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CHAPTER 14

THE MANAGEMENT OF WORKING CAPITAL

FOCUS Day to day business runs on working capital. We can't do without it, but we'd like to use as little aspossible. Our focus is on understanding what's involved in running the routine aspects of a businesseffectively without wasting resources. That means understanding the implications of decisions abouteach of the working capital accounts and about how working capital is financed.

PEDAGOGY Our approach is especially practical in this area. We stay away from obscure optimization modelsand concentrate on trade-offs that are generally analyzed with a little math and a lot of intuition. Weprovide a special insight into internal relations and company politics in the area of receivables.

TEACHING OBJECTIVES In this chapter students should gain an insight into the short term operating nature of workingcapital and its importance in running any company. In particular they should understand that workingcapital requires financing and appreciate the short term sources of funds available to support operatingneeds. Further they should have a detailed understanding of the issues and problems associated withmanaging each of the three major working capital assets: cash, receivables and inventories.

OUTLINE

I. WORKING CAPITAL BASICSThe short term nature of the assets and liabilities that arise from routine operations.

A. Working Capital, Funding Requirements, and the Current AccountsThe conceptual relationship between working capital and the current accounts. The need to fund net working capital. Spontaneous financing.

B. The Objective of Working Capital ManagementRunning the firm effectively with as little as possible tied up in W/C.

C. Operations - The Cash Conversion Cycle Two graphic portrayals of how cash flows in and out of a company and through the working

capital accounts. D. Permanent and Temporary Working Capital

The variation in W/C with business activity. E. Financing Net Working Capital W/C lends itself to short term financing.

Financing policies with respect to permanent and temporary W/C.F. Working Capital Policy

The elements of W/C policy defined.

II. SOURCES OF SHORT TERM FINANCINGA. Spontaneous Financing

The nature of accruals and payables. Credit terms, prompt payment discounts B. Bank Loans Notes, lines, revolvers, compensating balances. C. Commercial Paper The nature of commercial paper and its issuers.

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D. Short-Term Credit Secured by Current AssetsPledging and factoring receivables. Inventory financing, liens and warehousing.

III. CASH MANAGEMENT A. Definitions and Objectives

The motives for holding cash and the objective of achieving adequate liquidity while tying up minimum resources.

B. Marketable Securities Near cash liquidity with a modest return. C. Check Disbursement and Collection Procedures The check clearing system and how it works. D. Accelerating Cash Receipts Lock boxes, concentration banking, wire transfers. E. Managing Cash Outflow

Central vs. local cash management, remote disbursing. F. Evaluating the Cost of Cash Management Services

Cost benefit analyses to determine if cash management systems are worthwhile.

IV. MANAGING ACCOUNTS RECEIVABLE A. Objectives and Policy The balance between more revenue with easy customer relations and potential bad debt losses. A shared responsibility with sales. B. Determinants of the Receivables Balance Credit policy, terms of sale, collection policy, and the conflict with sales. C. Summary and Conclusion- A Practical Management Warning The politics of uncollected receivables can be a career pitfall for the CFO. V. INVENTORY MANAGEMENT Finance generally has an oversight responsibility for inventory management. A. Who Is Responsible for Inventory The primary responsibility is generally in manufacturing or operations. Finance has an

oversight function. B. The Benefits and Costs of Carrying Inventory Business runs smoother with more inventory but the costs include interest, storage, insurance,

and taxes along with exposure to shrinkage and obsolescence.C. Inventory Control and Management

Balancing the costs and benefits of inventory. D. The Economic Order Quantity (EOQ) Model The popular model to balance ordering and carrying costs. E. Safety Stocks, Reorder Points, and Lead Times The concepts incorporated with the EOQ model. F. Tracking Inventories - the ABC System The effort expended in control should be related to the cost and importance of the inventory. G. Just In Time (JIT) Inventory Systems The objective of JIT and the practical limitations on its use.

DISCUSSION QUESTIONS

1. Explain the differences between short-term and long-term money used by businesses withrespect to both the uses and sources of the funds.

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ANSWER: Whether money is long or short term depends on the longevity of the things it's used tosupport. Long-term money is used to acquire things that remain with the firm for substantial periodssuch as fixed assets or extended projects. These things are generally funded with money that doesn'thave to be paid back for similarly long periods like equity and long term loans. Short-term items likeinventory and receivables come and go quickly. They "turn over" constantly (there's always inventory,but the items within it change). These assets are generally funded by trade credit or by short termborrowing that has to be repaid in a relatively brief period. The idea of short or long term money idea is related to the maturity matching principle. Moneyshould be repayable when whatever it finances generates cash.

2. Because companies always have inventory and accounts receivable, most banks are happy tomake long term loans to support those assets. Either refute or support that statement.

ANSWER: The statement isn't true. Although firms always have inventory and receivables, theunderlying assets in which the value resides turn over constantly. Therefore banks are willing to makeonly short-term loans based on those items.

