants) which constrain the firm’s future actions. Short term credit agreements are generally less
expensive.

Sources of short-term financing

1. Accrued liabilities. These are continually recurring short-term liabilities, especially accrued wages and accrued taxes. These
increase automatically (spontaneously) as a firm’s operations expand. Further, this type of debt is “free” in the sense that no
explicit interest is paid on funds raised through accrued liabilities.
2. Accounts payable (trade credits). These are debt arising from credit sales and recorded as accounts receivables by the seller
and as an account payable by the buyer. It is the largest single category of short-term debt, representing about 40 percent of the
current liabilities of the average nonfinancial corporation. The percentage is somewhat larger for smaller firms; because small
companies often do not qualify for financing from other sources, they rely especially heavily on trade credit. Trade credit is a
“spontaneous” source of financing in the sense that it arises from ordinary business transactions.
 Components of trade credit:
1) Free trade credit – credit received during the discount period
2) Costly trade credit – credit in excess of free trade credit, whose cost is equal to the discount lost.
Formula in getting the cost of trade credit:
Nominal Cost of trade credit: Discount percent x # of days in a year
( 100% - Discount percent) (Days credit outstanding – Discount period)

Effective cost of trade credit:

Discount rate [# of days in a year/ (days credit outstanding – discount period)]

1+ (100% - Discount rate) - 1

Stretching Account payable – the practice of deliberately paying late.

3. Bank loans. Commercial banks, whose loans generally appear on the balance sheets as notes payable, are second in
importance to trade credit as a source of short-term financing for non-financial corporations. The banks’ influence is actually
greater than it appears from the peso amounts because banks provide nonspontaneous funds. As a firm’s financing need
increase, it requests additional funds from its bank.

Key features of bank loan:

 Maturity. Although banks do make longer-term loans, the bulk of lending is on a short-term basis – about 2/3 of all bank
loans mature min a year or less. Bank loans to businesses are frequently written as 90-day notes, so the loan must be repaid
or renewed at the end of 90 days. Of course, if a borrower’s financial position has deteriorated, the bank may refuse to
renew the loan. This can mean serious trouble for the borrower.
 Promissory notes. It is a document specifying the terms and conditions of a loan, including the amount, interest rate and
repayment schedule.
Key elements contained in promissory notes:
a) Interest only versus amortized. Loans are either interest-only, meaning that only interest is paid during the life of
the loan, and the principal is repaid when the loan matures, or amortized, meaning that some of the principal is
repaid on each payment date. Amortized loans are called instalment loans.
b) Collateral. If a short-term loan is secured by some specific collateral generally accounts receivable or inventories,
this fact is indicated in the note.
c) Loan guarantees. If the borrower is a small corporation, its bank will probably insist that the larger stockholders
personally guarantee the loan. Banks have often seen a troubled company’s divert assets from the company to some
other entity he or she owned, so banks protect themselves by insisting on personal guarantees. However, stockholder
guarantees are virtually impossible to get in the case of larger corporations that have many stockholders. Also,
guarantees are unnecessary for proprietorships or partnerships because here the owners are already personally liable
for the business’ s debts.
d) Nominal (stated) interest rate. The interest rate can be wither fixed or floating. If it floats, it is generally indexed
to the bank’s prime rate, to the T-bill rate or to the London Inter-Bank Offer rate (LIBOR). Most loans of any size
($25,000 and up) have floating rates if their maturities are greater than 50 days. The note will also indicate whether
the bank uses 360 – or 365 day year for purposes of calculating interest

Prime rate – a published interest rate charged by commercial banks to large, strong borrowers

e) Frequency of interest payments. If the note is on an interest-only basis, it will indicate how frequently interest
must be paid. Interest is typically calculated on a daily basis but paid monthly.
f) Maturity. Long-term loans always have specific maturity dates. A short-term loan may or may not have a specified
maturity. Banks never call demand notes unless the borrower’s creditworthiness deteriorates, so some “short-term
loans” remain outstanding for years, with the interest rate floating with rates in the economy.
g) Discount interest. Most loans call for interest to be paid after it has been earned, but discount loans require that
interest must be paid in advance. If the loan is on a discount basis, the borrower actually receives less than the face
amount of the loan and this increases the loan’s effective cost. It is an interest that is calculated on the face amount
of a loan but is paid in advance.
h) Add-on basis instalment loans. Auto loans and other types of consumer instalment loans are generally setup on an
“add-on basis”, which means the interest charges over the life of the loan are calculated and then added to the face
amount of the loan. Thus, the borrower signs a note for the funds received plus the interest. The add-on feature also
raises the effective cost of a loan.

Add on interest – interest that is calculated and added to funds received to determine the face amount of an
instalment loan.

Formula in computing
 Effective annual rate add-on: (1+kd)n – 1.0
 Annual percentage rate (APR): Periods per year x Rate per period

i) Other cost elements. Some loans require compensating balances, and revolving credit agreements often require
commitment fees. Both of these conditions will be spelled out in the loan agreement, and both raise the effective cost
of a loan above its stated nominal rate.

 Compensating balances. A minimum checking account balances that a firm must maintain with a commercial bank,
generally equal to 10 to 20 percent of the amount of loans outstanding.

9
  Informal Line of credit. It is an informal agreement between bank and a borrower indicating the maximum credit the bank
will extend to the borrower.
 Revolving credit agreement. It is a formal line of credit extended by a bank or other lending institutions. The bank has a
legal obligation to honor a revolving credit agreement and it receives a commitment fee. Neither the legal obligation nor the
fee exists under the informal line of credit.
Often a line of credit will have clean-up clause that requires the borrower to reduce the loan balance to zero at least
once a year. Keep in mind that a line of credit typically is designed to help finance negative operating cash flows that are
incurred.

Criteria in choosing a bank:

a) Willingness to assume risks e) Maximum loan size
b) Advice and counsel f) Merchant banking
c) Loyalty to customers g) Other services (e.g. management services)
d) Specialization

Cost of Bank loans (Effective Annual Rate)

Without compensating balance With compensating balance

 Not discounted Cost = Interest Cost = Interest

Amount received (Face value – Compensating balance)
 Discounted Cost = Interest Cost = interest
(face value – interest) (face value – Interest- Compensating balance)

4. Commercial paper. Unsecured, short-term promissory notes of large firms, usually issued in denominations of $100,000 or more
and having an interest rate somewhat below the prime rate.

