ASSIGNMENT

FINANCIAL STATEMENT ANALYSIS

1. INFO-IND Company Balance Sheet, December 21,20X3

Assets Liabilities & Equities
Cash 1,000,000 Notes payable, bank 4,000,000
Accounts Receivable 5,000,000 Accounts payable 2,000,000
Inventory 7,000,000 Accrued wages and taxes 2,000,000
Fixed Assets, net 17,000,000 Long-term debt 12,000,000
Preferred stock 4,000,000
Common stock 2,000,000
Retained Earnings 4,000,000

Total Assets Rs Total liabilities and Rs

30,000,000 Shareholders equity 30,000,000

INFO-IND Company Statement of Income and Retained Earnings,

Year ended December 31, 20X3

Net Sales
Credit Rs
Cash 16,000,000
Total 4,000,0
Cost and Expenses 00
Cost of Goods Sold Rs 12,000,000 Rs
Selling, general, and administrative 2,200,000 20,000,000
expenses 1,400,000
Depreciation 1,200,000
Interest
Net income before taxes
Taxes on income Rs
Net income after tax 16,800,000
Less: Dividends on preferred stock Rs
Net income available to common share 3,200,000
holders 1,200,
Add: Retained earnings at 1/1/X3 000
Sub total Rs
Less: Dividends paid on common stock 2,000,000
Retained earnings 12/31/X3 240,
000

Page 1 of 56
 Rs
1,760,000
2,600,0
00
Rs
4,360,000
360,00
00
Rs
4,000,000

a. Fill in the 20X3 column in the table that follows.

INFO-IND Company
Ratio 20X1 20X2 20X3 Industry
Norms
1. Current Ratio 250% 200% 225%
2. Acid-test Ratio 100% 90% 110%
3. Receivable turnover 5.0x 4.5x 6.0x
4. Inventory turnover 4.0x 3.0x 4.0x
5. Long-term debt/total 35% 40% 33%
capitalization 39% 41% 40%
6. Gross profit margin 17% 15% 15%
7. Net profit margin 15% 20% 20%
8. Return on equity 15% 12% 12%
9. Return on investment 0.9x 0.8x 1.0x
10.Total Asset turnover 5.5x 4.5x 5.0x
11.Interest coverage ratio

9. a)
(1) Current ratio = Current assets/Current liabilities
= $13M/$8M = 162.5%
(2) Acid-test ratio =
(Current assets - Inventories)/Current liabilities
= $6M/$8M = 75%
(3) Receivable turnover = Annual credit sales/Receivables
= $16M/$5M = 3.2x
(4) Inventory turnover = Cost of goods sold/Inventory
= $12M/$7M = 1.7x
(5) Long-term debt/Total capitalization
= $12M/($12M + $4M + $6M)
= $12M/$22M = 54.5%
(6) Gross profit margin = (Sales - Cost of goods sold)/Sales
= ($20M - $12M)/$20M = 40%
(7) Net profit margin = Net income after taxes/Sales
= $2M/$20M = 10%

Page 2 of 56
(8) Net income
Return after taxes - Dividends on preferred stock on equity =
────────────────────────────────────────────
Net worth - Par value of preferred stock
= $1,760,000/($10,000,000 - $4,000,000) = 29.3%
(9) Return on assets = Net income after taxes/Total assets
= $2M/$30M = 6.7%
(10) Total asset turnover = Sales/Total assets
= $20M/$30M = 0.67x
(11) Interest coverage = EBIT/Interest charges

= $4.4M/$1.2M=3.67x

Page 3 of 56
b. Evaluate the position of the company using information from the table. Cite
specific ratio levels and trends as evidence.
b)

(1) Ratios 1-5 uniformly indicate that liquidity is deteriorating.

(2) The gross profit margin (#6) remains relatively constant and at the
industry norm, while the net profit margin(#7) is declining. This indicates
that interest, depreciation, and selling and administrative expenses are
rising relative to sales.

(3) Part of the margin decline is accounted for by the rapid rise in debt
(#5). This increase also explains why the return on equity (#8) has been
rising while the return on assets (#9) has been falling. The impact of the
increase in debt and overall decline in profitability is also shown by the
reduction in coverage (#11).

(4) The intention of the authors was to depict a fundamentally deteriorating

situation that company officials had attempted to hide through the excessive
use of financial leverage.

Page 4 of 56
c. Indicate which ratios would be of most interest to you and what your decision
would be in each of the following situations:

i) Info-Ind wants to buy Rs 500,000 worth of merchandise inventory from

you, with payment due in 90 days.

ii) Info-Ind wants you, a large insurance company, to pay off its not at the
bank and assume it on a 10-year maturity basis at a current rate of 14
percent.

iii) There are 100,000 shares outstanding, and the stock is selling for Rs
80 a share. The company offers you 50,000 additional shares at this
price.
(1) Primary interest should be in ratios 1-4. The overall reduction in
liquidity, together with the large amount involved and the lengthy terms,
would argue against granting the credit. Of course, this argument would have
to be balanced against the importance to the vendor of this sale and possible
repeat sales.