3. Describe the maturity matching principle. What are the risks of not matching maturities? Howwould you characterize a firm that ignores the principle? Can you think of situations in which it wouldbe advisable for an otherwise prudent firm to deviate from the principle?

ANSWER: The maturity matching principle says that financing to support assets (and projects) shouldbe repayable at the time those items generate enough cash to make the repayments. Financing long term items with short term money tends to reduce interest costs (short rates aregenerally lower), but exposes one to the risk that refinancing will be either expensive or unavailablesometime during the item's life. A firm which does that exposes itself to additional financial risk. Thiscan occur if management is imprudent or ignorant, or is forced into the situation because long termmoney isn't available. Financing short-term needs with long term money ignores the maturity matching principle, but isconservative rather than risky. Such a policy implies funds will always be available for short-termneeds, but they may be more expensive than if acquired short term. Some very risk averse managersfeel this is the right thing to do.

4. Working capital spontaneously finances itself because it's being turned over all the time. Is thisstatement true, false, or a little of both? Exactly what is meant by spontaneous financing? Doesworking capital require funding? Why?

ANSWER: The statement is partially true. Spontaneous financing refers to the fact that someresources, mainly inventory and labor, don't have to be paid for immediately. These unpaid liabilitiesare reflected in the payables and accruals accounts. They remain on the balance sheet because newinventory and labor are being acquired and used all the time. Typically, however, spontaneousfinancing supports only a fraction of working capital requirements. Hence net working capital, thedifference between gross working capital (current assets) and spontaneous financing (current liabilities),requires funding.

5. Working capital is generally defined as the difference between current assets and currentliabilities. Is this definition precisely correct? Why?

ANSWER: No. The working capital concept involves the assets and liabilities that arise from thenormal day to day activities of a business. These are only roughly equivalent to the current accounts inmost companies. Things like prepaid expenses and the current portion of long term debt are included inthe current accounts but conceptually aren't working capital items.


6. Support or challenge each of the following statements individually: a. Because accounts receivables aren't purchased like inventory or fixed assets, they don't requirefinancing. b. Cash represents a pool of available money, so it actually reduces financing needs. ANSWER: a. A receivable is generated when product is shipped reflecting the fact that a sale has beenmade. Building the product, however, requires cash that isn't recovered until the receivable is collected.Therefore, receivables require funding. b. Cash is money in the bank available to pay bills and transact business. That money has to bedeposited and therefore represents an asset just like a machine or an inventory item. In effect, the firm"buys" an account balance at the bank. Therefore cash requires financing. It certainly doesn't reducethe need for financing.

7. You're a supervisor in the treasury department of Big Corp. Recently there's been increasingconcern about the firm's rising interest costs. Fred Eyeshade is an analyst in your group who transferredfrom the accounting department a short time ago. He has suggested that senior management mandate a50% across the board cut in cash, inventory, and receivables along with a doubling of payables toreduce the firm's financing needs for net working capital. Explain why this might not be a good ideawith respect to each of the elements of net working capital (four accounts).

ANSWER: Reducing current assets and increasing current liabilities reduces the money tied up inworking capital. That reduces related borrowing and saves interest expense. However these actions canbe overdone. Collecting receivables too aggressively offends customers and can reduce sales. Too littleinventory in production can cause expensive idle time and missed schedules. A lack of inventory canalso cause stockouts at the point of sale which delay customer orders and can result in lost business.Similarly, too little cash can make it impossible to pay bills on time and conduct business efficiently.Stretching payables offends vendors and can lead to higher prices for input and delays in resupply. Unless working capital is being managed very poorly, Fred's suggestion is probably too drastic andmight hurt more than it helps.

8. Things tend to run more smoothly and efficiently with more working capital. With respect toreceivables and inventory, explain why this statement isn't absolutely true. In other words, why might avery large inventory or receivables balance not do much good at all?

ANSWER: Large balances in receivables may indicate the presence of uncollectible items whichshould be written off. A big inventory account can imply material that's useless because it's damaged orobsolete. In both cases the items are "inactive," and lie under the things that are turning over. Theydon't help in running the company because they aren't used for anything.

9. How does a firm's operating cycle differ from its cash conversion cycle? Explain fully.

ANSWER: A business's operating cycle begins with the purchase of inventory which in time is turnedinto product and sold. The sale results in a receivable that becomes cash when collected. The cash isused to purchase more inventory starting the cycle again. The term operating cycle refers to both thesequence of events and the time required to go through it once. The cash conversion cycle is theoperating cycle in days less the payables deferral period, which is the time between receiving andpaying for inventory.

10. You work in the finance department of a manufacturing company. Over lunch, a friend in theengineering department said she'd heard that the firm used a lot of temporary working capital. Becausetemporary equipment is usually of lower quality than permanent material, she wonders why thecompany, which is quite prosperous, doesn't buy the best and store it when it isn't needed.