Cost of commercial paper:

[(interest + issue cost) / (Face value – Interest – Issue cost)] x [ # of days in a year / term]

EXERCISES

1. The primary objective of working capital management is to

a. Maximize the company’s total current assets c. Balance the amount of current assets and
b. Minimize the company’s total current liabilities current liabilities
d. Achieve a balance between risk and return
1) Answer: D

2. In a conservative (relaxed) working capital policy

a. Operations are conducted on a minimum amount of working capital
b. Operations are operated with too much working capital
c. Short-term liabilities are used to finance not only temporary current assets but also part or all of the
permanent current asset requirements
d. Company is exposed to risk of illiquidity because of low working capital position
2) Answer: B

3. Financing inventory build up with long term debt is an example of

a. Conservative working capital policy c. Aggressive working capital policy
b. Matching policy d. Hedging policy
3) Answer: A

4. A short term financing strategy where a company relies heavily on short-term borrowing to finance a portion of
their long term growth is called a(n)
a. Conservative strategy c. Matching strategy
b. Aggressive strategy d. Growth strategy
4) Answer: B

5. If a company prefers to finance its required assets with a small portion of short-term borrowings, then that firm is
utilizing a(n)
a. Conservative financing strategy c. Matching strategy
b. Aggressive financing strategy d. None of these
5) Answer: A

6. A firm that tends to finance permanent assets with long-term debt and seasonal assets with short-term borrowing
is following
a. Aggressive financing strategy c. Matching financing strategy
b. Conservative financing strategy d. None of these
6) Answer: C

7. Suppose a firm experiences a seasonal pattern in its sales, in addition to a long-term upward trend. Which of the
following financing plans has the potential to be less costly to the firm?
a. Conservative strategy c. Matching strategy
b. Aggressive strategy d. They are equally likely to be low cost
7) Answer: B

8. Which of the following statements is true?

a. Short-term debt is usually more expensive than long-term debt
b. Liquid assets do not ordinarily earn higher returns relative to long-term assets, so holding the former will
maximize the return on total assets

10
 c. A conservative working capital policy is characterized by higher current ratio and acid test ratio
d. Determining the appropriate level of working capital for a firm requires changing the firm’s capital structure
and dividend policy
8) Answer: C

9. The method in which pro-forma statements are constructed by assuring that all items grow in proportion to sales is
called the
a. Percentage of sales method c. Sales dilution method
b. Common size method d. Sales receipt method
9) Answer: A

10. The percentage of sales method for forecasting pro-forma financial statements assumes
a. That all income statement and balance sheet items grow in proportion to sales
b. That all income statement and balance sheet items grow at a growing proportion to sales
c. That all income statement and balance sheet items grow at a decreasing proportion to sales
10) Answer: A

11. Temporary working capital supports

a. Cash needs of the company c. Acquisition of capital requirement
b. Payment of long-term debt d. Seasonal peaks
11) Answer: D

12. Suppose a firm forecasts sales growth larger than its sustainable growth rate, but plans to add fewer assets than
the current assets to sales ratio implies. If other aspects if the firm’s performance remain constant, the pro-forma
external funds required (EFR)
a. Will likely be larger than the sustainable growth rate implies
b. Will likely be smaller than the sustainable growth rate implies
c. Will likely be the same as the sustainable growth rate implies
d. Cannot be determined from this information
12) Answer: B

13. During 2013, Westlife Company’s current assets increased by P120, current liabilities decrease by P50, and net
working capital
a. Increased by P70 c. Decreased by P170
b. Did not change d. Increased by P170
13) Answer: D

14. The Introvoys Company currently has assets of P 3 million and accounts payable of P200,000. The firm’s sales last
year were P10 million with a net profit margin of 1 percent. If the firm anticipates next year’s sales to grow by 8
percent over that of last year and the firm pays out 25 percent of its net income in dividends, then what is the
estimated external funds requirement for Introvoys?
a. P16,000 b. P81,000 c. P143,000 d. P240,000
14) Answer: C. EFR =[ change in sales x (Spontaneous Assets –Spontaneous liabilities)] – (Net profit margin ratio x
(current sales x (1+growth rate)] (1-dividend payout ratio)]
EFR = [(P10 million x 0.08) x (3million/10 million – 200,000/10 million)] – [0.01 x (10 million x 1.08)x(1-0.25)] ~
P143,000

15. Southborder Company has assets of P3 million and accounts payable of P200,000. The firm’s sales last year were
P10 million. If the firm anticipates next year’s sales to grow by 8 percent over that of last year and the firm pays
out 25 percent of its net income in dividends, then what net profit margin is required in order to have the
estimated external funds required to be equal to zero?
a. 27.00% b. 25.00% c. 2.77% d. 2.50%
15) Answer: C. EFR=CHANGE IN SALES (A/S-AP/S) –MS(1+G)(1-D)
0 = [(10,000,000 X 0.08) X [(3,000,000/10,000,000)-(200,000/10,000,000)]] – M(10,000,000)(1.08)(1-0.25)
0 = 224,000 – M(10,000,000)(1.08)(0.75) ~ M = P224,000 / 8,100,000 ~0.02765432 OR 0.0277 OR 2.77%

16. The 2016 balance sheet of Mars Pulp and Paper is shown below (millions of pesos):
Cash P3.0 Accounts payable P2.0
Accounts receivable 3.0 Notes payable 1.5
Inventory 5.0 Long-term debt 3.0
Current assets P11.0 Common equity 7.5
Fixed assets 3.0
Total assets P14.0 Total claims P14.0
In 2016, sales were P60 million. In 2017, management believes that sales will increase by 20% to a total of P72
million. The profit margin is expected to be 5% and the dividend payout ratio is targeted at 40%. The firm has
excess capacity and no increase in fixed assets will be required.
1) What is the additional funding requirement for 2017?
a. P0.36 million c. P0 million
b. P0.24 million d. –P0.36 million
2) Assume no excess capacity exists. How much can sales grow above the 2016 level of P60 million without
requiring any additional funds?
a. 0.1228 b. 0.1463 c. 0.1575 d. 0.1765
1. ANSWER: D. AFN = [(P11/60-P2/60) x (P60 x 0.20)] – [0.05 x (1-0.4) x (P60 x 1.20)]
= P1.8 – 2.16 ~ P-0.36 million
2. Answer: D. AFN = Ag-Lg-M[(S0)(1+G)(1-d) = 0
14G-2G -0.05[(P60)(1+g)(0.60)] =0
P12g-1(P3+3g)(0.60) =0
P12g-1.8-1.8g =0
10.20g =1.80 ~ 1.80/10.20 = 0.1765 or 17.65%

11
17. Which of the following is a source of discretionary (external) financing?
a. New debt issue c. New equity issue
b. Accounts payable d. Both (a) and (c)
16) Answer: D

18. Backstreet Boys follows an aggressive financing policy in its working capital management, while Boyzone follows a
conservative financing policy. Which one of the following statements is correct?
a. Backstreet boys has low ratio of short-term debt to total debt while Boyzone has a high ratio of short-term
debt to total debt
b. Backstreet boys has a low current ratio while Boyzone has a high current ratio
c. Backstreet boys has less liquidity risk while Boyzone has more liquidity risk
d. Backstreet boys finances short-term assets with long-term debt while Boyzone finances short term assets with
short-term debt
17) Answer: B