(2) If this were done, the new capitalization would be:

Debt (long-term) $16,000,000 61.5%
Preferred stock 4,000,000 15.4%
Common equity 6,000,000 23.1%

$26,000,000 100.0%
Pro forma interest coverage would be $4.4M/$1,760,000 = 2.5x (#11 pro forma.)
The student should be especially concerned with this ratio. In addition,
he/she would have to be concerned with all of the rest, as both deteriorating
liquidity and profitability would affect a 10-year note of the company. There
would appear to be little advantage in granting the loan.

(3) An easy answer would be to point to the high rate of return on equity (#8)
and say "buy." On the other hand, the high degree of leverage (#5) and the
declining profitability (#s 7, 8, and 9), would indicate caution. The student
should at least be aware of the multitude of fundamentally negative factors

Page 5 of 56
 FUNDS ANALYSIS, CASH-FLOW ANALYSIS, AND FINANCIAL PLANNING

2. At December 31, the balance sheet of Royal Malting Company was the following
(in thousands):
Cash Rs 50 Accounts Payable Rs 360
Accounts Receivable 530 Accrued expenses 212
Inventories 545 Bank Loan 400
Current Assets Rs 1,125 Current liabilities Rs 972
Net Fixed Assets 1,836 Long-term debt 450
Common stock 100
Retained earnings 1,439

Total Assets Rs 2,961 Total liabilities and Rs 2,961

Shareholder’s equity

The company has received a large order and anticipates the need to go to its bank
to increase its borrowings. As a result, it needs to forecast its cash requirements for
January, February, and March.

Typically, the company collects 20 percent of its sales in the month of sale, 70
percent in the subsequent month, and 10 percent in the second month after the
sale. All sales are credit sales.

Purchases of raw materials to produce malt are made in the month prior to the sale
and amount to 60 percent of sales in the subsequent month. Payments for these
purchases occur in the month after the purchase. Labor costs, including overtime,
are expected to be Rs. 150,000 in January, Rs. 200,000 in February, and Rs.160,000
in March. Selling, administrative, tax, and other cash expenses are expected to be
Rs. 100,000 per month for January through March. Actual sales in November and
December and projected sales for January through April are as follows (in
thousands):
November Rs.
December 500
January 600
February 600

Page 6 of 56
March 1,000
April 650
750

Page 7 of 56
On the basis of this information:

a. Prepare a cash budget for the months of January, February, and March.
2. a.
Cash budget (in thousands)
NOV DEC JAN FEB MAR APR
──────────────────────────────────────────────────────────────────
──────
Sales $500 $600 $600 $1,000 $650 $750
Cash Collections
20% of current month sales $120 $200 $130
70% of last month's sales 420 420 700
10% of 2-month old sales 50 60 60
──── ───── ────
Total cash receipts $590 $680 $890
Purchases $360 $600 $390 $450

Cash disbursements for purchases and operating expenses

100% of last month's purchases $360 $600 $390

Labor costs 150 200 160
Other expenses paid 100 100 100
──── ──── ────
Total cash disbursements $610 $900 $650

Cash receipts less $(20) $(220) $240

cash disbursements

Page 8 of 56
 b. Determine the amount of additional bank borrowings necessary to maintain a
cash balance of Rs 50,000 at all times. (Ignore interest on such borrowings)
b.
DEC JAN FEB MAR
──────────────────────────────────────────────────────────────────
──────
Beginning bank borrowings $400 $420 $ 640
Additional borrowings 20 220 (240)
──── ──── ──────
Ending bank borrowings $400 $420 $640 $ 400
──────────────────────────────────────────────────────────────────
──────
The amount of financing peaks in February owing to the need to pay for
purchases made the previous month and higher labor costs. In March,
substantial collections are made on the prior month's billings, causing a
large net cash inflow sufficient to pay off the additional borrowings.

Page 9 of 56
 c. Prepare a forecast balance sheet for March 31. (It should be noted that the
company maintains a safety stock of inventory and that depreciation for the
three-month period is expected to be Rs 24,000)
Forecast balance sheet at March 31 (in thousands)
______________________________________________________________________________
Actual Forecast
Assets 12-31 Change 3-31 Assumptions

Cash $ 50 0 $ 50 ■ Set at es t imated min imum

balance.
Receivables 530 + 90 620 ■ 80% March sa les p lus 10%
February sales.
Inventory 545 + 90 635 ■ Based on $545 p lus $1 ,985 i n purchases ( J an . -
Mar. ) minus

Current assets
$1,125 +180 $1,305 6 times $2,250 in sales
(Jan.-Mar.).
Net fixed 1,836 - 24 1,812 ■ Deprec ia t i on expec ted to $24
be
assets

Total assets $2,961 +156 $3,117

------------------------------------------------------------------------------
Liabilities

Bank borrowings $ 400 0 $ 400 ■ additional

Prev ious ba lance p lus ze ro financing needed.
Accounts payable 360 + 90 450 ■ 100% March purchases .
Accrued expenses 212 0 212 ■ No change expec ted .

Current
liabilities $ 972 + 90 $1,062
Long-term debt 450 0 450 ■ No change expec ted .
Common Stock 100 0 100 ■ No change expec ted .
Retained earnings 1,439 + 66 1,505 ■ Change i n re ta ined earn ings
equals sales,
minus payment for purchases, minus labor and shareholders' costs,
depreciation, and other expenses, for Jan.-Mar.