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What misconceptions does your friend have? Write a brief explanation for someone who knowsnothing about finance to straighten out her understanding.

ANSWER: Your friend probably thinks working capital is an asset that's purchased like a machine orbuilding. In this misconception she's confusing working capital with capital equipment. Working capital refers to the assets and liabilities that arise from the everyday running of thebusiness including cash, receivables, and inventory, less payables and accruals. These things depend onthe level of business being done at a point in time, and can vary over the year if volume is seasonal.Permanent working capital refers to the minimum level required during an annual cycle. Temporaryworking capital is the increase over the minimum level required when seasonal increases occur. Thereisn't a quality issue in the distinction.

11. Why does it make sense to finance net working capital separately from fixed assets?

ANSWER: The assets making up working capital turn over regularly in short periods. They also tendto generate cash shortly after they're held. This situation lends itself to short term financing. Fixedassets, on the other hand, require commitments of funds for long periods. It makes sense to financethese items separately, because of their different terms.

12. You work in the finance department of HiTech Inc. The firm's owner and CEO, CharlieDollars, is very profit oriented. He understands that short-term interest rates are quite low at themoment, and has suggested that the firm finance all of its working capital needs with short term loans.The CFO has asked you to prepare a memo for his signature outlining why this may not be the beststrategy. In your memo, outline the working capital financing options available to most firms anddiscuss the trade-offs involved in using long term versus short term financing

ANSWER: Working capital can be financed by either short- or long-term funds. Short-term money isalways borrowed while long-term funds can be either debt or equity. Short-term financing is usuallycheaper (lower interest) but has to be renewed periodically as loans become due for repayment. Thismeans a strategy of supporting working capital with short-term borrowing requires a continuous seriesof new loans. This creates a risk, because short rates do sometimes exceed long rates. Worse, situationsoccasionally occur in which refinancing isn't available at any rate. That can put a company out ofbusiness, because it suddenly has no way to sustain its working capital requirements. Therefore, in order not to risk ruin, most companies limit their short term financing, and use somelong-term debt and/or equity to support working capital.

13. What are the advantages and disadvantages of stretching payables? If you owned your ownbusiness, would you do it? Why or why not?

ANSWER: Slowing cash payments to vendors is known as stretching payables or leaning on the trade.It generally means paying in a longer period than specified by the terms of sale. The practice conservesthe payer's cash reducing the need for working capital financing which saves interest expense. Thedisadvantage is that it offends suppliers who want to be paid on time making them reluctant to dobusiness with the slow payer. In extreme cases suppliers refuse to make further credit sales to slowpaying customers demanding cash in advance. This can cause disruptions in the slow payers productionand administrative processes. Stretching payables also affects a firm's credit rating. Vendors report slow payers to credit bureauswhich include the information in their reports. Being labeled a slow payer makes it more difficult to getcredit of any kind. In other words, paying vendors slowly today can keep you from getting a bank loanor credit from a new vendor tomorrow.


The firm that stretches payables walks a fine line. Most vendors will tolerate a little tardiness, thetrick is not to overdo it. Whether you would do it or not is a matter of personal preference.

14. What's the difference between a promissory note, a line of credit, and a revolving creditagreement? Are they mutually exclusive? That is, might one be part of the other?

ANSWER: A promissory note is a contractual document associated with a specific loan. A line ofcredit and a revolving credit agreement are agreements between a company and a bank as to themaximum amount the firm can borrow during a specified period. The line is informal meaning theunused portion can be revoked by the bank at any time. The revolver is a commitment to have fundsavailable and requires a commitment fee on unused balances. Individual loans made under either a lineor a revolver may have separate promissory notes.

15. You and your friend Harry have started a business. Harry is a technical whiz, but doesn't knowmuch about business or finance. After several months you've been approved for a $100,000 bank loanat what seems to be a rather high interest rate, 16%. Harry is especially bothered by the rate. He thinksbanks shouldn't get any more than 4% or 5%, but doesn't really know why he feels that way. When youboth were about to sign the loan papers the banker mentioned that a minimum balance of $20,000 wouldhave to remain in the bank. Hearing this, Harry pulled out his calculator and made a calculation atwhich he became outraged. He then stormed out of the meeting. Why is Harry so upset? What calculation did he make? Write a short memo explaining bankingpractices to calm Harry down. Is there a kind of minimum balance requirement that might make Harry'scalculation invalid?