19. Alamid Enterprises is considering whether to pursue a restricted or relaxed current asset investment policy. The
firm’s annual sales are P400,000; its fixed assets are P100,000; debt and equity are each 50 percent of total
assets. EBIT is P36,000, the interest rate on the firm’s debt is 10 percent, and the firm’s tax rate is 40 percent.
With restricted policy, current assets will be 15 percent of sales. Under a relaxed policy, current asset will be 25
percent of sales. What is the difference in the projected return on equity (ROE) between the restricted and relaxed
policies?
a. 6.2% b. 5.4% c. 1.6% d. 3.8%
18) Answer: B.
15% of sales 25% of sales
(restricted) (relaxed)
Current assets (400,000 x 0.15) P 60,000 (400,000 x 0.25) P100,000
Fixed assets 100,000 100,000
Total assets P 160,000 P 200,000
Debt (50%) P80,000 P100,000
Equity 80,000 100,000
EBIT P36,000 P 36,000
INTEREST 80,000 X 0.10 8,000 100,000 X 0.10 10,000
EBT P 28,000 P 26,000
AFTER TAX RATE 0.60 0.60
NET INCOME P16,800 P 15,600
RETURN ON EQTY 16,800 / 80,000 0.21 15,600/100,000 0.156
DIFFERENCE IN ROE (0.21-0.156) = 0.054 OR 5.4%

20. Management of a company does not want to violate a working capital restriction contained in its bond indenture. If
the firm’s current ratio falls below 2.0 to 1, technically it will have defaulted. The firm’s current ratio is now 2.2:1. If
current liabilities are P200 million, the maximum new commercial paper that can be issued to finance inventory
expansion is
a. P20 million b. P40 million c. P240 million d. P180 million
19) Answer: B.
If X= maximum amount of new commercial paper
Then: (P440 million + X) / (P200 million + X) = 2.0
Therefore: P440 million + X = P400 million + 2X ~ X = P40,000,000
21. Moffats has 100,000 shares of stock outstanding. Below is part of Moffats statement of financial position for the
last fiscal year:
Moffats Corporation
Statement of financial position – selected items
December 31, 2013
Cash P455,000 Accrued liabilities P285,000
Accounts receivable 900,000 Accounts payable 550,000
Inventory 650,000 Current portion, long-term notes payable 65,000
Prepaid assets 45,000
What is the maximum amount Moffats can pay in cash dividends per share and maintain a minimum current ratio
of 2:1. Assume that all accounts other than cash remain unchanged.
a. P2.05 b. P2.50 c. P3.35 d. P3.80
20) Answer: B. (455,000+900,000+650,000+45,000) – (P900,000 x 2) = P250,000 (allowed reduction in cash for
dividends) ~ Dividend per share: P250,000 / 100,000 shares = P2.50 per share
22. The length of time between payment for inventory and the collection of cash is referred to as
a. Payable deferral period c. Operating cycle
b. Receivable conversion period d. Cash conversion cycle
21) Answer: D

23. 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
22) Answer: D

24. The time from the receipt of raw materials to the collections of the cash of the sale of the finished goods is called
a. Operating cycle c. Inventory period
b. Cash conversion cycle d. Accounts receivable period
23) Answer: A

25. As a firm’s cash conversion cycle increase, the firm

a. Becomes less profitable c. Reduces its accounts payable period
b. Increases its investment in working capital d. Incurs more shortage costs
12
 24) Answer: B

26. What can a company do to shorten its cash conversion cycle?

a. Turn inventory over as quickly as possible c. Pay accounts as slowly as possible
b. Collect accounts receivable as quickly as d. All of these
possible
25) Answer: D

27. If Side A Inc. had sales of P2,027,773 per year (all credit) and its days sales outstanding was equal to 35 days,
what was its average amount of accounts receivable outstanding? (assume a 365- day year)
a. P194,444 b. P57,143 c. P5,556 d. P97,222
26) Answer: A. (2,027,773/ 365 days) x 35 days ~ P194,444

28. The length of time from the receipt of inventory until it is sold is
a. Average age of inventory c. Average collection period
b. Cash conversion cycle d. Operating cycle
27) Answer: A

29. A firm has P5 million of inventory on average and annual sales of P30 million. Assume there are 365 days per year.
what is the firm’s inventory conversion period?
a. 30.25 days b. 60.83 days c. 45.00 days d. 72.44 days
28) Answer: B. 365 days / (30 million/5 million) ~ 60.83 days

30. The operating cycle is the length of time from the receipt of inventory until the
a. Beginning of the cash conversion cycle c. Payment of accounts payable
b. End of the cash conversion cycle d. Collection of cash from sales
29) Answer: D

31. The time between the points at which a firm pays for raw materials and at which it receives payment for finished
goods is
a. Average age of inventory c. Average collection period
b. Cash conversion cycle d. Operating cycle
30) Answer: B

32. Eraserheads has an average age of inventory of 35 days, an average collection period of 27 days and an average
payment period of 16 days. What is the company’s
1) Operating cycle? a. 35 days b. 27 days c. 62 days d. 8 days
2) Cash conversion cycle? a. 62 days b. 46 days c. 51 days d. 43 days
1. Answer: C. Operating cycle = Inventory period + Accounts receivable period
35 days + 27 days = 62 days
2. Answer: B. CCC = Inventory period+A/R period-A/P period ~ 62 days – 16 days = 46 days

33. Linkin Park has annual sales of P80 million and keeps average inventory of P20 million. On average, the firm has
accounts receivable of P16 million. The firm buys all raw materials on credit, its trade credit terms are net 35 days,
and it pays on time. The firm’s managers are searching for ways to shorten the cash conversion cycle. if sales can
be maintained at existing levels but inventory can be lowered by P4 million and accounts receivable lowered by P2
million, what will be the net change in the cash conversion cycle? (use a 365 day year. round to the closest whole
day)
a. +105 days b. -105 days c. +27 days d. -27 days
26) Answer: D.
Old With change
ICP= 365/(80/20) 91.25 365/[80/(20-4)] 73.000
DSO=365/(80/16) 73.00 365/[80/(16-2)] 63.875
DP (35) (35)
CCC 129.25 DAYS NEW CCC 101.875 DAYS
CHANGE (101.875-129.25) = -27.375 DAYS OR -27 DAYS

34. Side A wants to sharply reduce its cash conversion cycle. which of the following steps would reduce its cash
conversion cycle?
a. Company increases its average inventory without increasing its sales
b. Company reduces is days sales outstanding (DSO)
c. Company starts paying its bills sooner, which reduces its average accounts payable without reducing its sales
d. Statements (a) and (b) are correct
27) Answer: B

35. A working capital technique that increases the payable float and therefore delays the outflow of cash is
a. Electronic data interchange c. Draft
b. Automated fund transfer d. Baumol cash management model
32) answer: C

