Chapter 17 - Answer

Solutions Manual

CHAPTER 17 ADDRESSING WORKING CAPITAL POLICIES AND MANAGEMENT OF SHORT-TERM ASSETS AND LIABILITIES SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS I. Questions 1. These are firms with relatively long inventory periods and/or relatively long receivables periods. Thus, such firms tend to keep inventory on hand, and they allow customers to purchase on credit and take a relatively long time to pay. 2. These are firms that have a relatively long time between the time purchased inventory is paid for and the time that inventory is sold and payment received. Thus, these are firms that have relatively short payables periods and/or relatively long receivable cycles. 3. Carrying costs will decrease because they are not holding goods in inventory. Shortage costs will probably increase depending on how close the suppliers are and how well they can estimate need. The operating cycle will decrease because the inventory period is decreased. 4. Since the cash cycle equals the operating cycle minus the accounts payable period, it is not possible for the cash cycle to be longer than the operating cycle if the accounts payable period is positive. Moreover, it is unlikely that the accounts payable period would ever be negative since that implies the firm pays its bills before they are incurred. II. Multiple Choice Questions 1. 2. 3. 4. 5.

C C B C D

6. 7. 8. 9. 10.

A B D C B

11. 12. 13. 14.

C B D B

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III. Problems Problem 1 (Cash Equation) The total liabilities and equity of the company are the net book worth, or market value of equity, plus current liabilities and long-term debt, so: Total liabilities and equity = ₱10,380 + 1,450 + 7,500 = ₱19,330 This is also equal to the total assets of the company. Since total assets are the sum of all assets, and cash is an asset, the cash account must be equal to total assets minus all other assets, so: Cash = ₱19,330 – 15,190 – 2,105 = ₱2,035 We have NWC other than cash, so the total NWC is: NWC = ₱2,105 + 2,035 = ₱4,140 We can find total current assets by using the NWC equation. NWC is equal to: NWC = CA – CL ₱4,140 = CA – ₱1,450 CA = ₱5,590 Problem 2 (Changes in the Operating Cycle) a.

Increase. If receivables go up, the time to collect the receivables would increase, which increases the operating cycle.

b.

Increase. If credit repayment times are increased, customers will take longer to pay their bills, which will lead to an increase in the operating cycle.

c.

Decrease. If the inventory turnover increases, the inventory period decreases.

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d.

No change. The accounts payable period is part of the cash cycle, not the operating cycle.

e.

Decrease. If the receivables turnover increases, the receivables period decreases.

f.

No change. Payments to suppliers affects the accounts payable period, which is part of the cash cycle, not the operating cycle.

Problem 3 (Changes in Cycles) a.

Increase; Increase. If the terms of the cash discount are made less favorable to customers, the accounts receivable period will lengthen. This will increase both the cash cycle and the operating cycle.

b.

Increase; No change. This will shorten the accounts payable period, which will increase the cash cycle. It will have no effect on the operating cycle since the accounts payable period is not part of the operating cycle.

c.

Decrease; Decrease. If more customers pay in cash, the accounts receivable period will decrease. This will decrease both the cash cycle and the operating cycle.

d.

Decrease; Decrease. Assume the accounts payable period does not change. Fewer raw materials purchased will reduce the inventory period, which will decrease both the cash cycle and the operating cycle.

e.

Decrease; No change. If more raw materials are purchased on credit, the accounts payable period will tend to increase, which would decrease the cash cycle. We should say that this may not be the case. The accounts payable period is a decision made by the company’s management. The company could increase the accounts payable account and still make the payments in the same number of days. This would leave the accounts payable period unchanged, which would leave the cash cycle unchanged. The change in credit purchases made on credit will not affect the inventory period or the accounts payable period, so the operating cycle will not change.

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f.

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Increase; Increase. If more goods are produced for inventory, the inventory period will increase. This will increase both the cash cycle and operating cycle.