ANSWER: Harry's calculation probably figured the effective interest rate on the loan with a 20%minimum compensating balance. This would have been 16% / .8 = 20%, a rate that does seemexcessively high. It seems that the bank is being devious by quoting 16% when it's actually charging20%. However, minimum balances are a standard practice designed to "compensate" banks for theirservices. Further, Harry probably doesn't understand two things about the loan business, the bank's cost andits risk. The bank lends businesses money it "borrows" from depositors, and operates on the "spread"between the interest it pays out and the rate it charges on loans. When interest rates are up, both ofthese rates are high, but the bank doesn't get to keep any more money that it does when rates are lower.Spreads are generally between five and ten percent. Out of that the bank has to pay all of its operatingcosts, cover loans that default, and make a profit. Harry's anger should be directed at generally highrates, which usually reflect inflation, rather than at the bank. The other thing Harry should keep in mind is risk from the bank's viewpoint. To the loan committeeyour business is a high-risk venture with a good chance of failure which implies a default on their loan.The bank has to be compensated with interest for bearing that risk. Admittedly, it's hard forentrepreneurs to identify with that view of themselves. Things may not be as bad as they seem if the requirement is for an average minimum balance. Inthat case all of the loaned money can be used at times as long as an average balance of at least 20% ismaintained. You might have done that anyway.

16. Explain the difference between pledging and factoring receivables. Which is likely to be more amore expensive source of financing? Is factoring the same kind of financing as pledging?

ANSWER: Pledging involves borrowing money based on the collateral value of receivables. Theaccounts continue to belong to the borrowing company, which is responsible for their administrationand collection. Factoring means actually selling the receivable to the factor, who then takes care ofcollection. Factoring is more expensive because the financial institution does more work.

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17. Factoring may involve interest even though it isn't a loan. How can this come about?

ANSWER: If the factor pays its customer (the firm selling the receivable) before money is collectedfrom the customer, it is out funds until collection is actually made. In such cases the factor's chargeshave to include interest for that interim period.

18. What is the biggest problem associated with financing secured by inventory? How is itaddressed in practice?

ANSWER: The biggest administrative difficulty associated with inventory financing is keeping trackof the secured material and making sure it's available to the lender in the event of default. The difficultyarises because the borrower needs to continue to use the inventory during the financing period. Thismakes continuous monitoring necessary for complete security. Third party warehousing companies areable to do that, but their services are expensive.

19. Outline the reasons for holding cash and the big cost associated with it. How do these lead tothe objective of cash management? How do marketable securities help or hinder achievement of theobjective?

ANSWER: Cash is held to conduct normal business activities (transactions demand), to provide thecapability of handling emergencies (precautionary demand), and to take advantage of unexpectedopportunities (speculative demand). It may also be necessary to hold cash to satisfy compensatingbalance requirements. Having enough cash is known as having adequate liquidity The problem associated with holding cash is that it doesn't earn a return. Therefore it isn't wise totie up any more money than necessary in cash balances. The objective of cash management is to balancethe need for liquidity with cost of holding extra cash. Marketable securities help in achieving theobjective because they provide nearly the liquidity of cash, but also offer a modest return.

20. The Medco Supply Co. operates out of Waco, Texas, and has a number of customers aroundPortland, Maine. It seems to take a particularly long time for the Portland customers' payment checks toreach Medco. What can the company do to speed things up? Explain how your solution would work.

ANSWER: Medco's mail float from Maine can be reduced by installing a lockbox in Portland that isoperated by a local bank. Customers in that area would mail payment checks to the Portland lockboxwhich would be deposited in the check clearing system by the bank immediately. This avoids the delayof mailing all the way to Texas.

21. Sally Johnson lives in Baltimore, and does business with a large, national brokerage firm.When she sends the broker a check, she mails it to a local address in Baltimore. However, when shereceives a check, from the broker, it comes from San Francisco. Her sister Joan lives in Los Angelesand uses the same firm. She mails payments to an office a few blocks from her home, but receiveschecks from an office in Miami. What's going on? Should the Johnson sisters be upset?

ANSWER: The brokerage firm is playing the mail float to its advantage at the expense of clients.Receipts travel a short distance so the firm gets its money quickly. Disbursements, on the other hand,travel cross-country keeping customers' funds in the firm's account a few days longer where it earnsinterest. The Johnson sisters have a right to be upset. This kind of dealing is a violation of the trust inherentin the broker-client relationship (called a fiduciary relationship).

22. You're the cash manager for Huge Inc., which has factories and stores all over the country.Each operation has several bank accounts to receive deposits and pay vendors, so the company's cash is


spread all over the country under the control of divisional CFO's. It's essential that those divisionalexecutives have control of their cash to run their operations effectively. However, the rather substantialcash total isn't earning anything because it's too dispersed to be invested in marketable securities.Suggest a way to fix this problem and explain how it will work.

ANSWER: Huge should consider concentration banking in which a single bank monitors the amountsin remote locations daily, and sweeps excess amounts into a central account. The central balance islikely to be large enough to be invested effectively.

23. Every company should take full advantage of the sophisticated cash management servicesoffered by today's banking industry. Right or wrong? Explain.

ANSWER: Wrong. Cash management systems should only be used if they save money. The benefit ofsophisticated systems is that they reduce cash balances, which reduces the amount of working capitalfinancing needed, which in turn saves on interest expense. The cost generally involves a fixed annualfee for setup and maintenance and a variable charge related to volume. For the system to be costeffective, the interest savings it generates have to exceed its total cost. In small firms the cash volume affected by a system may not be large enough to generate interestsavings sufficient to cover its cost. In such cases sophisticated techniques shouldn't be used.