36. Hale Corporation uses the Baumol cash management model to determine its optimal cash balance. For the coming
year, the expected cash disbursements total P432,000. The interest rate on marketable securities is 5 percent per
annum. The fixed cost of selling marketable securities is P8 per transaction.
1) Using the Baumol cash management model, the company’s optimal cash balance is
a. P11,757.55 c. P142,000.00
b. P5,878.78 d. P1,175.76
2) Using the Baumol model, the average cash balance is
a. P11,757.55 b. P5,878.78

13
 c. P142,000.00 d. P1,175.76
1. Answer: A. √2 x P8 x P432,000 / 0.05 ~ P11,757.55
2. Answer: B. P11,757.55 / 2 ~ P5,878.78
37. A lockbox plan is
a. Method for safe keeping of marketable securities
b. Used to identify inventory safety stocks
c. System for slowing down the collection of checks written by a firm
d. System for speeding up a firm’s collections of checks received
28) Answer: D

38. Boyce Avenue currently fills mail orders from all over the US and receipts come in to headquarters in Little Rock
Arkansas. The firm’s average accounts receivable is $2.5 million and is financed by a bank loan with 11 percent
annual interest. Boyce is considering a regional lockbox system to speed up collections that it believes will reduce
A/R by 20%. The annual cost of the system is $15,000. What is the estimated net annual savings to the firm from
implementing the lockbox system?
a.
b. $500,000 c. $30,000 d. $60,000 e. $40,000
29) Answer: D. Net reduction in AR: (2,500,000 x 0.20) = $500,000; Interest savings : 500,000 x 0.11 =$55,000
Net annual savings: Interest savings – annual lockbox cost ~ $55,000 – 15,000 = $40,000

39. Which of the following statement completion is most correct? If the yield curve is upward sloping, then a firm’s
marketable securities portfolio, assumed to be held for liquidity purposes should be
a. Weighted toward long term securities because they pay higher rates
b. Weighted toward short-term securities because they pay higher rates
c. Weighted toward US treasury securities to avoid interest rate risk
d. Weighted toward short-term securities to avoid interest rate risk
34) answer: D

40. If a firm is contemplating a relaxation of its credit standards, which of the following might be expected to result?
a. Decreased in unit sales c. Increased investment in accounts receivable
b. Increased contribution margin d. Decreased bad debt expense
34) answer: C

41. N Sync is producing and selling brewery equipment to microbreweries nationwide. N Sync is charging $15,000 per
unit and all of their sales are on credit. Under the current credit policy, N Sync expect to sell 500 units. The
variable costs are $6,000 per unit and fixed costs are $1.5 million per year. the company is thinking about
changing their credit terms from net 30 to 3/10, net 30. The effect of this change would be a 5 percent increase in
unit sales, but also an increase in bad debt expenses from 2% to 4% of sales. The company expects 75% of its
customers to take advantage of the cash discount. Currently the company has an average collection period of 38
days, until the customers mail their payments and another 8 days to process the payments once they arrive. N
Sync’s opportunity cost of funds invested in accounts receivable is 12%.
1) What is N Sync’s marginal profit from increased sales?
a. $500,000 b. $225,000 c. $305,000 d. $425,000
2) What is N Sync’s total variable cost of annual sales under the:
A) Old credit policy? a. $3,150,000 b. $2,500,000 c. $3,000,000 d. $3,750,000
B) New credit policy? a. $3,150,000 b. $3,000,000 c. $2,500,000 d. $3,750,000
3) What is N Sync’s accounts receivable turnover under
A) Old credit policy? a. 14.61 b. 10.43 c. 12.69 d. 9.61
B) New credit policy? a. 15.87 b. 14.6 c. 12.69 d. 9.51
4) What is N Sync’s average investment in accounts receivable under
A) Old credit policy? a. $287,631 b. $236,407 c. $205,479 d. $312,175
B) New credit policy? a. $198,488 b. $302,013 c. $215,753 d. $236,407
5) What is N Sync’s cost of the marginal investment in accounts receivable?
a. $96,534 b. $9,653 c. -$13,642 d. $11,584
6) What is N Sync’s bad debt expense under
A) Old credit policy? a. $125,000 b. $100,000 c. $150,000 d. $175,000
B) New credit policy? a. $150,000 b. $315,000 c. $157,500 d. $300,000
7) What is N Sync’s cost of marginal bad debts?
a. $150,000 b. $165,000 c. $142,500 d. $175,000
8) What is N Sync’s new average collection period if they introduce the new credit term?
a. 23 days b. 33 days c. 25 days d. 30 days
9) What is N Sync’s cost savings from the reduced investment in accounts receivable if they implement the new
credit terms?
a. $13,660 b. $113,836 c. $19,493 d. $98,521
10) What is N Sync’s net profit(loss) from the proposed change in credit terms?
a. $61,472 b. $177,188 c. $13,660 d. $225,000
1. Answer: B. (500 units x 0.05) x ($15,000-$6,000) = $225,000 (marginal profit from increased sales)
2. (A) answer: C. 500 units x $6000 = $3 million (variable cost under the old policy)
(B) answer: A. (500 units x 1.05) x $6000 = $3,150,000 (variable cost under the new policy)
3. (A) answer: D. 365 days / 38 days ~ 9.61 times (AR turnover @ old policy)
(B) answer: A. (0.75 x 10 days) + (0.25 x 30 days) + 8 days = 23 days; 365 days / 23 days = 15.87 times
4. (A) answer: D. $3 million / 9.61 times = $312,175
(B) answer: A. $3,150,000 / 15.87 times = $198,488
5. Answer: C. (198,488 – 312,175) x 0.12 = -13,642
6. (A) answer: C. (500 units x $15,000) x 0.02 = $150,000
(B) answer: B. [(500 units x 105%) x $15,000] x 0.04 = $315,000
7. Answer: B. $315,000 – 150,000 = $165,000
8. Answer: A. (0.75 x 10 days) + (0.25 x 30 days) + 8 days (processing) = 23 days

14
 9. Answer: A.{ [(6000 x 500) x (38/365)] – [(6000 x 525 units) x (23/365)]} x 0.12 = $13,660 (cost savings
from the reduced investment in AR)
10. Answer: B.
Marginal profit in new sales (525-500) x (15000-6000) $225,000
Cost savings AR 113,836 x 0.12 13,660
Cost of cash discounts (0.03 x 15,000) x 525 x 0.75 (177,188)
Net profit $61,472

42. A firm that moves from traditional inventory stocking method to a just-in-time system should expect to see
a. Reduced inventory levels c. Potential for production halts
b. Funds released for alternative use d. All of these
36) answer: D

43. The economic order quantity formula does not assume that
a. Demand is known c. Cost of placing an order is constant
b. Usage is uniform d. Cost of inventory itself is constant
38) answer: D

