Solutions Manual

CHAPTER 17

ADDRESSING WORKING CAPITAL

POLICIES AND MANAGEMENT OF
SHORT-TERM ASSETS AND LIABILITIES

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS

I. Questions

1. These are firms with relatively long inventory periods and/or relatively
long receivables periods. Thus, such firms tend to keep inventory on
hand, and they allow customers to purchase on credit and take a
relatively long time to pay.

2. These are firms that have a relatively long time between the time
purchased inventory is paid for and the time that inventory is sold and
payment received. Thus, these are firms that have relatively short
payables periods and/or relatively long receivable cycles.

3. Carrying costs will decrease because they are not holding goods in
inventory. Shortage costs will probably increase depending on how close
the suppliers are and how well they can estimate need. The operating
cycle will decrease because the inventory period is decreased.

4. Since the cash cycle equals the operating cycle minus the accounts
payable period, it is not possible for the cash cycle to be longer than the
operating cycle if the accounts payable period is positive. Moreover, it is
unlikely that the accounts payable period would ever be negative since
that implies the firm pays its bills before they are incurred.

II. Multiple Choice Questions

1. C 6. A 11. C
2. C 7. B 12. B
3. B 8. D 13. D
4. C 9. C 14. B
5. D 10. B

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III. Problems

Problem 1 (Cash Equation)

The total liabilities and equity of the company are the net book worth, or
market value of equity, plus current liabilities and long-term debt, so:

Total liabilities and equity = ₱10,380 + 1,450 + 7,500 = ₱19,330

This is also equal to the total assets of the company. Since total assets are the
sum of all assets, and cash is an asset, the cash account must be equal to total
assets minus all other assets, so:

Cash = ₱19,330 – 15,190 – 2,105 = ₱2,035

We have NWC other than cash, so the total NWC is:

NWC = ₱2,105 + 2,035 = ₱4,140

We can find total current assets by using the NWC equation. NWC is equal
to:

NWC = CA – CL
₱4,140 = CA – ₱1,450
CA = ₱5,590

Problem 2 (Changes in the Operating Cycle)

a. Increase. If receivables go up, the time to collect the receivables would

increase, which increases the operating cycle.

b. Increase. If credit repayment times are increased, customers will take

longer to pay their bills, which will lead to an increase in the operating
cycle.

c. Decrease. If the inventory turnover increases, the inventory period

decreases.

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d. No change. The accounts payable period is part of the cash cycle, not
the operating cycle.

e. Decrease. If the receivables turnover increases, the receivables period

decreases.

f. No change. Payments to suppliers affects the accounts payable period,

which is part of the cash cycle, not the operating cycle.

Problem 3 (Changes in Cycles)

a. Increase; Increase. If the terms of the cash discount are made less
favorable to customers, the accounts receivable period will lengthen.
This will increase both the cash cycle and the operating cycle.

b. Increase; No change. This will shorten the accounts payable period,

which will increase the cash cycle. It will have no effect on the
operating cycle since the accounts payable period is not part of the
operating cycle.

c. Decrease; Decrease. If more customers pay in cash, the accounts

receivable period will decrease. This will decrease both the cash cycle
and the operating cycle.

d. Decrease; Decrease. Assume the accounts payable period does not

change. Fewer raw materials purchased will reduce the inventory
period, which will decrease both the cash cycle and the operating
cycle.

e. Decrease; No change. If more raw materials are purchased on credit,

the accounts payable period will tend to increase, which would
decrease the cash cycle. We should say that this may not be the case.
The accounts payable period is a decision made by the company’s
management. The company could increase the accounts payable
account and still make the payments in the same number of days. This
would leave the accounts payable period unchanged, which would
leave the cash cycle unchanged. The change in credit purchases made
on credit will not affect the inventory period or the accounts payable
period, so the operating cycle will not change.

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f. Increase; Increase. If more goods are produced for inventory, the

inventory period will increase. This will increase both the cash cycle
and operating cycle.

