Chapter 7 Working Capital Management
CHAPTER OUTLINE
Learning Objectives
Working Capital
Working Capital Management
Current Asset Management
Cash Management
Marketable Securities Management
Accounts Receivable Management
Inventory Management
REVIEW AND DISCUSSION QUESTIONS
1. Compare gross working capital and net working capital. Gross working capital consists of the current
2. For most businesses, what does cash consist of? Cash consists of the following items: petty cash; cash
on hand; cash in bank checking; cash in bank savings.
3. In current asset management, what is the float? How would paying by check allow a business to take
advantage of the float? The float is the time that elapses from when payment is made by check, until the
4. List and describe at least three methods a business can use to speed cash receipt time from its
debtors. The three methods used to speed up cash receipts are a lock-box system, electronic funds
5. What role do marketable securities play in current asset management? The role is to allow us to earn
more interest on excess cash by taking the money out of our checking or savings account and investing in
6. What methods can be used by small businesses to speed the collection of money that is owed to them?
7. What are the five Cs of credit? How do these serve as a yardstick for credit evaluation? The five Cs
of credit are CHARACTER, CAPACITY, CAPITAL, COLLATERAL and CONDITIONS.. Character
8. What corrective action can be taken for customers whose outstanding balances do not adhere to our
credit terms? The first of course is to just notify these customers and try to obtain payment. Second, is to
9. What is an ABC analysis with regard to inventory? The ABC analysis is based on the twenty eighty
rule (Pareto Rule). In most business operations, 5 to 10% of the inventory items (e.g., individual stock
10. List and describe three types of inventory. (1) Raw Materials are the items that a company uses in
11. How is a line of credit issued by a bank similar to a credit card? A line of credit is an open loan
agreement with a bank. An individual or business obtains a credit limit, but is not obligated to make
12. What is the difference between a line of credit and a short-term loan? The primary difference
13. If a firm does not provide for accrued liabilities, what problems may the firm face? The firm may not
be able to pay payroll taxes, benefits, and property and sales taxes when they are due. Government agencies
14. Compare standard quantity discounts to cumulative quantity discounts. Standard quantity discounts
apply to each order that is placed with our vendor. Cumulative quantity discounts provide the ordering firm
EXERCISES AND PROBLEMS
1. Joe Fellows is attempting to categorize several items from his company’s financial statements so he
can determine his working capital. Joe notices the following categories of accounts and amounts:
cash, $3,500; accounts payable, $10,200; accounts receivable, $15,000; sales taxes due city of Phoenix,
$750; sales taxes due the Arizona Department of Revenue, $3,450; inventory, $17,500; wages payable,
$5,350; taxes payable (federal), $2,570; money market fund, $12,300; and computer, $3,400.
a. List accounts classified as current assets and as current liabilities.
Current Assets
Cash $ 3,500
Accounts receivable 15,000
b. Determine the amount of gross working capital.
Cash 3,500, Accounts Receivable 15,000, Inventory 17,500, Money Market fund 12,300 =
$48,300.
c. Determine the amount of net working capital.
d. What is Joe’s current ratio?
2. If you have $50,000 in an interest-bearing savings account that pays 2 percent annual interest, how
much interest will you earn during a 30 day month?
3. Jane James owns an appliance store. She normally receives $50,000 worth of appliances per month.
She does not like to owe people money and always pays her bills on the day she receives the invoice.
Someone told her that if she delayed payment, she could actually increase her profit because the
money would be earning interest in her account. She went through her bills and found that she
actually had an additional ten days, on average to pay her invoices. She also found that she was
earning 2 percent interest on the money she had in her money market savings account.
a. If she delayed payment by the ten days, how much additional interest would she earn for the
year? She has an additional ten days to pay the invoices so if the $50,000 stayed in her account
4. Jane Marks has a restaurant in which she accepts credit cards and checks. Several of the places that
Jane shops now accept debit cards and do not accept checks. Jane’s banker explained that a debit
card would immediately transfer money into her account, but it would cost $50 per month for the
equipment and bank charges. Although she requires proper identification, Jane loses approximately
$590 a year as a result of bad checks. She also determined that on average she loses 115 days of
interest on all checks because the banks are closed on 11 holidays and weekends (52 weeks times 2
weekend days = 104 + 11 holidays). Jane currently earns 3 percent interest on her bank accounts
and accepts an average of $2,000 a day in checks.
c. Should Jane implement the system? With this problem, it is a toss-up. Would she lose some
5. Larry’s Lawn Equipment Company gives terms of 2/10, n/30. Larry has annual credit sales of
$500,000 and average accounts receivable of $60,000.
a. What is Larry’s accounts receivable turnover?
b. What is Larry’s average daily collection?
Average days collection = 365/8.33 = 43.82 days
c. What is the relationship between the terms that Larry is giving and his average daily
collection?