44. O-Town Inc. sells cellphone cases which it buys from a local manufacturer. O-Town sells 24,000 cases evenly
throughout the year. the cost of carrying one unit in inventory for one year is P11.52 and the order cost per order
is P38.40.
1) What is the economic order quantity? a. 400 b. 283 c. 200 d. 625
2) If O-Town would buy in economic order quantities,
A) the total order costs is: a. P921,600 b. P2,304 c. P76,800 d. P460,800
B) the total inventory carrying costs is: a. P276,480 b. P2,304 c. P23,040 d. P138,240
1. answer: A. EOQ = √2(P38.40)(24,000)/P11.52 ~ 400 units
2. (A) Answer: B. (24,000 / 400) x P38.40 = P2,304
(B) Answer: B. (400 / 2) x P11.52 = P2,304 *@ EOQ total ordering costs is equal to total carrying cost
45. the basic EOQ model equals the square root of the (1) product of twice the demand times the cost per order; (2)
divided by the periodic carrying cost per unit. If the annual demand increases by 44 percent, the EOQ will increase
(decrease) by
a. 0.0663 b. 0.2000 c. 0.0938 d. 0.1200
39) answer: B. EOQ=√2ad/k; √2a(1.44d)/k~ √1.44(2ad/k)~1.2√2ad/k: The EOQ will increase by 20% from 1 or 100%
to 1.2 or 120%

46. The following information is available for Bon Jovi Corporation’s Material X:
Annual usage 12,600 units Normal lead time 20 days
Working days per year 360 days
The units of Material X are required evenly throughout the year.
1) What is the reorder point? a. 35 units b. 20th day c. 700 units d. 630 units
2) Assuming that occasionally, the company experiences delay in the delivery of Material X, such that the lead time
reaches a maximum of 30 days, how many units of safety stock should the company maintain and what is the
reorder point?
a. b. c. d.
Safety stock 350 350 0 1,050
Reorder point 1,050 700 1,050 700
1. ANSWER: C. (12,600 / 360 days) x 20 days = 700 units
2. Answer: A. (30 days – 20 days) x 35 units = 350 units (safety stock); reorder point: 700+350= 1,050 units
47. Using the EOQ model, Teeth Corporation determined the economic order quantity for a merchandise items to be
800 units. To avoid stockout costs, it maintains 200 units in safety stock. What is Teeth’s average inventory of
such merchandise item?
a. 400 units b. 600 units c. 500 units d. 1,000 units
42) answer: B. (800 units / 2) + 200 units= 600 units
48. On January 7, 2013, A1 discounted its own P100,000, 180-day note at United Bank at a discount rate of 20%. A1
repaid the note on July 6, 2013, due date. Based on a 360-day year, the effective rate of interest on the borrowing
is
a. 0.182 b. 0.200 c. 0.222 d. 0.250
47) answer: D. 20% / (1-0.20) = 0.25 or 25%
49. LFO has just acquired a large account and needs to increase its working capital by P100,000. The controller of the
company has identified the four sources of funds given below:
A) Pay a factor to buy the company’s receivables, which averages P125,000 per month and have an average collection period
of 30 days. The factor will advance up to 80 percent of the face value of receivables at 10 percent interest and charge a fee
of 2 percent on all receivables purchased. The controller estimates that the firm would save P24,000 in collection expenses
over the year. assume the fee and interest are not deductible in advance
B) Borrow P110,000 from a bank at 12 percent interest. A 9 percent compensating balance would be required.
C) Issue P110,000 of 6-month commercial paper for P100,000. (new paper would be issued every 6 months)
D) Borrow P125,000 from a bank on a discount basis at 20 percent. No compensating balance would be required
Assume a 360-day year in all of your calculations.
1) Cost of alternative A is: a. 0.10 b. 0.12 c. 0.132 d. 0.16
2) Cost of alternative B is: a. 0.09 b. 0.12 c. 0.132 d. 0.16
3) Cost of alternative C is: a. 0.091 b. 0.10 c. 0.182 d. 0.20
4) Cost of alternative D is: a. 0.20 b. 0.25 c. 0.40 d. 0.50
1. Answer: D. [(P100,000 x 0.10)+(P1,500,000 x 0.02) – 24,000] / 100,000 = 0.16
2. Answer: C. (110,000 x 0.12) / [110,000 x (1-0.09)] = 0.132 or 0.12/0.91 ~ 0.132
3. Answer: D. (110,000-100,000) / 100,000 = 0.10 (for six months) or 20 percent for 1 year
4. Answer: B. (125,000 x 0.20) / (125,000 – 25,000) = 0.25

LONG PROBLEMS WITH SOLUTIONS

15
1) What is cash position management? What types of firms set a target cash balance? Why? What is the purpose of a
bank’s requiring the firm to maintain a minimum balance in its checking account? How does this relate to a bank
account analysis statement? Cash position management involves looking at, on a daily basis, the collection,
concentration and disbursements of funds for the company. The cash manager looks at the amount of funds to be
collected, moves balances to appropriate accounts and funds projected disbursements. The cash position can be
managed into the future when future cash flows can be properly forecasted. Smaller firms that do not engage in
active cash position management may set a target cash balance for their checking accounts. Generally this is
determined based on transactions requirements or a minimum balance set by the bank. The transactions
requirement is determined by how much cash a firm needs for its day to day operations. A bank account analysis
statement determines the value of the balances a firm leaves on deposit and matches that to the value of the
services provided by the bank. Minimum balances somewhat offset the fees charged by the bank for its services.
2) Why would a firm wish to minimize its cash conversion cycle even though each of its components is important to
the operation of the business? What key actions should the firm pursue to achieve this objective? A firm wishes to
convert raw material expense into cash as quickly as possible. As with the operating cycle, collecting sooner and
paying later provide the company with the most cash available for investing. The firm should work to maximize its
inventory turnover, minimize its average collection period and maximize its average payment period.
3) What is a float? What are its four basic components? Which of these components is the same from both a
collection and a payment perspective? What is the difference between availability float and clearing float? And
from which perspective – collection or payment – is each relevant? Float refers to funds that have been sent by the
payer but are not yet usable funds to the payee. The four components of float are:
 Mail float – the time delay between when payment is placed in the mail and when it is received
 Processing float – time between receipt of the payment and its deposit into the firm’s accounts
 Availability float – time between deposit of the check and the availability of the funds of the firm
 Clearing float – time between the deposit of the check and the presentation of the check back to the bank on
which it is drawn
From a collection and payment perspective, mail and processing float are generally same. Availability and clearing
float are concerns of the firm, not the payer of funds to the firm.
4) What is credit scoring? In what types of situations is it useful? If you were developing a credit scoring model, what
factors might be useful in predicting whether or not a credit customer would pay in a timely manner? Credit
scoring applies statistically derived weights for key financial and credit characteristics to predict whether a
potential customer will pay in a timely manner. The score measures the applicant’s overall credit strength. It is
most commonly used by large credit card operations, such as those of banks, oil companies and department
stores. Most useful factors might include credit references, home ownerships, income range, payment history,
year at address and years on the job.
5) (WORKING CAPITAL MANAGEMENT POLICIES) Assume that MLTR Co. Has P2 million in assets. If it goes with low
liquidity, it can earn a return of 18 percent but with high liquidity plan the return will be 14 percent. If the firm
goes with a short-term financing plan, the financing cost on the P2 million will be 10 percent and with a long-term
financing plan, the financing costs on the P2 million will be 12 percent.
Compute the anticipated return after financing on the following asset-financing mix:
a. Most aggressive
Low liquidity P2 million x 0.18 P360,000
Short term financing 2 million x 0.10 (200,000)
Anticipated return P 160,000
b. Most conservative
High liquidity P2 million x 0.14 P 280,000
Long term finance P 2million x 0.12 (240,000)
Anticipated return P 40,000
c. Moderate policies
(1) (2)
High liquidity P2 million x 0.14 P 280,000 Low liquidity P2 million x 0.18 P360,000
Short term finance P2million x 0.10 (200,000) Long term finance P2 million x 0.12 (240,000)
P 80,000 P 120,000
6) (CASH CONVERSION CYCLE) A1 is concerned about managing its operating assets and liabilities efficiently.
Inventories have an average of 110 days and accounts receivable have an average age of 50 days. Accounts
payable are paid approximately 40 days after they arise. The firm has annual sales of $36 million, its cost of goods
sold represents 75 percent of sales and its purchases represent 70 percent of cost of goods sold. Assume a 365
day year.
a) Calculate the firm’s:
1. operating cycle : Operating cycle = Average age of Inventory + Average age of collection period
OC = 110 days + 50 days ~ 160 days (operating cycle)
2. cash conversion cycle: Cash Conversion cycle = AAI + ACP – APP or Operating cycle – APP
CCC = 110 days + 50 days – 40 days ~ 120 days or 160 days – 40 days = 120 days
b) calculate the amount of total resources A1 has invested in its cash conversion cycle
Inventory 36 million x 0.75 x 110/365 $8,136,986
Accounts receivable 36 million x 50/365 4,931,507
Accounts payable 36 million x 0.75 x 0.70 x 40/365 (2,071,233)
Resources invested $10,997,260
7) (CHANGES IN CASH CONVERSION CYCLE) a firm is considering five plans that affect several current accounts. Given
the five plans and their probable effects on inventory, receivables and payables, as shown in the following table,
which plan would you favour? Explain.
Change
Plan Average age of Average collection Average payment
inventory (days) period (days) period (days)
A +35 +20 +10
B +20 -15 +10
C -10 +5 0
D -20 +15 +5
E +15 -15 +20
Answer:
Change

