Part 7
Short-Term Financial Decisions
Chapters in This Part
Chapter 15 Working Capital and Current Assets Management
Chapter 16 Current Liabilities Management
Integrative Case 7: Casa de Diseño
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Chapter 15
Working Capital and Current Assets Management
Instructor’s Resources
Overview
This chapter introduces the fundamentals and describes the interrelationship of net working capital, profitability,
and risk in managing a firm’s current asset accounts. The chapter then focuses on the management of three major
current asset accountscash, accounts receivable, and inventory. Also discussed are general inventory management
policies, international inventory management, and several specific inventory management techniques: ABC,
economic order quantity (EOQ), reorder point, materials requirement planning (MRP), and just-in-time (JIT). The
key aspects of accounts receivable management are discussed: credit policy, credit terms, and collection policy.
The chapter also discusses the additional risk factors involved in managing international accounts receivable.
Examples demonstrate the effect of changes in credit policy. Also discussed are the impacts of changes in cash
discounts. The chapter describes how managers and individuals often have to make choices that involve tradeoffs
between quantity and price.
Suggested Answer to Opener-in-Review Question
In the chapter opener you learned that U.S. companies had been building up their cash balances after the
financial crisis, despite the fact that the interest rates that they could earn on low-risk, liquid investments
were extremely low. Describe the tradeoff that companies face when they are deciding how much cash to
hold.
A large cash reserve is usually considered a good sign for any company. It helps companies to tide over temporary
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Answers to Review Questions
1. Working capital management, the management of a firm’s current assets and liabilities, is one of the most
2. The more predictable a firm’s cash inflows, the lower the level of net working capital with which it can safely
3. If a firm increases the ratio of current assets-to-total assets, it will have a larger proportion of current assets.
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4. A firm’s operating cycle is the period when a firm has its money tied up in inventory and accounts receivable
5. If a firm does not face a seasonal cycle, then it will face only a permanent funding requirement. With seasonal
6. An aggressive strategy finances a firm’s seasonal needs, and possibly some of its permanent needs, with
7. The longer the cash conversion cycle, the greater the amount of investment tied up in low return assets. Any
8. Financial managers will tend to keep inventory levels low to reduce financing costs. Marketing managers
9. The ABC system divides inventory into three categories of descending importance based on certain criteria
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10. The need to ship materials and products to foreign countries creates challenges for international inventory
11. A firm uses a credit selection process to determine if credit should be extended to a customer and if so, how
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12. Credit scoring is the ranking of an applicant’s overall credit strength. It is derived as a weighted average of
13. The tradeoffs in tightening credit standards are that while investment in accounts receivable and bad debt
14. The risks of international credit management include exposure to foreign exchange rate fluctuations and
15. A firm’s credit terms conform to those of its industry for competitive reasons. If its terms are less restrictive
16. Active monitoring allows a manager to determine whether credit customers are complying with the stated
The aging of accounts receivable breaks a firm’s existing accounts receivable balance into groups based on
17. Float refers to funds that have been dispatched by a payer but are not in a form that can be spent by the payee.
18. A firm desires to reduce collection float to decrease the investment in accounts receivable. Benefits are received
19. The three main advantages of cash concentration are as follows:
20. Three mechanisms of cash concentration are (1) depository transfer checks, (2) automated clearing house, and
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21. To be marketable, a security must have both a ready market and safety of principal. The market should have
Suggested Answer to Focus on Practice Box: RFID: The Wave of the
Future?
What problem might occur with the full implementation of radio frequency identification (RFID)
technology in retail industries? Specifically, consider the amount of data that might be collected.
Suggested Answer to Focus on Ethics Box: Stretching Accounts
Payable: Is It a Good Policy?
Although vendor discounts for early payment are very rewarding, what are some of the difficulties that may
arise to keep a firm from taking advantage of those discounts?
Answers to Warm-Up Exercises
E15-1. Operating Cycle
Answer:
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E15-2. Maximum and minimum seasonal funding requirements
Answer:
–Funding requirement = cash + inventory + accounts receivable accounts payable
Maximum funding requirement $35,000 $125,000 $70,000 $65,000 $165,000
Minimum funding requirement $10,000 $55,000 $40,000 $35,000 $70,000
= + + – =
= + + – =
E15-3. EOQ and reorder point
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E15-4. Evaluation of change in credit standards
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E15-5. Cash discount plan
Answer: The minimum average collection period after the discount is introduced can be determined when the
Step 1: Calculate profit contribution from additional sales
Step 2: Find current turnover of accounts receivable
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Step 4: Let X equal the average investment in accounts receivable after the discount is introduced. Use
the equation below to balance the costs and benefits of introducing the discount policy.
Step 5: Solve for the average investment in AR, after the discount is introduced, which will balance
the equation in Step 4.
$0 $22,000 [0.15 ($181,250 )] (0.02 0.80 37,000 $40)
$0 $22,000 ($27,187.50 0.15 ) $23,680
0.15 $22,000 $27,187.50 $23,680 $25,507.50
$170,050
X
X
X
X
= + ´ – – ´ ´ ´
= + – –
= + – =
=
Step 4: Solve for the new average collection period.
Solutions to Problems
P15-1. CCC
LG 2; Basic
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a. OC Average age of inventories Average collection period
b. CCC Operating cycle Average payment period
c. To calculate the amount of resources needed, you must calculate the amount of inventory, receivables,
and accounts payable.
d. Shortening either the AAI or the ACP, lengthening the APP, or a combination of these can reduce the
CCC.
P15-2. Changing CCC
LG 2; Intermediate
a. AAI 365 days 5 times inventory 73 days
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b. The inventory balance equals cost of goods sold divided by inventory turnover:
c. The change in working capital is driven entirely by the reduction in inventory because neither the
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