Total liabilities

equity $2,961 +156 $3,117

Page 10 of 56
3. Mahalakshmi Nautical Company expects sales of Rs 2.4 million next year and the
same amount following year. Sales are spread evenly throughout the year. On the
basis of the following information, prepare a forecast income statement and balance
sheet for year end:

• Cash: Minimum 4 percent of annual sales.

• Accounts receivable: 60-day average collection period based on annual sales.

• Inventories: Turnover of eight times a year.

• Net fixed assets: Rs 500,000 now. Capital expenditures equal to depreciation.

• Accounts payable: One month’s purchases.

• Accrued expenses: 3 percent of sales.

• Bank borrowings: Rs 50,000 now. Can borrow up to Rs 250,000.

• Long-term debt: Rs 300,000 now, payable Rs 75,000 at year end.

• Common stock: Rs 100,000. No additions planned.

• Retained earnings: Rs 500,000 now.

• Net profit margin: 8 percent of sales.

• Dividends: None.

• Cost of goods sold: 60 percent of sales.

• Purchases: 50 percent of cost of goods sold.

• Income taxes: 50 percent of before-tax profits.

_______________________________________________________________________
Assumptions and/or sources
of information
─────────────────────────────────
Net sales $2,400 ■ Based on sa les f o recas t .
Cost of goods sold 1,440 ■ Fo recas t at 60% o f net sa les .
Gross profit 960
Expenses 576 ■ 24% o f net sa les ; requ i red
produce
to 16% before-tax
profit margin (see below).

Profit before taxes  384  ■ 16% of net sales; based on an 8% net profit margin 

and 50% tax rate.

Taxes     192  ■ Forecast at 50%.

Page 11 of 56
──────
Profit after taxes $ 192 ■ Fo recas t at 8% o f net sa les .
Dividends 0 ■ None expec ted .

Increase in $ 192 ■ sheet.

Car r i ed to f o recas t ba lance

retained earnings

Page 12 of 56
Forecast balance sheet (in thousands)
_______________________________________________________________________
End of
Assets year Assumptions
────────────────── ────────
─────────────────────────────────────────
Cash $ 96 ■ Set at es t imated min imum ba lance ; 4%annual
of sales of $2.4
M.
Receivables 400 ■ Based on 60 -day average co l l ec tperiod;
i on (net sales of $2.4
M)/(360/60).

Inventory 180 ■ Based on an annua l tu rnove r o(cost

f 8 ; of goods sold of $1.44
M)/8.

Total Current assets $ 676

Net fixed assets 500 capital expenditures

■ $500 ,000 at beg inn ing o f year and
expected to equal depreciation charge for the year.

Total assets $1,176

Liabilities
──────────────────
Bank borrowings $ 27 ■ all the individual
Plug figure equa l to to ta l asse ts minus
items listed below.
Accounts payable 60 ■ (.5)(cost
1 month ' s purchases ; of goods sold of
$1.44M)/12.
Accrued expenses 72 ■ Es t imated at 3% o f sa les o f 2 .4 M.

Current
liabilities $ 159

Long-term debt 225 ■ $300 ,000 minus yea r - end $75 ,000 pr inc payment.
ipa l
Common Stock 100 ■ No change expec ted .
Retained earnings 692 ■ $500 ,000 p lus $192 ,000 change i n re ta earnings
ined per
forecast income statement.

Total liabilities
and shareholders'
equity $1,176

_______________________________________________________________________

Page 13 of 56
 WORKING CAPITAL MANAGEMENT

4. What does working capital management encompass? What functional decisions

are involved, and what underlying principle or trade-off influences the decision
process?

Working capital management encompasses the administration of the firm's

current assets -- namely, cash and marketable securities, receivables, and
inventory -- and the financing (especially, current liabilities) needed to
support current assets. The fundamental decisions underlying this management
involve the level of investment in current assets and the appropriate mix of
short-term and long-term financing used to support this investment in current
assets. Such decisions are governed by the important financial principle of a
trade-off between risk and profitability. Usually, increased profitability is
only possible with the addition of risk.

Page 14 of 56
5. Distinguish between “temporary” and “permanent” working capital.
When we speak of working capital, we mean current assets.
Therefore, "temporary" working capital is the amount of current assets that
varies with a firm's seasonal needs. "Permanent" current assets, on the other
hand, is the amount of current assets required to meet a firm's long-term
minimum needs.

Page 15 of 56
6. Some firms finance their permanent working capital with short-term liabilities
(Commercial paper and short-term notes). Explain the impact of this decision on the
profitability and risk of these firms.
In general, short-term debt carries a lower explicit cost of capital. The
decision to finance the permanent component of working capital with short-term
debt may result in higher reported earnings per share. If stockholders do not
perceive a higher risk characteristic for the firm as a result of higher
proportions of short-term debt, the financial manager may be exploiting an
imperfection in the capital market to maximize the wealth of stockholders.
However, the existence of this imperfection is doubtful.

Page 16 of 56
7. What are the costs of maintaining too large level of working capital? Too small a
level of working capital?
Too large an investment in working capital lowers the firm's profitability
without a corresponding reduction in risk. (In fact, risk might actually
increase - - see answer to Question #8.) Too small a level of working capital
could also lower profitability due to stock outs and too few credit sales
(because of an overly strict credit policy).