16
 Plan Average age of Average collection
Average In cash
inventory (days) period (days) payment period conversion cycle
(days)
A +35 +20 +10 +45
B +20 -15 +10 -5
C -10 +5 0 -5
D -20 +15 +5 -10
E +15 -15 +20 -20
**Plan E will have the most beneficial impact on the collection cycle, with an increase in inventory and a
decrease in the collection period cancelling each other, leaving payments stretched by 20 days. This plan results
in the biggest reduction (20 days) in the cash conversion cycle.
8) (OPTIMAL CASH BALANCE) Boys 2 Men expects to make monthly cash payments of P160,000, evenly during the
month. The average return on money market placements is 8 percent per annum and it expects P250 per cash
transfer. Determine the following:
a) Optimal cash balance:
Annual cash demand: P160,000 x 12 months = P1,920,000
Optimum cash balance: √2 x 1,920,000 x P250/ 0.08 = P109,544
b) Average cash balance: P109,544/ 2 = P54,772
c) Number of cash transfer: P1,920,000 / 109,544 = 17.53 times or 18 times
d) Total relevant costs at: P50,000, Optimal cash balance and P400,000
Total relevant cost = Total transaction cost + Total holding costs
@50,000 @Optimal cash Balance @ 400,000
Total transaction cost
@50,000 (1,920,000/ 50,000) x P250 P 9,600
@ optimal cash balance (1,920,000/ 109,544) x P250 P4,382
@400,000 (1,920,000 / 400,000) x P250 Lowest total P1,200
Total Holding cost: relevant
@50,000 (50,000/2) x 0.08 2,000 cost 
@ optimal cash balance (109,544 / 2) x 0.08 4,382
@400,000 (400,000 / 2) x 0.08 16,000
Total relevant cost P 11,600 P8,764 P 17,200
9) (PLAYING THE FLOAT) Five estimates that its customers’ payments are in the mail for 3 days, and once received,
they are processed in 2 days. After the payments are deposited in the firm’s bank, the funds are made available to
the firm by the bank in 2.5 days. The firm estimates its total annual collections, received at a constant rate, from
credit customers to be P87 million. Its annual opportunity cost of funds is 9.5 percent. Assume a 365 day year.
a. How many days of collection float does Five have?
Collection float= Mail float + Processing float +Availability float
= 3 days + 2 days + 2.5 days ~ 7.5 days
b. What is the current annual dollar cost of Five’s collection float?
Average daily receipts: P87 million / 365 days = P238,356
Collection float (P): P238,356 x 7.5 days = P1,787,670
Annual dollar cost: P1,787,670 x 0.095 = P169,829
c. If the installation of an electronic invoice presentment and payment (EIPP) system would result in a 4-day
reduction in Five’s collection float, how much could the firm earn annually on this float reduction?
Annual earnings: Float reduction in days x average daily receipts x opportunity cost
4 days x P238,356 x 0.095 = P90,575
d. Based on your finding in part (c), should Five install the EIPP system if its annual cost is P85,000? Five should
install the proposed EIPP system. The annual earnings of P90,575 exceed the annual cost of P85,000, thereby
resulting in an annual profit contribution of P5,575.
10) (MARKETABLE SECURITIES MANAGEMENT) Savage Garden has P2 million in excess of cash that it might invest in
marketable securities. In order to buy and sell the securities however, the firm must pay transaction fee of
P45,000.
Required:
a) Would you recommend purchasing the securities if they yield 12 percent annually and are held for: (1) one
month; (2) two months; (3) three months; (4) six months
Month/s Comparison Recommendation
One P2 million x 0.12 x 1/12 P20,000 < P45,000 No
Two P2 million x 0.12 x 2/12 P40,000 < P45,000 No
Three P2 million x 0.12 x 3/12 P60,000 > P45,000 Yes
Six P2 million x 0.12 x 6/12 P120,000 > P45,00 Yes
b) What minimum yield would the securities have to return for the firm to hold them for three months (what is the
breakeven yield for a 3-month holding period)?
Let % = the breakeven yield rate
P2 million x % x 3/12 = P45,000
P2 million x % = P180,000
% = P180,000/ 2 million ~ 0.09 or 9 percent (breakeven yield)
11) (ACCOUNTS RECEIVABLE MANAGEMENT) D12 currently has an average collection period of 35 days and annual
sales of P72 million. Assume a 365-day year.
a) What is the firm’s average accounts receivable balance? P72 million x 35/365 days = P6,904,110
b) If the variable cost of each product is 70 percent of sales, what is the firm’s average investment in accounts
receivable? 6,904,110 x 0.70 = P4,832,877
c) If the equal risk opportunity cost of the investment in receivable is 16 percent, what is the total annual cost of
the resources invested in accounts receivable? 4,832,877 x 0.16 = P773,260
d) If the firm can shorten the average collection period to 30 days by offering a cash discount of 1 percent for
early payment, and 60 percent of the customers take this discount, should the firm offer this discount
assuming its cost of bad debts will rise by P150,000 per year? if the firm offers a cash discount of 1% and 60%
of customers take the discount, it will lose collections of P72 million x 0.01 x 0.60 = P432,000. By shortening
the average collection period to 30 days the firm will free up 5 days of receivables (35 to 30 days) balance.
Annual savings on this reduction would be 0.60 x P72,000,000 x 0.70 x 5/365 = P110,466, which is not enough
to offset the loss in collections and the increase in bad debts.