24. Outline the costs and benefits involved in the trade-off between a tighter versus a looserreceivables policy.

ANSWER: A tighter receivables policy means credit is granted only to higher quality customers andoverdue receivables are pursued more aggressively. This reduces bad debt losses but also tends tooffend customers and lower sales.

25. You're the CFO of the Wachusett Window Company, which sells windows to residentialbuilders. The firm's customers tend to be small, thinly capitalized construction companies that arefrequently short of cash. Over the past year, there's been a slump in the housing industry andWachusett's sales have slowed. Several months ago the marketing department initiated a program toattract new customers to counteract the downward sales trend. The VP of Marketing and the presidentagreed that the firm would have to deal with even smaller, newer builders if it was going to keep salesup. At the time the president overruled your concerns about the credit quality of such customers. Hepersonally approved a number of accounts brought in by the sales department that ordinarily wouldn'thave qualified for credit. More recently receivables have gone up substantially, and collection efforts have been lesssuccessful than usual. Collectors have asked for help from sales representatives in chasing downdelinquent customers, but the VP of marketing says they don't have time because "reps have to be out onthe street selling." The president has suddenly become concerned about the receivables increase, and has demanded toknow why Finance has let it happen. Prepare a memo explaining the processes behind the creation andmanagement of receivables and explain what's behind the increase. Tactfully explain why the blameshould not be placed solely on the finance department. Can you argue that finance is completelywithout fault in this matter?

ANSWER: Receivables are ordinarily considered the responsibility of the finance department.However, the appropriate management of problem accounts calls for consideration of how they arise inthe first place. In the normal course of events receivables come from credit sales proposed by the sales/marketingdepartment and approved by the credit and collections department. The approval by the credit

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department is key to the idea that finance is responsible for collection. It signifies a judgement byspecialists that the debt is likely to be collectible. Rejection signifies a high probability that the account will not be collected and will result in a loss.

The sales department, on the other hand, is responsible for delivering customers. Salespeopledon't generally worry too much about credit worthiness, because under normal conditions the creditdepartment takes care of that. In our current situation, we made the decision to extend credit despite concern about severalcustomers' ability to pay. This has created a delinquency situation which we have to work together toresolve. When a receivable isn't paid, the credit department starts calling and writing the customer. Thosecontacts, however, tend to be with lower level administrative personnel. In collecting from cash poorcompanies, the trick is to get the debtor to prioritize our bill over those of other vendors. People in thecustomer's payables department don't have the authority or motivation to do that. Getting paid bytroubled companies generally takes an executive decision, and it's relatively hard for collectors to get tothe customer's executives. The sales force, on the other hand, tends to have an ongoing relationship with people higher up inthe customer organization who can prioritize bill payments. In problem situations, that relationship canbe crucial to successful collection of the account. The sales rep is in the best position to present thecustomer with the reality that unless the old bill is paid, we can't supply any more product. In smallcash poor companies, that pitch generally has to be made to the president, and the salesperson has muchbetter access to that office than the bill collector. It's therefore imperative that the collections department get some help from sales to work theoverdue receivables. Without that we're unlikely to collect much. This needs to happen quickly,because the older receivables get, the less likely they are to be collected. In this case, because of the nature of the customers involved, we should probably get ready for someloss whatever we do. (Notice the wording of the first four paragraphs. The problem is the fault of the president and theVP of marketing, because they made the decision to lower credit standards over the CFO's objection.However, it would rarely be wise to come right out and say that. Saying, "I told you so," to your bossisn't likely to get you anything but grief. The idea is to gently remind the president of how the situationcame about without accusing anyone of fault, and then to quickly focus on the team effort required tofix the problem. Particularly notice the wording in the fourth paragraph "we" made the decision..., not"you" made the decision... Also notice the last paragraph. It would be unwise to give the impression that everything will be okif you get some help from sales. There's very likely to be a write-off required, and its better not tosurprise the president with that later. Unfortunately, it's possible that the CFO is going to be the scapegoat in this situation regardless ofwhat he or she does. Many top executives don't like to admit that they were wrong, and routinely laythe blame for mistakes elsewhere.)

26. In the situation at Wachusett Window outlined in the last question, do you think a higherprompt payment discount alongside the new sales program would have kept receivables down? Why?

ANSWER: No. The problem customers aren't likely to have the cash to pay their bills promptlyregardless of the incentive offered. An additional discount would probably hurt because it would betaken by customers who are already paying on time.

27. Speculate on the nature of the relationship between the credit and collections department andthe sales department at Wachusett Window in questions 25 and 26.


ANSWER: It probably isn't too good. Credit and collections is likely to be resentful of the override oftheir rejections and to be really upset that the accounts are now proving to be problems. The fact thatsales is unwilling to help in the collection effort is probably rubbing salt in the wound.