Page 17 of 56
8. Amtek Company currently has total assets of Rs 3.2 million, of which current
assets comprise Rs 0.2 million. Sales are Rs 10 million annually, and the before-
tax net profit margin (the firm currently has no interest-bearing debt) is 12
percent. Given renewed fears of potential cash insolvency, an overly strict credit
policy, and imminent stockouts, the company is considering higher levels of
current assets as a buffer against adversity. Specifically, levels of Rs 0.5 million
and Rs 0.8 million are being considered instead of the Rs 0.2 million presently
held. Any addition to currents assets would be financed with new equity capital.

a. Determine the total asset turnover, before-tax return on investment, and

before-tax net profit margin under the three alternative levels of current
assets.
1. a.

Sales (millions) $10.0 $10.0 $10.0

EBIT (millions) 1.2 1.2 1.2

Total assets (millions) 3.2 3.5 3.8

Total asset turnover 3.125 2.857 2.632

Before-tax return on assets 37.5% 34.3% 32.6%

Before-tax net profit margin 12.0% 12.0% 12.0%

The before-tax net profit margin is unchanged, as sales and

earnings before interest and taxes (EBIT) are the same regardless
of the liquidity policy employed.

Page 18 of 56
 b. If the new additions to current assets were finance with long-term debt at
15 percent interest, what would be the before-tax interest “cost” of the
two new policies?
b.

Additional debt $300,000 $600,000

Additional interest 45,000 90,000

The "cost" of financing additional current assets could be reduced by the

amount that could be earned on any additional investment of cash in marketable
securities. Also, more lenient credit terms may lead to increased sales and
profits. A hidden cost is that part of the debt capacity of the firm is used
up by virtue of financing increased levels of current assets with debt.

Page 19 of 56
9. Ace Metal Specialties, Inc. has a seasonal pattern to its business. It borrows under
a line of credit from Central Bank at 1 percent over prime. Its total asset
requirements now (at year end) and estimated requirements for the coming year
are (in millions):
Now 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
Total asset Rs 4.5 Rs 4.8 Rs 5.5 Rs 5.9 Rs 5.0
requirement

Assume that these requirements are level throughout the quarter. At present the
company has Rs 4.5 million in equity capital plus long-term debt plus the permanent
component of current liabilities, and this amount will remain constant throughout
the year. The prime rate currently is 11 percent, and the company expects no
change in this rate for the next year. Ace Metal Specialties is also considering
issuing intermediate-term debt at an interest rate of 13.5 percent. In this regard,
three alternative amounts are under consideration: zero, Rs 500,000, and Rs 1
million. All additional funds requirements will be borrowed under the company’s
bank line of credit.

a. Determine the total rupee borrowing costs for short-and intermediate-term

debt under each of the three alternatives for the coming year. (Assume that
there are no changes in current liabilities other than borrowings.) Which
alternative is lowest in cost?
2. a)

1st 2nd 3rd 4th

Quarter Quarter Quarter Quarter Total
Alternative 1:
Incremental
borrowings $300,000 $1,000,000 $1,400,000 $500,000

Bank loan
cost* 9,000 30,000 42,000 15,000 $96,000

Alternative 2:
Term Loan
Cost ($500,000 at 13.5%) $67,500

Incremental
borrowings 0 $500,000 $900,000 0

Bank loan
cost* 0 15,000 27,000 42,000

Page 20 of 56
 $109,500
Alternative 3:
Term Loan Cost ($1,000,000 at 13.5%) 135,000
Incremental
borrowings 0 0 $400,000 0
Bank Loan
Cost* 12 ,000 12 ,000
$147,000

• (11% + 1%)/4 = 3% per quarter.

Alternative 1 is lowest in cost because the company borrows at a lower rate,

12 percent versus 13.5 percent, and because it does not pay interest on funds
employed when they are not needed.

Page 21 of 56
 b. Is there a consideration other than expected cost that deserves our
attention?
While alternative 1 is cheapest it entails financing the expected build up in
permanent funds requirements ($500,000) on a short-term basis. There is a
risk consideration in that if things turn bad the company is dependent on its
bank for continuing support. There is risk of loan renewal and of interest
rates changing.

Alternative 2 involves borrowing the expected increase in ermanent funds

requirements on a term basis. As a result, nly the expected seasonal component
of total needs would be Financed with short-term debt.

Alternative 3, the most conservative financing plan of the three,

involves financing on a term basis more than the expected build-up in
permanent funds requirements. In all three cases, there is the risk that
actual total funds requirements will differ from those that are
expected.

Page 22 of 56
 CASH AND MARKETABLE SECURITIES MANAGEMENT

10. Define the function of cash management.

Cash management involves the efficient collection and disbursement of cash and
any temporary investment of cash while it resides with the firm. The general
idea is that the firm will benefit by "speeding up" cash receipts and "slowing
down" cash payouts.

11. Money market instruments are used as investment vehicles for otherwise idle
cash. Discuss the most important criterion for asset selection in investing
temporarily idle cash.
The lock-box system may improve the efficiency of cash management by reducing
the float. The funds made available by this reduction in float may be invested
to produce additional profit.

Page 23 of 56
12. Assuming that the return on real assets of a company exceeds the return on
marketable securities, why should a company hold any marketable securities?