6. A firm has $400,000 in credit sales and $100,000 in accounts receivable. Compute accounts receivable
turnover and average number of collection days. How do these numbers relate to the terms of 2/10
net/30?
7. If Larry in exercise 5 has accounts receivable of $100,000 rather than $60,000:
a. What is Larry’s accounts receivable turnover?
b. What is Larry’s average collection period?
Average collection period = 365/5 = 73 days
c. What should Larry do, if anything?
Larry has to do a better credit evaluation. Right now he has to age his accounts receivable and
8. You are managing a company that stocks and distributes hardware. The company employs two
purchasing agents who receive combined salaries of $90,000. They process six thousand purchase
requests per year. Average inventory in storage is $600,000, and the total cost of running the
warehouse is $200,000. You are told that the company purchases five thousand hammers per year at
a cost of $5.34 per hammer.
a. Using the EOQ formula, how many hammers should be ordered at one time?
b. If the hammer vendor stated that it would charge $5.00 per hammer if you ordered two
hundred or more at a time, what would you do? Since the EOQ is greater than 200 hammers we
9. Calculate the Economic Order Quantity, or EOQ, for exercise 8 if annual demand is 10,000 thousand
units, inventory storage costs average 20 percent, unit price is $50, and ordering costs are $30.
10. Harriet has been told about an ABC inventory analysis. She has accumulated the following annual
figures for her flower shop: roses, $10,000; ribbon, $100; bud vases, $1,000; pins, $15; glass bowls,
$500; ceramic pots, $3,000; wrapping paper, $250; carnations, $5,500.
a. Using the percent of total inventory cost, if these were her total inventory costs, what items
should be classified as A items?
Since Roses and Carnations make up approximately 75 percent of our total cost of inventory, they are the A
items.
b. What items are C items? C items that make up approximately 10 percent of our total cost are bud
vases, glass bowls, wrapping paper, ribbons, and pins.
11. Your firm sells home appliances at retail. When ordering washing machines from the manufacturer,
you notice the following terms listed in the catalogue:
If you take advantage of all trade discounts, find the net price you will pay for the washing machine.
0.6056(.95)(.75)(.85)factor ratecost net
==
Harriet’s ABC Analysis
Item
Annual
Cost
Percentage
of Sales
Cumulative
Percentage
ABC
Classification
Roses 10,000$ 49.10% 49.10% A
Carnations 5,500 27.01% 76.11% A
Ceramic Pots 3,000 14.73% 90.84% B
12. Explain the following terms:
a. 2/10, n /30
If you pay within the first ten days, you get a two percent discount off of the invoice, otherwise the
entire net is due within 30 days.
c. n/40
The entire net is due within 40 days
d. What is the effective rate of interest you will pay if you do not take advantage of the cash
discounts described?
medicount tinet time
360
paidpercent
percentagediscount
Rate Effective /30n 2/10,for
−
=
13. Bernie’s Bike Shop receives the following trade discounts: 35/25/15. The vendor’s price list indicates
that 35 percent off list price is for purchasing bikes in quantities of 100 or more, 25 percent off list
price is for assembling the bikes for customers, and 15 percent is for sales promotion and local
advertising.
a. If the manufacturer’s list price is $470, what should Bernie pay for each bike if he orders 110
bikes at a time, assembles the bikes, and displays and advertises them? To obtain the net cost
rate factor or percent paid, take the complements of each discount in the series and obtain the
b. What is Bernie’s single equivalent discount rate?
c. How much will Bernie pay the manufacturer for each bike if he orders ten bikes at a time and
takes advantage of the other discounts?
14. In exercise 13, Bernie is given terms of 4/15 n/30, and he pays by day 15.
a. How much will he pay the manufacturer for the order of 110 bikes?
Price is $194.76 per bike times 110 bikes = $21,423.60.
b. For how much will the manufacturer credit Bernie’s account?
c. If Bernie has a cash flow problem and waits until day 30 to pay the manufacturer, what is his
effective rate of financing for the year?
It cost Bernie 4 percent interest for the use of 96 percent of the money for the next 15 days because
terms are 4/15 n30. The cost of 4 percent for the use of 96 percent equals 0.0417 for a fifteen day
RECOMMENDED TEAM ASSIGNMENT
1. Interview several business owners or managers in the community in different industries. How
important is proper inventory management to them with respect to its roll in the business enterprise?
2. Survey several businesses who receive large shipments from their vendors. Do they take advantage of
CASE STUDY PROBLEMS
1. How important was Ian’s knowledge of the billing procedures used within the steel industry in his
being able to establish his business? Given his cash position when he opened his business, do you
believe he would have been successful without this knowledge? How much risk did he take? Ian’s
knowledge of the billing procedures were extremely critical. It allowed him to establish a discount policy
2. When providing a product like steel to a customer, how important is experience and knowledge of
the industry to business success? Based on the case study, it appears that experience and knowledge of
the industry is extremely critical.