28. Inventory management is a shared responsibility between finance and manufacturing just asreceivables management involves both sales and finance. Right or wrong? Explain.

ANSWER: Wrong. Finance rarely has a direct responsibility for inventory. Manufacturing oroperations executives usually determine what and how much to carry. Finance has an overviewresponsibility to ensure inventory is usable and current and that the firm isn't carrying more than itneeds.

29. Because of the advances in computer technology, inventory management is a precise science,and there's no excuse for not having the optimal quantity on hand at all times. Is that statement true orfalse? Explain.

ANSWER: Wrong. Inventory management is far from an exact science. Cost effective inventories areachieved through frequent reviews of what is needed and what is on hand, attention to detail, and acombination of manual and automated tracking systems.

30. Does the EOQ model properly applied prevent stockouts? Does it address stockouts at all? Doyou think the EOQ model solves very many of management's inventory problems?

ANSWER: The EOQ model itself doesn't address stockouts. The safety stock concept does. Hencewhen EOQ is combined with a safety stock the overall model does help to manage stockouts. EOQitself just balances the cost of ordering against the cost of holding inventory. These issues are a smallpart of overall inventory management. EOQ is presented in most text because it is concise and easy tounderstand. However, it may give the impression that there's less to inventory management than therereally is, and that the subject is more precise than it actually is.

31. Wildebrant Inc runs out of inventory all the time both in the factory and at the point of sale.However, the company is profitable, and no one worries about it much. Is this ok? What's probablygoing on that management doesn't see? Why don't they see it? What would you suggest to fix theproblem? How would it work?

ANSWER: The problem is that the cost of running out of inventory isn't identified on financialstatements. Shortages result in lower sales when they prevent filling orders and higher costs when theydisrupt production, but those effects are buried in the financial results and aren't explicitly identified asbeing the result of inventory problems. When a company is profitable, such inefficiencies tend to beoverlooked. They frequently aren't identified until times get tough and people start to look for ways toincrease sales and lower cost. This, of course, is a mistake, because the firm could be doing even betterin good times if it controlled inventory more effectively. The problem can be addressed by a tracking system that creates a report whenever a stockout occurs.An estimate can then be made of the financial consequences of each stockout. Compiling a list of allstockouts every month for management review will go a long way to motivate some attention towatching inventory levels more closely.

32. The Philipps Lighting Company manufactures decorative light fixtures. Its revenues are about$100 million a year. It purchases inputs from approximately 20 suppliers most of which are much largercompanies located in various parts of the country. Sam Spade, the vice president of manufacturing is asophisticated executive who has always been very impressed by the latest innovative techniques inmanagement.

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Last week Sam came into a meeting of the executive team with a proposal to cut inventory costs toalmost nothing. Just in time (JIT) is the wave of the future, he said, and proposed that Philipps enterinto negotiations with of all its suppliers to implement the concept immediately. You're the CFO and tend to be more skeptical about new methods. Prepare a memo to the team,tactfully outlining the problems and risks involved in Sam's proposal.

ANSWER: Staff: JIT is a great idea in theory, but it has two important practical problems. The firmusing JIT is essentially pushing the task of carrying its inventory back onto its suppliers. That meansthe suppliers have to be willing to work very hard to maintain the inventory and to ensure preciselytimed shipments arrive "just in time" for production. Suppliers are generally willing to do that only ifthe customer using JIT is very important to them. For example, suppose a company makes piston rings,and sells 90% of its output to General Motors. That firm will go to any lengths to keep GM's business,including orchestrating timely JIT deliveries. If the piston ring manufacturer sold its output to 20 or 30different customers, it wouldn't be particularly motivated to do JIT for any of them. Since Philipps doesn't buy a large portion of the output of any of our suppliers, it's hard to imaginethat they would be willing to go to the trouble of managing JIT shipments for us. Distance is another complicating factor. If suppliers are located far away, a trucking company isbetween them and the JIT company. That means the trucker also has to commit to precisely timeddeliveries to make the JIT idea work. That can be almost impossible if large distances are involved.This would be a big problem in our case, since our suppliers are from several hundred to thousands ofmiles away. Further, the risks of JIT are substantial. If we're not carrying inventory and a promised shipmentfails to arrive, everything stops. That can obviously be very costly.

In summary, although JIT has some benefits for very large and powerful companies, I doubtthat it will be feasible for us.

PROBLEMS

1. The Grass Ridge Company has the following current asset accounts

Cash $1,900,000 Accounts Receivable $4,600,000 Inventory $5,500,000

its current ratio is 2.5:1. The bank is willing to lend the company enough to finance its working capitalneeds under a $10 million revolving credit arrangement at a base rate of 12% with a 3/8% commitmentfee on the unused balance. If the current accounts stay relatively constant throughout the year, what willGrass Ridge pay the bank for working capital financing?