17
12) (RELAXATION OF CREDIT POLICY) E17 products sells for P10 a unit of which P7 represents variable costs before
taxes including credit departmental costs. Current annual credit sales are P2.4 million. The firm is considering a
more liberal extension of credit, which will result in a slowing in the average collection period from one month to
two months. The relaxation in credit standards is expected to produce 25 percen t increase in sales. assume that the
firm’s required rate of return on investment is 20 percent before taxes. Bad debt losses will be 5 percent of
incremental sales and collection expenses will increase by P20,000. Should the company liberalize its credit policy?
Incremental CM from additional units [(P2.4 million/P10) x 0.25] x (10-7) P 180,000
Bad debts 600,000 x 0.05 (30,000)
Collection expenses (20,000)
Incremental profit (loss) P130,000
Required return on additional investments:
Present level of receivables 2.4 million / 12 months P200,000
Level of receivable after the change in policy (2.4 million x 1.25) / 6 months (500,000)
Additional receivables P 300,000
Additional investment on receivables P300,000 x 0.70 P 210,000
Required return on additional investment on receivables P210,000 x 0.20 P 42,000
**in as much as the additional sales of P130,000 exceeds the required return on the additional investment of
P42,000. The firm would be well advised to relax its credit standards.
13) (AGING OF RECEIVABLES) After Image’s accounts receivable totalled P1.75 million on August 31,2009. A
breakdown of these outstanding accounts on the basis of the month in which the credit sale was initially made
follows. The firm extends net 30, EOM credit terms to its credit customers.
Month of credit sale Accounts receivable Month of credit sale Accounts receivable
August 2009 P640,000 May 2009 P390,000
July 2009 500,000 April 2009 56,000
June 2009 164,000
a) Prepare an aging schedule for After Image’s August 31,2009, accounts receivable balance
Month of sale Age of accounts Accounts receivable Percentage of A/R
August 2009 0-30 days P640,000 36.6%
July 2009 31-60 days 500,000 28.6%
June 2009 61-90 days 164,000 9.3%
May 2009 91-120 days 390,000 22.3%
April 2009 121+ days 56,000 3.2%
Total accounts receivable P1,750,000 100%
b) Using your findings in (a) evaluate the firm’s credit and collection activities
The firm has a large percentage of uncollected accounts that are 90-120 days old resulting from sales made in
May 2009.
c) What are some probable causes of the situations discussed in part (b)? The high percentage of May 2009
uncollected accounts could be attributable to large disputed account, the hiring of a new credit manager, the
bankruptcy of a major customer and so on.
14) (INVENTORY MANAGEMENT) Hunks Manufacturing is mulling over a plan to rent a proprietary inventory control
system at an annual cost of $4.5 million. The firm predicts its sales will remain relatively stable at $585 million and
its gross profit margin will continue to be 28 percent. It expects that as a result of the new inventory control
system, its average age of inventory (AAI) will drop from its current level of 83 days to about 46 days. The firm’s
required return on similar risk investments is 12 percent. Assume a 365 day year.
a. Calculate Hunk’s average investment both currently and assuming it rents the inventory control system
Cost of goods sold $585 million x (1-0.28) $421,200,000
Average inventory investment:
 Current $421,200,000 x 83/365 $95,779,726
 Proposed $421,200,000 x 46/365 53,082,740
b. Use your findings in (a) to determine the annual savings expected to result from the proposed inventory
control system
Annual savings: (95,779,726 – 53,082,740) x 0.12 = $5,123,638
c. Based on your findings in (a) and (b), would you recommend the Hunks rent the inventory control system?
Explain your recommendation. Answer: Hunks should rent the system because the annual savings are greater
than the annual cost.
15) (ECONOMIC ORDER QUANTITY) Metallica buys 200,000 motors per year from a supplier that can fulfil orders within
two days of receiving them. Metallica transmits its orders to this supplier electronically so the lead time to receive
orders is 2 days. Metallica’s order cost is about P295 per order and its carrying cost is about P37 per motor per
year. the firm maintains a safety stock of motors equal to 6 days usage. Assume a 365 day year.
a) What is Metallica’s economic order quantity? EOQ: √(2 x 200,000 x P295)/ P37 ~ 1,786 units
b) What is the total cost at the EOQ?[P295 x (200,000/1,786)] +[P37 x (1,786/2)] = P66,076
c) How large a safety stock in units of motors should Metallica maintain? (6/365) x 200,000 = 3,288
d) What is Metallica’s reorder point for motors? (2 x (200,000/365)) + 3,288 = 4,384
e) If Metallica has an opportunity to reduce by 10 percent either its order cost or its carrying cost, which would
result in the lowest total cost at the associated new EOQ?
Reduction by 10% on
Ordering cost Carrying cost
EOQ √2 x 200,000 x (295x0.90)/37 1,694 units
√2 x 200,000 x 295 / (37 x 0.90) 1,882 unit
Total cost: [P265.50 x (200,000/1,694)]+[(1,694/2) x P37] P62,685
[P295 x (200,000/1882)]+[(1,882/2) x P33.30] P62,685
**both changes provide about the same total cost.

