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Chapter 15
Current Liabilities Management
Instructor’s Resources
Overview
This chapter introduces the fundamentals and describes the interrelationship of net working capital, profitability,
and risk in managing the firm’s current liability accounts. The management of current liabilities requires
choosing appropriate levels of financing and involves tradeoffs between risk and profitability. This chapter also
reviews sources of secured and unsecured short-term financing, including the role of international loans.
Spontaneous sources, such as accounts payable and accruals, are differentiated from negotiated bank sources, such
as lines of credit. The cash discount offered on accounts payable and the cost of forgoing such discounts are
described. Secured sources include bank and commercial finance company loans, backed by collaterals such as
inventory or accounts receivable. Whether borrowing funds as a manager or for their own personal use, effective
management of current liabilities is essential, making Chapter 15 relevant at the professional and personal levels.
Answers to Review Questions
1. The two major sources of spontaneous short-term financing (financing that arises from the normal operating
cycle) are accounts payable and accruals. Both of these sources are spontaneous because they increase and
2. There is no cost⎯stated or unstated⎯associated with taking a cash discount; there is a cost of giving up a
cash discount. By giving up a cash discount, the purchaser pays the full price for merchandise but can make
3. Stretching accounts payable is the process of delaying the payment of accounts payable for as long as
4. The prime rate of interest is a rate charged on business loans to creditworthy business borrowers. It is usually
used by lenders as a base rate. Lenders add a premium to that base rate that depends on the borrower’s credit
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11. Lenders view secured and unsecured short-term loans as having the same degree of default risk. The benefit
12. The interest rate charged on secured short-term loans is typically higher than the interest rate on unsecured
short-term loans. Typically, companies that require secured loans may not qualify for unsecured debt, and
13. a. A pledge of accounts receivable is the use of a firm’s receivables to secure a short-term loan. The lender
evaluates the quality of the accounts receivable, selects acceptable accounts, and files a lien on the
collateral. After the selection of accounts, the lender determines the percentage advanced against
receivables. Typically ranging from 50% to 90% of the face value of the acceptable receivables, this
14. a. Floating inventory liens are made by lenders and secured by a claim on general inventory consisting of a
diversified and low-cost group of merchandise. Generally less than 50% of the book value of the average
inventory is advanced. The interest charge on a floating lien is typically 3% to 5% above the prime rate.
b. Trust receipt inventory loans are often made by manufacturers’ financing subsidiaries to their customers.
Under this arrangement, merchandise is typically expensive (automotive, industrial and consumer-
durable equipment, for example) and remains in the hands of the borrower. The lender advances 80% to
100% of the cost of the salable inventory. The borrower is free to sell the merchandise and is trusted to
remit the loan amount plus accrued interest to the lender immediately. The interest charge is generally
2% or more above the prime rate.
c. A warehouse receipt loan is an arrangement whereby the lender receives control of the pledged
collateral. The inventory may be retained by the borrower in the firm’s warehouse with security
administered by a field warehousing company, or it may be stored in a terminal warehouse located in the
geographic vicinity of the borrower. Generally, less than 75% to 90% of the collateral’s value is
advanced to the borrower at an interest rate from 4% to 8% above the prime rate.
324 Zutter/Smart • Principles of Managerial Finance Brief, Eighth Edition
Suggested Answer to Focus on Practice Box: The Ebb and Flow of
Commercial Paper
What factors would contribute to an expansion of the commercial paper market? What factors would cause
a contraction in the commercial paper market?
E15-1. Cash discount and the simplified formula
E15-2. Managing accruals
E15-3. Effective annual interest rate
E15-4. Effective annual interest rate
E15-5. Commercial paper interest rate
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P15-1. Payment dates
LG 1; Basic
P15-2. Cost of giving up cash discount
LG 1; Basic
a. (0.02 ÷ 0.98) × (365 ÷ 20) = 37.24%
P15-3. Credit terms
LG 1; Basic
a. 1/15 net 45 date of invoice
2/10 net 30 EOM
2/7 net 28 date of invoice
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P15-4. Cash discount versus loan
LG 1; Basic
P15-5. Personal finance: Borrow or pay cash for an asset
LG 2; Intermediate
a. Calculate the down payment on the loan
Loan principal
$ 14,500
$780.48)
e. Opportunity cost
N
et initial cash outlay
$ 780.48
$ 11,100
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P15-6. Cash discount decisions
LG 1, 2; Intermediate
a. Approximate cost of giving up discount from each supplier:
J: 1% × (365/25) = 14.6%; or the more precise calculation is (1/99) × (365/25) = 14.75%
P15-7. Changing payment cycle
LG 2; Basic
P15-8. Spontaneous sources of funds, accruals
P15-9. Cost of bank loan
LG 3; Intermediate
P15-10. Personal finance: Unsecured sources of short-term loans
LG 3; Challenge
a. Fixed-rate loan
Interest expense = loan amount × (prime rate + percent over prime) × (loan period ÷ 365)
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P15-11. Effective annual rate
LG 3; Basic
Because this is a discount loan, interest is essentially paid up front. Given that the interest rate is 6%,
P15-12. Compensating balances and effective annual rates
LG 3; Intermediate
a. Compensating balance requirement = $800,000 borrowed × 15%
= $120,000
P15-13. Compensating balance versus discount loan
LG 3; Intermediate
a. State Bank interest = $150,000 × 0.09 × 6/12 / ($150,000 – ($150,000 × 0.10)) =
$6,750 / $135,000 = 5.00 %
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P15-14. Integrative—comparison of loan terms
LG 3; Challenge
P15-15. Cost of commercial paper
LG 4; Intermediate
−=
P15-16. Accounts receivable as collateral
LG 5; Intermediate
a. Acceptable accounts receivable
Customer Amount
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1. Amount required: $2,500,000 short term and $1,000,000 long term
1. Amount required: $7,000,000 long term and $0 short term
1. Calculation of short-term requirements
Month
(1)
Total Funds
Requirements
(2)
Permanent
Requirements
Seasonal
Requirements
January $1,000,000 $3,000,000 $0
February 1,000,000 3,000,000 0
Monthly average: Permanent = $3,000,000
Seasonal = $1,166,667 (sum of seasonal requirements ÷ 12)
Seasonal = $1,166,667 (14,000,000 ÷ 12)
2. Cost: (10% × $1,166,667) + (14% × $3,000,000) = $536,667
b. Net working capital = current assets − current liabilities
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expensive long-term financing, it is the most expensive ($980,000) and the least profitable. It is the lowest-
risk strategy, however, reserving short-term financing for emergencies. The high level of working capital also
reduces risk.
The tradeoff strategy falls between the two extremes in terms of both profitability and risk. The cost
($536,667) is higher than the aggressive strategy because the permanent funds requirement of $3,000,000 is
financed with more costly long-term funds. In five months (January, February, March, November, and
December), the company pays interest on unneeded funds. The risk is less than with the aggressive strategy;
Note: Other recommendations are possible, depending on the student’s risk preference. Of course, the student
should present sound reasons for his or her choice of strategy.
d. 1. Effective interest, line of credit:
2. Effective interest, revolving credit agreement:
Cost of borrowing:
12.92%
==
12.92%) by using the line of credit. The only negative is that if Third National lacks loanable funds, Kanton
may not be able to borrow the needed funds. Under the revolving credit agreement, funds availability would
