d. Is there any reason to think that RR may be holding too much inventory?
Answer: As pointed out in part a, RR’s inventory turnover (10.8) is considerably lower than
e. If RR reduces its inventory without adversely affecting sales, what effect should
this have on free cash flow: (1) in the short run and (2) in the long run?
Answer: A one-time reduction in inventory causes an identical one-time increase in free cash
f. Johnson knows that RR sells on the same credit terms as other firms in its
industry. Use the ratios presented earlier to explain whether RR’s customers pay
more or less promptly than those of its competitors. If there are differences, does
that suggest RR should tighten or loosen its credit policy? What four variables
make up a firm’s credit policy, and in what direction should each be changed by
RR?
Answer: RR’s DSO is 45.63 days as compared with 32 days for the average firm in its
The four variables that make up a firm’s credit policy are (1) discount amount and
period, (2) credit period, (3) credit standards, and (4) collection policy. Cash
discounts generally produce two benefits: (1) they attract new customers who view
Credit period is the length of time allowed all “qualified” customers to pay for
their purchases. The shorter a firm’s credit period, the shorter the firm’s days sales
In order to qualify for credit in the first place, customers must meet the firm’s
credit standards. These dictate the minimum acceptable financial position required of
customers to receive credit. Also, a firm may impose differing credit limits
Finally, collection policy refers to the procedures that the firm follows to collect
past-due accounts. These can range from a simple letter or phone call to turning the
A tightening of credit policy would tend to decrease sales, decrease the level of
receivables held, and decrease the amount of bad debt expenses.
g. Does RR face any risks if it tightens its credit policy?
h. If the company reduces its DSO without seriously affecting sales, what effect
would this have on its free cash flow (1) in the short run and (2) in the long run?
Answer: Similar to the situation with inventory, a one-time reduction in DSO causes an
i. What is the impact of higher levels of accruals, such as accrued wages or accrued
taxes? Is it likely that RR could make changes to accruals?
Answer: Higher levels of accruals increase free cash flow. No, RR could not make greater use
of its accruals. Accruals arise because (1) workers are paid after they have actually
The amount of accruals is generally limited by the amount of wages paid and the
firm’s profitability, as well as by industry conventions regarding when wage
payments are made and IRS regulations regarding tax payments. (Increasingly,
j. Assume that RR purchases $200,000 (net of discounts) of materials on terms of
1/10, net 30, but that it can get away with paying on the 40th day if it chooses not
to take discounts. How much free trade credit can the company get from its
equipment supplier, how much costly trade credit can it get, and what is the
percentage cost of the costly credit? Should RR take discounts?
Answer: If RR’s net purchases are $200,000 annually, then, with a 1% discount, its gross
If the discount is taken, then RR must pay this supplier at the end of Day 10 for
purchases made on Day 1, on Day 11 for purchases made on day 2, and so on. Thus,
in a steady state, RR will on average have 10 days’ worth of purchases in payables,
so,
If the discount is not taken, then RR will wait 40 days before paying, so
Therefore:
Trade credit if discounts are not taken: $21,918 = total trade credit
439,16$
020,2$
= 0.1229 = 12.29%.
Here is a formula that can be used to find the nominal annual interest rate of costly
trade credit:
credit tradeof
cost Nominal
=
.
period discount taken aysD
Days536
% iscount D- 1
% iscountD
In this situation,
%.912.2 = 290.12 = 1667.12 0.0101 =
10 – 40
536
99
1
Note (1) that the formula gives the same nominal annual interest rate as was
calculated earlier, (2) that the first term is the periodic cost of the credit (RR spends
If RR can obtain financing from its bank (or from other sources) at an interest rate
of less than 13.01%, it should borrow the funds and take discounts.
k. Cash doesn’t earn interest, so why would a company have a positive target cash
balance?
Answer: 1. Transactions balances. A company must have some cash to pay current bills.
2. Precautionary balances (i.e.,“Safety stock”) to handle unexpected needs. These
l. What might RR do to reduce its target cash balance without harming
operations?
Answer: 1. Synchronize cash inflows and outflows.
2. Use float.
m. RR tries to match the maturity of its assets and liabilities. Describe how RR
could adopt either a more aggressive or more conservative financing policy.
Answer: There are three alternative current asset financing policies: aggressive, moderate, and
relaxed. A moderate financing policy matches asset and liability maturities. (Of
course exact maturity matching is not possible because of (1) the uncertainty of asset
n. What are the advantages and disadvantages of using short-term debt as a source
of financing?
Answer: Although using short-term credit is generally riskier than using long-term credit,
short-term credit does have some significant advantages. A short-term loan can be
obtained much faster than long-term credit. Lenders insist on a more thorough
Even though short-term debt is often less expensive than long-term debt,
short-term debt subjects the firm to more risk than long-term financing. The reasons
o. Would it be feasible for RR to finance with commercial paper?
Answer: It would not be feasible for RR to finance with commercial paper. Commercial paper
is unsecured, short-term debt issued by large, financially strong firms and sold
primarily to other business firms, to insurance companies, to pension funds, to money
market mutual funds, and to banks. Maturities are generally 270 days (9 months) or
p. In an attempt to better understand RR’s cash position, Johnson developed a cash
budget. Data for the first 2 months of the year are shown below. (Note that
Johnson’s preliminary cash budget does not account for interest income or
interest expense.) She has the figures for the other months, but they are not
shown. After looking at the cash budget, answer the following questions.
RR’S CASH BUDGET FOR JANUARY AND FEBRUARY
November December January February March April
Sales
(1) Sales (Gross) $71,218 $68,212.00 $65,213.00 $52,475.00 $42,909 $30,524
Collections:
(2) During Month Of Sale
(0.2)(0.98)(Month’s Sales) 12,781.75 10,285.10
Purchases:
Payments
(7) Payments For Purchases 44,603.75 36,472.65
(8) Wages And Salaries 6,690.56 5,470.90
Net Cash Flows
Cash Surplus (or Loan Requirement)
e. 1. What does the cash budget show regarding the target cash level?
e. 2. Should depreciation expense be explicitly included in the cash budget? Why or
why not?
Answer: No, depreciation expense is a noncash charge and should not appear explicitly in the
e. 3. What are some other potential cash inflows besides collections?
Answer: 1. Proceeds from fixed asset sales.
e. 4. How can interest earned or paid on short-term securities or loans be
incorporated in the cash budget?
Answer: 1. Interest earned: Add line in the collections section.
e. 5. In her preliminary cash budget, Johnson has assumed that all sales are collected
and thus that RR has no bad debts. Is this realistic? If not, how would bad debts
be dealt with in a cash budgeting sense? (Hint: Bad debts will affect collections
but not purchases.)
Answer: It is not realistic to assume zero bad debts. When credit is granted, bad debts should
be expected. Collections in each month would be lowered by the percentage of bad