Problem 4 (The Operating and Cash Cycles)

We first need the turnover ratios. Note that we use the average values for all
balance sheet items and that we base the inventory and payables turnover
measures on cost of goods sold:

Inventory turnover = ₱11,375/ [(₱1,273 + ₱1,401)/2] = 8.51 times

Receivables turnover = ₱14,750/ [(₱3,782 + ₱3,368)/2] = 4.13 times
Payables turnover = ₱11,375/ [(₱1,795 + ₱2,025)/2] = 5.96 times

We can now calculate the various periods:

Inventory period = 365 days/8.51 times = 42.89 days

Receivables period = 365 days/4.13 times = 88.38 days
Payables period = 365 days/5.96 times = 61.24 days

So the time it takes to acquire inventory and sell it is about 43 days.

Collection takes another 88 days, and the operating cycle is thus 43 + 88 =
131 days. The cash cycle is thus 131 days less the payables period: 131 – 61
= 70 days.

Problem 5 (Working Capital)

a. Working Capital = ₱400,000

Net Working Capital = ₱400,000 − ₱200,000 = ₱200,000
Current Ratio = ₱400,000/₱200,000 = 2 times

b. Five Star’s return on equity is 12.5 percent (₱62,700/₱500,000).

Five Star Manufacturing Company

Income Statement
For the Year Ended December 31, 2011

Net sales ₱800,000

EBIT (20% of sales) 160,000
Less: Interest expense
Short-term debt (10%) 20,000

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Long-term debt (15%) 45,000

Earnings before taxes 95,000
Less: Income taxes (34%) 32,300
Net income ₱62,700
c. The net working capital and current ratios for each strategy are shown
below:

Strategies
Current Assets as a Percent of Sales
30% 50% 70%
Current assets (CA) ₱300,000 ₱ 500,000 ₱ 700,000
Fixed assets 600,000 600,000 600,000
Total assets ₱900,000 ₱1,100,000 ₱1,300,000

Current liabilities (CL)* ₱180,000 ₱ 200,000 ₱ 260,000

Long-term liabilities 270,000 330,000 390,000
Total liabilities ₱450,000 ₱ 550,000 ₱ 650,000
Stockholders’ equity (SE) 450,000 550,000 650,000
Total liabilities and equity ₱900,000 ₱1,100,000 ₱1,300,000

Net working capital (CA – CL) ₱120,000 ₱ 300,000 ₱ 440,000

Current ratio (CA/CL) 1.7 times 2.5 times 2.7 times

*Assume that all current liabilities are in the form of short-term debt.

d. The firm’s liquidity position, as measured by the amount of net working

capital and current ratio, improves when current assets are a higher
percentage of sales.

e. The rate of return on equity for each strategy is shown below:

Strategies
Current Assets as a Percent of Sales
30% 50% 70%
Net sales ₱1,000,000 ₱1,000,000 ₱1,000,000
EBIT (18% of sales) 180,000 180,000 180,000
Interest expense
Short-term debt (10%) 18,000 20,000 26,000
Long-term debt (15%) 40,500 49,500 58,500
Earnings before taxes (EBT) 121,500 110,500 95,500
Income taxes (34%) 41,310 37,570 32,470

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Net income ₱ 80,190 ₱ 72,930 ₱ 63,030

Return on equity (NI/SE) 17.8% 13.0% 9.7%

f. Five Star’s profitability decreases as liquidity increases. For example, the

firm’s liquidity (current ratio = 2.7 times) is the highest but profitability
(ROE = 9.7 percent) is the lowest when current assets are 70 percent of
sales.

g. The return on equity, net working capital and current ratio for each
strategy are shown below:

Financing- Mix Strategies

Restricted Compromise Flexible
EBIT ₱180,000 ₱180,000 ₱180,000
Interest expenses
Short-term (10%) 10,000 30,000 45,000
Long-term (15%) 52,500 22,500 0
Earnings before taxes (EBT) 117,500 127,500 135,000
Income taxes (34%) 39,950 43,350 45,900
Net income ₱77,550 ₱84,150 ₱89,100

Return on equity (NI/SE) 17.2% 18.7% 19.8%

Net working capital (CA – CL) ₱200,000 0 (₱150,000)
Current ratio (CA/CL) 3.0 times 1.0 times 0.7 times

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