SOLUTION: C/L = $12M/$2.5M = $4.8M Net W/C = $12M − $4.8M = $7.2M = Average amount borrowed Unused commitment = $10M − $7.2M = $2.8M

Interest = $7.2M × .12 = $864,000 Commitment fee = $2.8M × .00375 = 10,500 Total W/C financing charges $874,500


2. Bridgeport Inc has a $30 million revolving credit agreement with its bank at prime plus 3.2%based on a calendar year. Prior to the month of April, it had taken down $15 million that wasoutstanding for the entire month. On April 10, it took down another $5M. Prime is 8.2%, and thebank's commitment fee is .25% annually. Calculate the charges associated with Bridgeport's revolvingcredit agreement for the month of April.

SOLUTION: k = 8.2% + 3.2% = 11.4% => .95% monthly commitment fee = .25% => .0208% monthly

Outstanding in April: $15M for the whole month $ 5M for 2/3 month

Unused balance: $30M − $15M = $15M for 1/3 month $30M − $15M − $5M = $10M for 2/3 month

Interest: [$15M + (2/3)$5M](.0095) = $174,167

Commitment fee: [(1/3)$15M + (2/3)$10M](.000208) = 2,427

$176,594

3. Southport Inc. has an inventory turnover of 10X, an ACP of 45 days, and turns over its payablesonce a month. How long are Southport's operating and cash conversion cycles? (Use a 360-day year.)

SOLUTION:Inventory Conversion Period = 360/10 = 36 days

Operating Cycle = Inventory Conversion Period + ACP = 36 + 45 = 81 days

Cash conversion Cycle = Operating Cycle − Payables Deferral Period = 81 − 30 = 51 days

4. The Langley Corporation is in a seasonal business. It requires a permanent base of net workingcapital of $10 million all year long, but that requirement temporarily increases to $20 million during afour-month period each year. Langley has three financing options for net working capital. 1. Finance the peak level year-round with equity which costs 20%, and invest temporarily unused

funds in marketable securities which earn 6%. 2. Finance permanent net working capital with equity and temporary net working capital with a

short-term loan at 12%. 3. Finance all net working capital needs with short-term debt at 12.5%.Calculate the cost of each option. Which would you choose? Why?

SOLUTION: Net W/C levels: $10M for 8 months $20M for 4 months

1. $20M × .20 = $4,000,000 −$10M × .06 (8/12) = −400,000 $3,600,000

Chapter 14204

2. $20M × .20 = $2,000,000 +$10M × .12 (4/12) = 400,000

$2,400,000

3. $10M × .125 = $1,250,000 +$10M × .125(4/12) = 416,667 $1,666,667

The decision is subjective depending on the firm's profitability and the likely prospects for futureincreases in short term rates.

5. Calculate the effective interest rate implied by the following terms of sale, using a 365-day year. 2/10, net 30 1/5, net 15 .5/10, net 30 2.5/10, net 25 1/5, net 20

SOLUTION: (365/20) × 2 = 36.5% (365/10) × 1 = 36.5% (365/20) × 1/2 = 9.125% (365/15) × 2.5 = 60.833% (365 /15) × 1 = 24.333%

6. What is the effective interest rate on a $750,000 loan at 8% for 120 days if a 20% minimumcompensating balance is required?

SOLUTION: 8%/(1−.20) = 10%

7. The York Company has an average receivables balance of $55,000, which turns over once every30 days. It offers all of its receivables to its bank as collateral for short-term borrowing (pledging). Thebank generally accepts 60% of the accounts offered and advances cash equal to 85% of those. Interestis 3% over prime and the bank charges a 1% administrative fee on the gross value of all accountsoffered. The prime rate is currently 9.5%. What effective rate is York paying for its receivablesfinancing?

SOLUTION: Gross amount offered = $55,000 × 12 = $660,000 Administrative charge rate: × .01 Administrative fee $ 6,600

Average loan balance = $55,000 × .60 × .85 = $28,050 Interest rate = 9.5% + 3% = 12.5%: × .125

$ 3,506

Total financing charges $10,106


Effective interest:

%0.36050,28$

106,10$

BalanceLoan Average

Charges Financing Total==

8. Southern Fabrics Inc factors all of its receivables. The firm does $150 million in business eachyear, and would have an ACP of 36.5 days if it collected its own receivables. The firm's gross margin is35%. The factor operates without recourse and pays immediately upon taking over the accounts. Itdiscounts by 10% the gross amount factored and pays Southern immediately. Because the factor doesn'tcollect from customers until they pay, it charges interest at 10% in the interim. a. Calculate the gross cost of factoring to Southern Fabrics if all receivables are collectible. b. What interest rate is implied by the arrangement? c. Suppose Southern is considering giving up the factoring arrangement and handling its owncollections. Should the firm do it if bad debt losses are expected to average 3% of gross sales andrunning a collections department will cost about $1.5 million per year? d. What is the implied interest rate in the factoring arrangement if the costs in part c are taken intoaccount?