Marketable securities serve as a temporary investment for funds which later

will be needed for transaction purposes. They also serve as a liquidity buffer
for unforeseen cash drains. This buffer can be quickly converted into cash. In
this sense, marketable securities serve as precautionary balances.

13. What are the three motives for holding cash?

The three motives for holding cash are: 1) transactions to meet ordinary
payments; 2) precautionary to maintain a safety cushion or buffer against
unexpected cash drains; and 3) speculative to try to take advantage of
temporary opportunities.

Page 24 of 56
14.The Zindler Company currently has a centralized billing system. Payments are
made by all customers to the central billion location. It requires, on average, four
days for customers’ mailed payments to reach the central location. An additional
day and a half is required to process payments before a deposit can be made.
The firm has a daily average collection of Rs 500,000. The company has recently
investigated the possibility of initiating new system. Is has estimated that with
such a system customers’ mailed payments would reach the receipt location two
and one-half days sooner. Further, the processing time could be reduced by an
additional day bank would pick up mailed deposits twice daily.

a. Determine how much cash would be freed up (released) through the use
of a new system.

a.

Total time savings = 2.5 + 1 = 3.5 days

Time daily cash
savings X average collection = released

3.5 X $500,000 = $1,750,000

Page 25 of 56
b. Determine the annual gross rupee benefit of the new system, assuming
the firm could earn a 5 percent return on the released funds in Part (a) by
investing in short-term instruments.

b. 5% X $1,750,000 = $87,500

Page 26 of 56
 c. If the annual cost of the new system will be Rs 75,000, should such a
system be initiated?
c. Since the dollar gross benefit of the lockbox system ($87,500) exceeds the
cost of the lockbox system ($75,000), the system should be initiated.

Page 27 of 56
15.Speedway Company franchises “Gas and Go” stations in Maharashtra and
Gujarat. All payments by franchisees for gasoline and oil products, which
average Rs 420,000 a day, are by check. At present, the overall time between
the mailing of the check by the franchisee to Speedway and the time the
company has collected or available funds at its bank is six days.

a. How much money is tied up in this interval of time?

a) $420,000 x 6 = $2,520,000.

Page 28 of 56
 b. To reduce this delay, the company is considering daily pickups from the
stations. In all, three cars would be needed that three additional people
hired. This daily pickup would cost Rs 93,000 on annual basis, and it would
reduce the overall delay by two days. Currently, the opportunity cost of
funds is 9 percent, that being the interest rate on marketable securities.
Should the company inaugurate the pickup plan? Why?

Funds released = $420,000 x 2 = $840,000

Value of funds released on an annual basis =
$840,000 x 9 percent = $75,600

The company should not inaugurate the plan.

Page 29 of 56
 c. Rather than mail checks to its bank, the company could deliver them by
messenger service. This procedure would reduce the overall delay by one
day and cost Rs 10,300 annually. Should the company undertake this
plan? Why?

Value of funds released on an annual basis = $420,000 x 9 percent = $37,800

The company should undertake the plan.

Page 30 of 56
16.The food world company has a weekly payroll of Rs 150,000 paid on Friday. On
average, its employees cash their check in following manner:
Day check cleared on company’s Percentage of checks
account cashed
Friday 20
Monday 40
Tuesday 25
Wednesday 10
Thursday 5

As treasurer of the company, how would you arrange your payroll account? Are
there any problems?

If the company were certain of the pattern shown, it would wish to

have the following deposits in its payroll account in order to
cover the checks that were cashed:
Friday $ 30,000
Monday 60,000
Tuesday 37,500
Wednesday 15,000
Thursday 7,500
────────
$150,000

If employee check cashing behavior is subject to fluctuations, the company

will need to maintain "buffer" cash in the account. The greater the
uncertainty, the greater the buffer that will be needed.

Page 31 of 56
 ACCOUNTS RECEIVABLE AND INVENTORY MANAGEMENT
17.Is it always good policy to reduce the firm’s bad debts by “getting rid of the
deadbeats?”
No. Only if the added profitability of the additional sales to the "deadbeats"
(less bad debt loss and other costs) does not exceed the required return on
the additional (and prolonged) investment in accounts receivable should the
firm cease sales to these customers. Some firms (such as jewelry or audio
equipment dealers) are very happy to sell to almost any "deadbeat" because
their margins are very high.

18.Is an increase in the collection period necessarily bad? Explain.

No. Liberalizing credit terms may stimulate sales. The incremental profit may
be greater than the required return on the investment necessary to finance added
accounts receivable.

Page 32 of 56
19.What are the various sources of information you might use to analyze a credit
applicant?

To analyze a credit applicant, one might turn to financial statements provided by the
applicant, credit ratings and reports, a check with the applicant's bank (particularly
if a loan is involved), a check with trade suppliers, and a review of your own credit
experience if the applicant has done business with you in the past. Each step
involves a cost and the value of additional information must be balanced against
the profitability of the order and the cost of the information.

20. What are the principal factors that can be varied in setting credit policy?
The quality of account accepted, the credit period, the discount,

and the discount period.

Page 33 of 56
Page 34 of 56
21. The analysis of inventory policy is analogous to the analysis of credit policy.
Propose a measure to analyze inventory policy that is analogous to the aging of
accounts receivable.

