Concept explainers
- a. Working capital; net working capital; net operating working capital
- b. Current asset usage policies: relaxed policy, restricted policy, and moderate policy
- c. Permanent operating current assets; temporary operating current assets
- d. Current asset financing policies: maturity matching, aggressive, and conservative
- e. Inventory conversion period; average collection period; payables deferral period; cash conversion cycle
- f. Cash budget; target cash balance
- g. Transactions balances; compensating balances; precautionary balances
- h. Trade (cash) discounts
- i. Credit policy; credit period; credit standards; collection policy; cash discounts
- j. Account receivable; days sales outstanding; aging schedule
- k. Accruals; trade credit
- l. Stretching accounts payable; free trade credit; costly trade credit
- m. Promissory note; line of credit; revolving credit agreement
- n. Commercial paper; secured loan
a)
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To discuss: The terms working capital, net working capital and net operating working capital.
Explanation of Solution
Working capital refers to company’s short term investments such are used in operations. Net working capital is nothing but current assets minus all current liabilities. Net operating working capital is operating current assets minus operating current liabilities.
b)
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To discuss: Current asset usage policy, restricted policy, relaxed policy and moderate policy.
Explanation of Solution
A relaxed current usage policy is nothing but a firm holds relatively large amounts of cash, marketable securities and the inventories are carried and under which sales are stimulated by a liberal credit policy, leading to a high level of assets.
A restricted policy refers to a policy below that holdings of cash, securities, inventories and assets are minimized, whereas, a moderate current asset investment policy lies in between the restricted and relaxed policies.
c)
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To discuss: Temporary operating current assets and permanent operating current assets.
Explanation of Solution
Temporary operating current assets are current operating assets needed higher than the permanent level once the economy is powerful or seasonal sales are high.
Permanent current operative assets are the current operating assets required even at the low purpose of trade cycles. For a growing firm, in an exceedingly growing economy, permanent current assets tend to extend over time.
d)
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To discuss: Current asset financing policies, conservative and aggressive, and maturity matching.
Explanation of Solution
Maturity matching: Involves matching, to the extent possible, the maturities of assets and liabilities, so temporary current operating assets are supported with short term debt and permanent current operating assets and fixed assets are supported with equity or long-term debt.
Aggressive financing policy: Some permanent current operating assets, and may be even some fixed assets ate supported with short term debt.
Conservative financing policy: Would be to use long term sources to finance all permanent working capital and a few of the temporary current operating assets.
e)
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To discuss: Inventory conversion period, payables deferral period, and average collection period and cash conversion cycle.
Explanation of Solution
Inventory conversion period is nothing but the average time needed to convert materials into finished goods then to sell those goods, its amount ¼ of inventory divided by cost of goods sold per day.
Average collection period is the average length of time needed to convert firm’s assets into cash- that is, to gather cash by following a sale,
Cash conversion cycle is that the length of time between firm’s actual cash expenditures on productive resources (labour and materials) and its own cash receipts from sale of products. Thus, cash conversion cycle equals the length of time that the firm has funds tied up in current assets.
Payments deferral period is that the average length of time between a firm’s purchase of materials and labour and therefore, the payment of money for them It is calculated by dividing accounts payable by credit purchases (per day).
f)
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To discuss: Cash budget and target cash balance.
Explanation of Solution
A cash budget may be a schedule showing cash flows (receipts, disbursements and cash balances) for a firm over a fixed period. The target cash balance is that the desired cash balance that a firm plans to keep up so as to conduct business.
g)
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To discuss: Compensating balances, transaction balances and precautionary balances.
Explanation of Solution
Transactions balance (routine) is that the money balance related to payments and collections, the balance necessary for day-to-day operations. A compensating balance is an amount that a firm should maintain in its bank account to compensate the bank for services rendered or for granting a loan.
A precautionary balance could be a cash balance held in reserve for random, unforeseen fluctuations in cash outflows and inflows.
h)
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To discuss: Trade (cash) discounts.
Explanation of Solution
Trade discounts that are also referred as cash discounts, are the price reductions that suppliers provide customers for early payments of bills.
i)
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To discuss: Credit standards, credit policy, cash discounts and collection policy, and credit period.
Explanation of Solution
Credit policy refers to set of procedures, rules regarding collection and granting of credit. It contains four elements, they are credit policy, credit policy variables, credit standards, collection policy and discounts.
Credit standards confirm the minimum financial strength needed to become a credit, versus cash and customer. The optimal credit standards equate the progressive prices of credit to the incremental profits on increased sales.
Collection policy is the procedure for collection of accounts receivable. A change in collection policy will affect the sales, bad debt losses, day sales outstanding and percentage of customers taking discounts.
Trade discounts that are also referred as cash discounts, are the price reductions that suppliers provide customers for early payments of bills.
Credit period is the distance of time for which credit is protracted. When the credit period is lengthened the sales would usually raise and as would accounts receivable. It will helps to raise the requirements of finance and perhaps raise bad debts losses. Shortening of period of credit will have the opposite impact.
j)
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To discuss: Account receivables, aging schedule and day sales outstanding.
Explanation of Solution
Account receivables: These are current assets (which are converted into cash within one year) from them cash is to be free for the credit sale created to them.
Aging schedule: It is a schedule of summarised breakup of “invoice issued to receivable” “bill received by company”, and also the “due date relating to these bills and invoices”. This schedule provides the information relating to those payments and receipts behind the due date.
Day’s sales outstanding: It is nothing but the estimated number of days calculated by company to receive the credit sale amount which was previously made to account receivable. It is also a average collection period.
k)
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To discuss: Accruals and trade credit.
Explanation of Solution
Accruals are adjustments for the revenues that are attained, but not received in money and for the expenses that are incurred, however not paid in money.
Trade credit is an agreement of purchasing goods from supplier without paying cash on that purchases, but to pay on later date for those goods.
l)
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To discuss: Stretching accounts payable, costly trade credit and free trade credit.
Explanation of Solution
Stretching accounts payable is that the practice of deliberately paying accounts payable late. Trade credit is credit received throughout the discount amount. Credit taken in far more than free trade credit, whose cost is up to the discount lost is termed costly trade credit.
m)
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To discuss: Promissory note, revolving credit agreement and line of credit.
Explanation of Solution
A promissory note is a document denoting the terms and conditions of a loan, and includes interest rate, amount and repayment schedule. A line of credit is an arrangement during which a bank agrees to lend up to a specified maximum amount of funds during a designated period.
A revolving credit agreement is a formal, committed line of credit extended by a bank or alternative financial institution.
n)
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To discuss: Commercial paper and secured loan.
Explanation of Solution
Commercial paper is unsecured and short term promissory notes of large companies and issued in larger denominations like $100,000 or more and having an interest rate somewhat below the prime rate.
Whereas, a secured loan is backed by security collateral, typically inventories or assets.
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Chapter 21 Solutions
Intermediate Financial Management
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