16) (REORDER POINT) Damage has the following production data: annual requirement 40,000 units; number of
working days 320 days; normal lead time 10 days; maximum lead time 16 days; maximum usage 150 units and
economic order quantity 5,000 units. Determine the following:
a) Normal daily usage: annual requirement / number of working days: 40,000 units / 320 days = 125 units
b) Lead time quantity: normal daily usage x normal lead time: 125 units x 10 days = 1,250 units
c) Safety stock quantities:
In usage: (maximum usage – normal usage) x normal lead time: (150 units – 125 units) x 10 days = 250 units
18
 In time: (maximum lead time – normal lead time) x normal usage: (16 days – 10 days) x 125 units = 750 units
Total safety stock: safety stock in time + safety stock in usage: 750 units + 250 units = 1,000 units
NOTE: If the problem is silent with regards to safety stock and the information given has both maximum usage and lead time
information, PLAY SAFE consider both in getting the safety stock in quantity. (just like what we did in (c))
d) Reorder point: lead time quantity + safety stock quantity
1,250 + 1,000 units = 2,250 units
NOTE: if there is no safety stock given or to be computed in the problem, the LEAD TIME QUANTITY can now be considered
as the reorder point.
e) Maximum inventory level: economic order quantity + safety stock: 5,000 units + 1,000 units = 6,000 units
17) (STOCKOUT COSTS) Assume a company uses an inventory where it places 12 orders per year; the cost of the
stockout is P200 per occurrence, the carrying co st per unit is P2 per year and the probabilities of stockout have
been estimated for various levels of safety stock as follows:
Safety stock (units) Probability of stockout Safety stock (units) Probability of stockout
0 0.60 400 0.20
100 0.50 600 0.10
200 0.40
Determine the optimal safety stock level.
Safety Probability of Carrying cost Expected Cost of stockout per Total costs
stock stockout (A) stockout per occurrences (A + B)
units year (B)
0 0.60 (0 x P2) = 0 (12 x 0.60)= 7.2 (7.2 x P200) = P1,440 (0+1,440)=P1440
100 0.50 100 x 2 = P200 (12 x 0.50) = 6 6 x P200 = P1,200 200+1200= P1,400
200 0.40 P400 4.8 P960 P1,360
400 0.20 P800 2.4 P480 P1,280**
600 0.10 P1,200 1.2 P240 P1,440
**optimal safety stock level (choose the lowest cost)
18) (SHORT-TERM FINANCING) Maroon 5 is considering changing its pay period for its salaried management from
paying salaries every two weeks to paying salaries monthly. The firm’s CFO believes that such action will free up
cash that can be used elsewhere in the business, which currently faces a cash crunch. In order to avoid a strong
negative response from the salaried managers, the firm will simultaneously announce a new health plan that will
lower manager’s cost contributions without cutting benefits. Maroon 5’s analysis indicates that the salaried
managers’ bimonthly payroll is P1.8 million and is expected to remain at that level for the foreseeable future. With
the bimonthly system, there were 2.2 pay periods in a month. Because the managers will be paid monthly, the
monthly payroll will be about P4 million (2.2 x P1.8 million). The annual cost to the firm of the new health plan will
be P180,000. Maroon 5 believes that because managers’ salaries accrue at a constant rate over the pay period,
the average salaries over the period can be estimated by dividing the total amount by 2. The firm believes that it
can earn 15 percent annually on any funds made available through the accrual of the managers’ salaries.
a) How much additional financing will Maroon 5 obtain as a result of switching the pay period for managers’
salaries from every two weeks to monthly?
The average amounts of financing provided are:
Pay period Payroll Average amount of financing
Monthly P4 million (P4 million / 2) =P2 million
Every 2 weeks P1.8 million (P1.8 million /2) = 900,000
Additional financing provided P1,100,000

b) Should the firm implement the proposed change in pay period?

Earnings on additional financing invested 0.15 x P1.1 million P165,000
(-) Cost of new health plan 180,000
Net loss from proposal P(15,000)
**NO. The firm should not change the pay period as proposed because the annual return on the additional
financing of P165,000 is less than the P180,000 annual cost of the new health plan. A net loss of P15,000
would result from implementing the proposal.
19) (COST OF TRADE CREDIT) BB Mak wishes to evaluate the credit terms offered by its four biggest suppliers of raw
materials. The prime rate is currently 7 percent and BB Mak can borrow short term funds at a spread 2.5 percent
above the prime rate. Assume a 365 day year and that the firm always pays its supplier on the last day by their
stated credit terms. The terms offered by each supplier are listed below:
Supplier 1 2/10, net 40 Supplier 3 3/10, net 70
Supplier 2 1/15 net 60 Supplier 4 1/10 net 50
a. Calculate the interest rate associated with not taking the discount from each supplier
Rate: (discount rate / (1-discount rate)) x (# of days in a year / (credit period – discount period))
Supplier
1 [0.02 / (1-0.02)] x [365 days – (40 days – 10 days)] 0.2483
2 [0.01 / (1-0.01)] x [365 days – (60 days – 15 days)] 0.0819
3 [0.03 / (1-0.03)] x [365 days – (70 days – 10 days)] 0.1879
4 [0.01 / (1-0.01)] x [365 days – (50 days – 10 days)] 0.0922
b. Assuming the firm needs short-term financing and considering each supplier separately, indicate whether the
firm should take or not take the discount from each supplier
Bank loan rate: Prime rate + Spread rate: 0.07 + 0.025 ~ 0.095 or 9.5%
Supplier Decision
1 0.2483 > 0.095 Take the discount
2 0.0819 < 0.095 Don’t take the discount
3 0.1879 > 0.095 Take the discount
4 0.0922 > 0.095 Take the discount
c. If the firm did not need any short-term financing, when should it pay each of the suppliers? If the firm needs no
short-term financing, it should pay each supplier at the end of its cash discount period – days 10,15,10 and 10
for suppliers 1,2,3 and 4 respectively. Clearly, the firm in this case should take the discounts rather than not
take them and borrow unneeded funds from their suppliers.
20) (COMMERCIAL PAPER) Nirvana plans to sell P100 million in 180-day maturity paper, which it expects to pay
discounted interest at an annual rate of 12 percent per annum due to this commercial paper, Nirvana expects to
incur P100,000 in dealer placement fees and paper issuance costs. The effective cost of Nirvana’s credit
is:______________

19
 Answer: {[100 million x 0.12 x 180/360) + 100,000] / (100 million – 6 million – 100,000)} x (360 days / 180 days) =
0.1299 or 12.99%
21) (EFFECTIVE BORROWING RATE) Hanson has arranged a 1-year P2 million credit line with its lead bank. The bank
set the interest rate at the prime rate plus a spread of 1.50 percent. The prime rate is expected to remain stable at
5.25 percent during the coming year. In addition, the bank required Hanson to pay a 0.50 percent commitment fee
on the average unused portion of the line. Assume a 365 day year.
 Calculate the effective borrowing rate on Hanson’s line of credit during the coming year assuming an average
loan balance outstanding during the year is:
1. P1.8 million
Effective Borrowing Rate (EBR): {[(Interest rate x Average loan)+(commitment fee x (total credit line –
average loan)]/ average loan} / (number of days in a year / days loan outstanding)
 Interest rate: Prime rate + Spread rate: 0.0525 + 0.0150 = 0.0675 or 6.75 percent
 EBR: {[(0.0675 x P1.8 million) + [0.0050 x (P2 million – P1.8 million)]/ P1.8 million} x (365 days / 365
days) = 0.0681 or 6.81%
2. P0.80 million
{[(0.0675 x 0.8 million) + [0.0050 x ((P2million – P0.8 million)] / 0.8 million} x (365 days / 365 days) =
0.0750 or 7.50%

20