Aging accounts receivable represents an effort to determine the age

composition of receivables. A similar approach for inventory could involve
determining the inventory turnover in days (ITD) of product lines and of
individual products. For example, General Electric may evaluate inventory
policy by comparing the trend in inventory turnover in days of home
appliances. Within the home appliance category, the inventory turnover in days
of refrigerators, for example, may yield an insight into inventory policy.

22. What are the principal implications to the financial manager of ordering costs,
storage costs, and cost of capital as they relate to inventory?

The greater the ordering costs, the more inventory that will be maintained,
all other things the same, and the greater the funds that will be tied up in
inventory. The greater the storage costs and cost of capital, the less
inventory that will be maintained.

Page 35 of 56
23. How can the firm reduce its investment in inventories? What costs might the
firm incur from a policy of very low inventory investment?

The firm could lower its investment in inventories by:

a) Shortening the lead time on purchases.
b) Improving sales forecasts.
c) Trimming the product line or standardizing parts.
d) Scheduling smaller, more flexible production runs.
e) Shifting inventory burden to suppliers (purchases shipped on consignment)
or to customers (manufacturing to order or shipping upon discretion).

Increased costs include:

a) Higher prices from suppliers.
b) Increased ordering costs.
c) Loss of sales due to stockout or shifted inventory burden.
d) Increased production costs.

24. Do inventories represent an investment in the same sense as fixed assets?

From the standpoint of dollars committed, the two are the same. However,
inventories change rapidly over time whereas fixed assets do not. Therefore,
one is concerned with the level of investment in inventories, as opposed to
the investment in a specific asset as would be the case with fixed asset.

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25. Should the required rate of return for investment in inventories of raw materials
be the same as that for finished goods?
Usually a company will use the same required rate of return for both. However,
if one type of inventory was significantly more risky than the other, one
might wish to apply a higher required rate of return. This might occur if the
raw materials had a ready market with little price fluctuation whereas the
finished products were subject to considerable uncertainty.

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26.Kids-Kemp Company currently gives credit terms of “net 30 days.” Is has Rs 60
million in credit sales, and its average collection period is 45 days. To stimulate
demand, the company may give credit terms of “net 60 days.” If it does instigate
these terms, sales are expected to increase by 15 percent. After the change, the
average collection period is expected to be 75 days, with no difference in
payment habits between old and new customers. Variable costs are Rs 0.80 for
every Rs 1.00 of sales, and the company’s before-tax required rate of return on
investment in receivables is 20 percent. Should the company extend its credit
period? (Assume a 360-day year.)

1.

Old receivable turnover = 360/45 = 8 times

New receivable turnover = 360/75 = 4.8 times

Profitability of additional
sales = .2 x $9,000,000 = $1,800,000

Additional receivables
associated with the new sales = $9,000,000/4.8 = $1,875,000

Investment in additional
receivables associated
with the new sales = .8 x $1,875,000 = $1,500,000

Level of receivables before

credit period change = $60,000,000/8 = $7,500,000

New level of receivables

associated with original sales = $60,000,000/4.8 = $12,500,000

Investment in additional
receivables associated
with original sales = $12.5M - $7.5M = $5,000,000

Total investment in
additional receivables = $1.5M + $5.0M = $6,500,000

Required before-tax return

on additional investment = .20 X $6.5M = $1,300,000

As the profitability on additional sales, $1,800,000, exceeds the

required return on the investment in additional receivables,
$1,300,000, the company should lengthen its credit period from 30 to 60 days.

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27.Clean Air company is a distributor of air filter to retail stores. It buys its filters
from several manufacturers. Filters are ordered in lot sizes of 1,000, and each
order costs Rs 40 to place. Demand from retails stores is Rs 20,000 filters per
month, and carrying cost is Rs 0.10 a filter per month.

a. What is the optimal order quantity with respect to so many lot sizes
( that is, what multiple of 1,000 units should be ordered)?
a. ┌───────── ┌─────────────
│ 2(O)(S) │ 2($40 ) (20 )
Q* = │ ─────── = │ ─────────── = 4 (thousand-unit) lots
\│ C \│ 100
The optimal order size would be 4,000 filters, which represents
five orders a month.
(Note: carrying costs (C) per 1,000-unit lot = $.10 X 1,000 = $100)

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 b. What would be the optimal order quantity if the carrying cost were cut
in half to Rs 0.05 a filter per month?

b. ┌───────── ┌─────────────
│ 2(O)(S) │ 2($40 ) (20 )
Q* =│ ─────── = │ ─────────── =5.66 (thousand-unit) lots
\│ C \ │ 50
Since the lot size is 1,000 filters, the company would order 6,000 filters
each time. The lower the carrying cost, the more important ordering costs
become relatively, and the larger the optimal order size.

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 c. What would be the optimal order quantity if the carrying cost were
reduced to Rs 10 per order?

c. ┌───────── ┌─────────────
│ 2(O)(S) │ 2($10 ) (20 )
Q* =│ ─────── = │ ─────────── = 2 (thousand-unit) lots
\│ C \│ 100
The lower the order cost, the more important carrying costs become relatively,
and the smaller the optimal order size.