Problem 4 (The Operating and Cash Cycles) We first need the turnover ratios. Note that we use the average values for all balance sheet items and that we base the inventory and payables turnover measures on cost of goods sold: Inventory turnover = ₱11,375/ [(₱1,273 + ₱1,401)/2] = 8.51 times Receivables turnover = ₱14,750/ [(₱3,782 + ₱3,368)/2] = 4.13 times Payables turnover = ₱11,375/ [(₱1,795 + ₱2,025)/2] = 5.96 times We can now calculate the various periods: Inventory period = 365 days/8.51 times = 42.89 days Receivables period = 365 days/4.13 times = 88.38 days Payables period = 365 days/5.96 times = 61.24 days So the time it takes to acquire inventory and sell it is about 43 days. Collection takes another 88 days, and the operating cycle is thus 43 + 88 = 131 days. The cash cycle is thus 131 days less the payables period: 131 – 61 = 70 days. Problem 5 (Working Capital) a. Working Capital = ₱400,000 Net Working Capital = ₱400,000 − ₱200,000 = ₱200,000 Current Ratio = ₱400,000/₱200,000 = 2 times b. Five Star’s return on equity is 12.5 percent (₱62,700/₱500,000). Five Star Manufacturing Company Income Statement For the Year Ended December 31, 2011 Net sales EBIT (20% of sales) Less: Interest expense Short-term debt (10%) 17-4

₱800,000 160,000 20,000

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Long-term debt (15%) 45,000 Earnings before taxes 95,000 Less: Income taxes (34%) 32,300 Net income ₱62,700 c. The net working capital and current ratios for each strategy are shown below:

Current assets (CA) Fixed assets Total assets

Strategies Current Assets as a Percent of Sales 30% 50% 70% ₱300,000 ₱ 500,000 ₱ 700,000 600,000 600,000 600,000 ₱900,000 ₱1,100,000 ₱1,300,000

Current liabilities (CL)* Long-term liabilities Total liabilities Stockholders’ equity (SE) Total liabilities and equity

₱180,000 ₱ 200,000 ₱ 260,000 270,000 330,000 390,000 ₱450,000 ₱ 550,000 ₱ 650,000 450,000 550,000 650,000 ₱900,000 ₱1,100,000 ₱1,300,000

Net working capital (CA – CL) Current ratio (CA/CL)

₱120,000 ₱ 300,000 ₱ 440,000 1.7 times 2.5 times 2.7 times

*Assume that all current liabilities are in the form of short-term debt. d. The firm’s liquidity position, as measured by the amount of net working capital and current ratio, improves when current assets are a higher percentage of sales. e. The rate of return on equity for each strategy is shown below:

Net sales EBIT (18% of sales) Interest expense Short-term debt (10%) Long-term debt (15%) Earnings before taxes (EBT) Income taxes (34%)

Strategies Current Assets as a Percent of Sales 30% 50% 70% ₱1,000,000 ₱1,000,000 ₱1,000,000 180,000 180,000 180,000 18,000 40,500 121,500 41,310 17-5

20,000 49,500 110,500 37,570

26,000 58,500 95,500 32,470

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Net income

₱

Return on equity (NI/SE) f.

80,190

₱ 72,930

₱ 63,030

17.8%

13.0%

9.7%

Five Star’s profitability decreases as liquidity increases. For example, the firm’s liquidity (current ratio = 2.7 times) is the highest but profitability (ROE = 9.7 percent) is the lowest when current assets are 70 percent of sales.

g. The return on equity, net working capital and current ratio for each strategy are shown below:

EBIT Interest expenses Short-term (10%) Long-term (15%) Earnings before taxes (EBT) Income taxes (34%) Net income Return on equity (NI/SE) Net working capital (CA – CL) Current ratio (CA/CL)

Financing- Mix Strategies Restricted Compromise Flexible ₱180,000 ₱180,000 ₱180,000 10,000 52,500 117,500 39,950 ₱77,550

30,000 22,500 127,500 43,350 ₱84,150

45,000 0 135,000 45,900 ₱89,100

17.2% ₱200,000 3.0 times

18.7% 0 1.0 times

19.8% (₱150,000) 0.7 times

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