16-13 a.
Current year sales are expected to be $1,600,000x(1.25) = $2,000,000.
Return on equity may be computed as follows:
Restricted Moderate Relaxed
Current assets
(% of sales Sales) $ 900,000 $1,000,000 $1,200,000
Fixed assets 1,000,000 1,000,000 1,000,000
Total assets $1,900,000 $2,000,000 $2,200,000
b. No, this assumption would probably not be valid in a real world situation. A firm’s
c. As the answers to Part a indicate, the tighter policy leads to a higher expected return.
However, as the current asset level is decreased, presumably some of this reduction
comes from accounts receivable. This can be accomplished only through higher
restrictive receivable policies might involve some additional costs (collection, and so
forth) but would also probably reduce bad debt expenses. Lower current assets would
also imply lower liquid assets; thus, the firm’s ability to handle contingencies would
be impaired. Higher risk of inadequate liquidity would increase the firm’s risk of
insolvency and thus increase its chance of failing to meet fixed charges. Also, lower
inventories might mean lost sales and/or expensive production stoppages. Attempting
to attach numerical values to these potential losses and probabilities would be
*November purchases = $140,000.
b. If the company began selling on credit on December 1, then it would have zero
receipts during December, down from $160,000. Thus, it would have to borrow an
Answers and Solutions: 16 – 2
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
16-17 a. Size of bank loan = (Purchases/Day)(Days late)
=
Alternatively, one could simply recognize that accounts payable must be cut to half of
its existing level, because 30 days is half of 60 days.
b. Simple interest rate per day = Nominal rate/Days in year
Interest charge for month = Rate per day × Loan amount × Days in month
(3) Enter the following inputs into your calculator:
d. Given the limited information, the decision must be based on the rule-of-thumb
comparisons, such as the following:
Raattama’s debt ratio is 73%, as compared to a typical debt ratio of 50%. The
firm appears to be undercapitalized.
The current ratio appears to be low, but current assets could cover current
liabilities if all accounts receivable can be collected and if the inventory can be
liquidated at its book value.
Answers and Solutions: 16 – 4
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
The quick ratio indicates that current assets, excluding inventory, are only
sufficient to cover 27% of current liabilities, which is very bad.
SPREADSHEET PROBLEM
16-18 The detailed solution for the spreadsheet problem, Ch16 P18 Build a Model
Solution.xlsx, is available on the textbook’s Web site.
Answers and Solutions: 16 – 5
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
MINI CASE
Karen Johnson, CFO for Raucous Roasters (RR), a specialty coffee manufacturer, is
rethinking her company’s working capital policy in light of a recent scare she faced when
RR’s corporate banker, citing a nationwide credit crunch, balked at renewing RR’s line of
credit. Had the line of credit not been renewed, RR would not have been able to make
payroll, potentially forcing the company out of business. Although the line of credit was
ultimately renewed, the scare has forced Johnson to examine carefully each component of
RR’s working capital to make sure it is needed, with the goal of determining whether the
line of credit can be eliminated entirely. In addition to (possibly) freeing RR from the need
for a line of credit, Johnson is well aware that reducing working capital will improve free
cash flow.
Historically, RR has done little to examine working capital, mainly because of poor
communication among business functions. In the past, the production manager resisted
Johnson’s efforts to question his holdings of raw materials, the marketing manager resisted
questions about finished goods, the sales staff resisted questions about credit policy (which
affects accounts receivable), and the treasurer did not want to talk about the cash and
securities balances. However, with the recent credit scare, this resistance became
unacceptable and Johnson has undertaken a company-wide examination of cash,
marketable securities, inventory, and accounts receivable levels.
Johnson also knows that decisions about working capital cannot be made in a
vacuum. For example, if inventories could be lowered without adversely affecting
operations, then less capital would be required, and free cash flow would increase.
However, lower raw materials inventories might lead to production slowdowns and higher
costs, and lower finished goods inventories might lead to stock-outs and loss of sales. So,
before inventories are changed, it will be necessary to study operating as well as financial
effects. The situation is the same with regard to cash and receivables. Johnson has begun
her investigation by collecting the ratios shown below.
RR Industry
Current 1.75 2.25
Quick 0.92 1.16
Total liabilities/assets 58.76% 50.00%
Turnover of cash and securities 16.67 22.22
Answers and Solutions: 16 – 6
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
a. Johnson plans to use the preceding ratios as the starting point for discussions
with RR’s operating team. Based on the data, does RR seem to be following a
relaxed, moderate, or restricted current asset usage policy?
Answer: A company with a relaxed current asset usage policy would carry relatively large
amounts of current assets relative to sales. It would be guarding against running out
of stock or of running short of cash, or losing sales because of a restrictive credit
b. How can one distinguish between a relaxed but rational working capital policy
and a situation in which a firm simply has excessive current assets because it is
inefficient? Does RR’s working capital policy seem appropriate?
Answer: RR may choose to hold large amounts of inventory to avoid the costs of “running
short,” and to cater to customers who expect to receive their coffee immediately. RR
It is clear from the data in the table that RR is not as profitable as the average firm
Answers and Solutions: 16 – 7
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
c. Calculate the firm’s cash conversion cycle given annual sales are $660,000 and
cost of goods represent 80% of sales. Assume a 365-day year.
Answer: A firm’s cash conversion cycle is calculated as:
period
conversion
Inventory
+ –
period
deferral
Payables
=
cycle
conversion
Cash
We need to determine the RR’s inventory conversion period from the data given. We
RR’s average collection period is equal to its DSO. Its DSO is given as 45.6 days.
We are given that its payables deferral period is 30 days, so now we have all the
individual components to calculate RR’s cash conversion cycle.
Thus, RR’s cash conversion cycle is approximately 49 days.
Answers and Solutions: 16 – 8
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.