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28.To increase sales from their present annual Rs 24 million, Kim Chi Company, a
wholesaler, may try more liberal credit standards. Currently, the firm has an
average collection period of 30 days. It believes that, with increasingly liberal
credit standards, the following will result:

Credit Policy
A B C D
Increase in sales from previous level ( in Rs Rs Rs Rs 6
millions) 2.8 1.8 1.2 144
Average Collection period from incremental 45 60 90
sales (days)

The prices of its products average Rs 20 per unit, and variable costs average Rs
18 per unit. No bad debt losses are expected. If the company has a pre-tax
opportuinity cost of funds of 30 percent, which credit policy should be pursued?
Why? (Assume 360 day year)
1.
________________________________________________________________________
Credit Policy A B C D

a. Incremental
sales $2,800,000 $1,800,000 $1,200,000 $600,000
b. Incremental
profitability1 280,000 180,000 120,000 60,000
c. New receivable
turnover 8 6 4 2.5
d. Additional
receivables3 $350,000 $300,000 $300,000 $240,000
e. Additional
investment 315,000 270,000 270,000 216,000
f. Opportunity cost
94,500 81,000 81,000 64,800
g. (b) > (f)? yes yes yes no
________________________________________________________________________

1(10% contribution margin) x (incremental sales)

2(360 days/new average collection period)
3(incremental sales/new receivable turnover)
4(0.9) x (additional receivables)
5(.30) x (additional receivables)

Page 42 of 56
The company should adopt credit policy C because incremental profitability
exceeds the increased carrying costs for policies A, B, and C, but not for
policy D.

Page 43 of 56
29.The Amtek Manufacturing company is considering extending trade credit to the
Saint Jones Company. Examination of the records of Saint Jones has produced the
following financial statements:

Assets 20X1 20X2 20X3

Current Assets
Cash and Cash equivalents Rs 1.5 Rs 1.6 Rs 1.6
Receivables 1.3 1.8 2.5
Inventories (at lover of cost or 1.3 2.6 4.0
market) 0.4 0.5 0.4
Other Rs 4.5 Rs 6.5 Rs 8.5
Total Current assets
Fixed Assets 2.0 1.9 1.8
Building (net) 7.0 6.5 6.0
Machinery and equipment (net) Rs 9.0 Rs 8.4 Rs 7.8
Total Fixed Assets 1.0 0.8 0.6
Other assets Rs 14.5 Rs 15.7 Rs 16.9
Total Assets

Liabilities
Current liabilities
Notes Payable (8.5%) Rs 2.1 Rs 3.1 Rs 3.8
Trade payables 0.2 0.4 0.9
Other payables 0.2 0.2 0.2
Total Current liabilities Rs 2.5 Rs 3.7 Rs 4.9
Term loan 4.0 3.0 2.0
Total laibilities Rs 6.5 Rs 6.7 Rs 6.9
Net worth
Preferred stock (6.5%) 1.0 1.0 1.0
Common stock 5.0 5.0 5.0
Retained Earnings 2.0 3.0 4.0
Total liabilities and net worth Rs 14.5 Rs 15.7 Rs 16.9

Saint Jones Company income statements (in millions)

20X1 20X2 20X3
Net Credit Sales Rs 15.0 Rs 15.8 Rs 16.2
Cost of Goods sold 11.3 12.1 13.0
Gross Profit Rs 3.7 Rs 3.7 Rs 3.2
Operating expenses 1.1 1.2 1.0
Net profit before taxes Rs 2.6 Rs 2.5 Rs 2.2
Tax 1.3 1.2 1.2
Profit after taxes Rs 1.3 Rs 1.3 Rs 1.0
Dividends 0.3 0.3 0.0

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 Total retained earnings Rs 1.0 Rs 1.0 Rs 1.0

Inquiries into its banking disclosed balances generally in the low millions. Five
suppliers to Saint Jones revealed that the firm takes its discounts from the three
suppliers offering “2/10 net 30” terms, though it is about 15 days slow in paying
the two firms offering terms of “net 30.”

Analyze the Saint Jones Company’s application for credit. What positive factors
are present? What negative factors are present?
6. Positive factors:
a) The firm has maintained a reasonably good cash position over
the period.
b) The firm has reduced by 50% its outstanding long-term debt.
c) The firm has been increasing its net worth by $1 million
annually.
d) The firm has taken cash discounts when offered.

Negative factors:
a) The firm has only a "fair" Dun & Bradstreet rating.
b) The firm has been a slow payer to trade creditors not offering
a discount.
c) The liquidity of the firm has been reduced substantially over the past
three years as the acid-test ratio went from 1.28 to 1.05 to 0.92. Short-term
debt and trade credit from suppliers have increased faster than total
liabilities and net worth while inventory and receivable turnovers have
slowed.

d) Cost of goods sold has increased from 75.3% to 76.6% to 80.2%.