SOLUTION:a. Factor's Discount = $150M × .10 = $15M Interest = (36.5 / 365) × .10 × $150M = 1% × $150M = $1.5M Total charges = $16.5Mb. Ordinary A/R balance = $150M × (36.5/365) = $15M Implied interest = Total financial charges/loan balance = $16.5M/$15M = 110%

c. The cost of doing the collections job includes the cost of product lost on the bad debts (not theentire amount of the lost revenue since the gross margin on those sales isn't an actual loss) and the costof running a collections department.

Bad debt losses = $150M × 3% × .65 = $2.9M Collection department expense = $1.5M Interest on A/R balance @ 10% = $1.5M $5.9MSouthern is better off to do the job itself, since the cost is considerably less than the $16.5M the firm ispaying to the factor.d. ($16.5M − $5.9M)/$15M = 70.67%

9. The Shamrock Company has a raw materials inventory of $20M, which is completely replacedapproximately 10 times a year. The Bridgewater Bank is willing to advance financing of 75% of thevalue of Shamrock's inventory at an interest rate of 12%. However, it requires a warehousing system tosecure its interests. A warehousing company will install and operate the system for $800,000 a yearplus .5% of the value of materials entering the system. What is the effective cost of this financing toShamrock?

SOLUTION:Entering inventory charge:

$20M × 10 × .005 = $200M × .005 = $1.0M Base charge: .8M

Total warehousing charges $1.8MAverage loan amount advanced: $20M × .75 = $15M

Chapter 14206

Warehousing as a percent of loan = $1.8M/$15M = 12% Plus traditional interest = 12% Total effective financing charges = 24%

10. The Hadley Motor Company is located in Florida but has a number of customers in the PacificNorthwest. Sales to those customers are $30 million a year paid in checks that average about $1,500.The checks take an average of nine days to clear into Hadley's Florida bank. A bank in Oregon willoperate a lock box system for Hadley for $8,000 a year plus $.50 per check. The system can beexpected to reduce the clearing time to six days. a. Is the lock box system worthwhile if Hadley borrows at 13.5%? b. What is the minimum number of days of float time the system has to save (to the nearest tenth of aday) to make it worthwhile?

SOLUTION:a. (9 - 6) days

Float reduction: 575,246$days 365

days 69M3$ =

−×

Interest savings = $246,575 × .135 = $33,288

Costs: # of checks = $30M/$1,500 = 20,000

Variable cost = 20,000 × $.50 = $10,000 Fixed cost = 8,000

$18,000

The lock box is a good idea since the interest savings exceeds the cost.

b. Interest saving per day of float saved: ($30M/365) × .135 = $11,096Minimum # of days to make system pay: $18,000/$11,096 = 1.62 days

11. The Kranberry Kids Klothing Kompany is in the volatile garment business. The firm hasannual revenues of $250 million and operates with a 30% gross margin on sales. Bad debt lossesaverage 3% of revenues. Kranberry is contemplating an easing of its credit policy in an attempt toincrease sales. The loosening would involve accepting a lower quality customer for credit sales. It isestimated that sales could be increased by $20 million a year in this manner. However, the collectionsdepartment estimates that bad debt losses on the new business would run four times the normal level,and that internal collection efforts would cost an additional $1 million a year. a. Is the policy change a good idea? b. Is it likely that coupling an increased prompt payment discount with the looser guidelines wouldreduce the bad debt losses? c. Is it possible that the idea in part b could have a net negative impact? How?


SOLUTION:a. Bad debt loss rate = 3% × 4 = 12% Margin on added revenue actually collected = $20M × .88 × .30 = $5.3M

Bad debt losses on new business = $20M × .12 = $2.4M Cost of bad debt losses = $2.4M × .7 = $1.7M Collection effort = $1.0M Total loss/cost = $2.7M

The policy change looks like a good idea, since the added margin on new sales exceeds the expectedlosses and costs.

b. No, because the new customers are likely to be so cash poor that they won't take the discount.

c. An increased discount might hurt because it would be taken by customers who are alreadypaying on time, but not by those who create collection problems.

12. Smithson Hydraulics Inc. carries an inventory of valves that cost $25 each. The firm'sinventory carrying cost is approximately 18% of the value of the inventory. It costs $38 to place,process, and receive an order. The firm uses 20,000 valves a year. a. What ordering quantity minimizes the inventory costs associated with the valves? (Round to thenearest unit.) b. How many orders will be placed each year if the EOQ is used? c. What are the valves' carrying and ordering costs if the EOQ is used?

SOLUTION:a. EOQ = [2FD/C]1/2

where: C = .18 × $25 = $4.50, F = $38, and D = 20,000

EOQ = [2($38)(20,000)/$4.50]1/2

= 581

b. 20,000/581 = 34.4

c. Ordering cost = 34.4 × $38 = $1,307 Carrying cost = (581/2) × $25 × .18 = $1,307

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