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30.A college bookstore is attempting to determine the optimal order quantity for a
populat bok on Economics. The store sells 5,000 copies of this book a year at a
retail price of Rs 125, and the cost to the store is 20 percent less, which
represents the discount from publisher. The store figures that it costs Rs 1 per
year to carry a book in inventory and Rs 100 to prepare an order for new books.

a. Determine the total inventory costs associated with ordering 1, 2, 5,

10, and 20 times a year.
a) C(Q/2) + O(S/Q) = TC
(1X): $1(5,000/2) + $100(5,000/5,000) = $2,600
(2X): $1(2,500/2) + $100(5,000/2,500) = $1,450
(5X): $1(1,000/2) + $100(5,000/1,000) = $1,000
(10X): $1(500/2) + $100(5,000/500) = $1,250

(20X): $1(250/2) + $100(5,000/250) = $2,125

Page 46 of 56
 b. Determine the economic order quantity.

b) ┌──── ┌─────────────────
│ 2OS │ (2 ) ($100) (5 ,000 ) ┌───────
Q* = │ ─── = │ ──────────────── = \ │ 1 mi l l i on
= 1 ,000
\│ C \ │ $1

Page 47 of 56
 c. What implicit assumptions are being made about the annual sales
rate?
It is assumed that sales are made at a steady rate, which may not be correct
for textbooks. The nature of academics suggests that sales would occur at the
beginning of each term.

Page 48 of 56
31.The Hedge Company manufactures only one product: planks. The single raw
material used in making planks is the dint. For each plank manufactured, 12
dints are required. Assume that the company manufactures 150,000 planks per
year, that demand for planks is perfectly steady throughout the year, that it
costs Rs 200 each time dints are ordered, and that carrying costs are Rs 8 per
dint per year.

a. Determine the economic order quantity of dints.

a) Total number of dints required = 150,000 x 12 = 1,800,000

┌─────────────────────
│ (2)($200)(1,800,000) ┌───────────
Q* = │ ─────────────────── = \ │ 90 ,000 ,000 = 9 ,487 un i t s
\│ $8

Page 49 of 56
 b. What are total inventory costs for Hedge (total carrying costs plus total
ordering costs)?
TC = C(Q/2) + O(S/Q)
= $8(9,487/2) + $200(1,800,000/9,487)

= $37,948 + $37,947 = $75,895

Page 50 of 56
 c. How many times per year would inventory be ordered?

1,800,000/9,487 = (approx.) 190 times a year, or every 2 days

Page 51 of 56
 SHORT-TERM FINANCING

32.Explain why trade credit from suppliers is a “spontaneous source of funds.”

Trade credit from suppliers is spontaneous because there is no formal

negotiation for the funds. By merely purchasing merchandise on credit,
funds are acquired.

33.Stretching payables provides “free” funds to customers for a short period. The
supplier, however, can face serious financial problems if all its customers stretch
their accounts. Discuss the nature of the problems the supplier may face, and
suggest different approaches to cope with stretching.
Stretching payables creates problems for suppliers since their ability to
forecast cash flows is substantially impaired. The more uncertain the cash
projections, the higher the level of protective liquidity a firm must hold.
Also, investors may perceive a higher degree of risk for the supplier, thus
increasing the supplier's cost of capital. Methods of preventing the
stretching of payables include severe penalties for late payment (such as a

Page 52 of 56
10% late charge), friendly reminders to the customers, and other acceptable
collection procedures.

34.Would you rather have your loan on a “collect basis” or a “discount basis” if you
were a borrower, all other things being the same? If you were a lender?

A line of credit is an informal lending arrangement, usually for one year, where the
bank expresses a willingness to lend up to some specified amount of funds at an
interest rate related to the prime rate or to the bank's cost of funds. A revolving
credit agreement is a legal commitment to extend credit up to some maximum
amount anytime a company wishes to borrow. Usually the commitment is for
multiple years, often three. Also, the company must satisfy certain restrictions
(called protective covenants) specified in the agreement. If satisfied, however, the
loan cannot be denied whereas it can be legally denied under a line of credit should
the company evolve itself into financial difficulty.

Page 53 of 56
35.What determines whether a lending arrangement is unsecured or secured?
The quality of the borrower and its cash flow ability to service debt largely
determine whether a lender is willing to make an unsecured loan. If the lender
does not have a very high degree of confidence in the ability of the borrower to
repay, it will insist on some type of secured lending arrangement.

Page 54 of 56
36.List assets that you would accept as collateral on a short-term loan in your order
of preference. Justify your priorities.

1. Hypothecation of Loan

2. Discounting of Accounts Receivable

3. Borrowing against Marketable Securities

Page 55 of 56
37.The Pawlowski Supply Company needs to increase its working capital by Rs 4.4
million. The following three financing alternatives are available (assume a 365-
day year):

a. Forgo cash discounts (granted on a basis of “3/10, net 30”) and pay on
the final due date.

b. Borrow Rs 5 million from a bank at 15 percent interest. This alternative

would necessitate maintaining a 12 percent compensating balance.

c. Issue Rs 4.7 million of six-month commercial paper to net Rs 4.4

million. Assume that new paper would be issued every six months.
(Note: Commercial paper has no stipulated interest rate. It is sold at a
discount, and the amount of the discount determines the interest and
cost to the issuer.)

Assuming that the firm would prefer the flexibility of bank financing, provided
the additional cost of this flexibility was no more than 2 percent per annum,
which alternative should Pawlowski select? Why?

Annualized costs are as follows:

a. Trade credit: (3/97)(365/20) = 56.47%

b. Bank financing: ($5,000,000 x .15)/($4,400,000) = 17.05%
c. Commercial paper: ($300,000/$4,400,000) x 2 = 13.64%

The bank financing is approximately 3.4 percent more expensive than the
commercial paper; therefore, commercial paper should be issued.

Page 56 of 56