6-2. Working Capital Management

Question 1

A/R Management: What is it concerned with?

Answer 1

• Conditions leading to the recognition of receivables

* Process that results in elimination (e.g. collection) of receivables

Question 2

A/R Management: What is involved in the process?

Answer 2

• Establish general terms of credit
• Determine customer creditworthiness and setting credit limits
• Collecting A/R

Question 3

A/R Management: what must a firm selling on credit establish?

Answer 3

General terms under which credit will be granted - will be influenced by terms common in its industry.

Question 4

A/R Management: What are elements of general terms of credit decisions?

Answer 4

• Total credit period - the maximum period for which credit may be extended
• Discount to be offered for early pmt if any
• Penalty for late pmt
• Nature of credit sales documentation if any

Question 5

A/R Management: What is the objective when deciding whether or not to grant credit to each customer and how much?

Answer 5

Maximize profits, not minimize credit losses.

Question 6

A/R Management: What happens when the credit policy is too strict?

Answer 6

Strict: Reduces uncollectible accounts, but may result in not making credit sales that would be collected.

Question 7

What are 2 major approaches to determine whether or not to grant credit?

Answer 7

• Use credit-rating service: obtain and use a rating report from a credit agency (Equifax, Experion, Transunion, Dun & Bradstreet)
• Do financial analysis - usually done by large firms or in special circumstances

Question 8

A/R Management: What is the objective for collection?

Answer 8

To keep post-sales losses to a minimum.

Question 9

A/R Management: What are process?

Answer 9

• Monitoring A/R continuously
• Identify overdue accounts
• Prompt collection action

Question 10

A/R Management: what can a firm use to monitor A/R at aggregate level?

Answer 10

Use averages and ratios;

• Average collection period
• Day’s sales in A/R
• A/R turnover
• A/R to current or total assets
• Bad debt to sales

Question 11

A/R Management: what can a firm use to monitor A/R at the individual account level?

Answer 11

Use aging of A/R
*Shows the amount owed and how long it has been due for each customer
*amount would be grouped by;
not yet due, 1-30 days over due, 30-60 days, greater than 60 days etc.

Question 12

A/R Management: What costs may drastic collection actions have?

Answer 12

Financial and goodwill costs

Question 13

Inventory Management: What is a risk-reward tradeoff?

Answer 13

Under investing to save costs = risk of shortages

Over investing to provide cushion = risk of excessive costs

Question 14

Inventory Management: Objective?

Answer 14

To neither under invest nor over invest.

Question 15

Inventory Management: What are 2 general approaches (systems) in US?

Answer 15

• Traditional Materials Requirement Planning (MRP) system

* Just-in-time (JIT) inventory system

Question 16

Inventory Management: What is Traditional Materials Requirement Planning (MRP) system?

Answer 16

Predominant in US from 1960s to advent of JIT.

• Supply push = goods are produced in anticipation of their sale
• The inventory buffers = inventory is maintained at every level as buffers against unexpected demand
• Production based on long set-up time and long production runs - inflexible system
• Impersonal relationships with suppliers - purchase based on lowest bid
• Quality stds set at an “acceptable” level - allow for certain defects
• Emphasis = job order and processing cost approaches

Question 17

Inventory Management: What is Just-in-Time inventory (JIT) system?

Answer 17

Originates with Toyota

• Based on obtaining (on the supply side) and delivering (on the sell side) inventory just as and only when needed
• Demand pull = goods are produced only when and as needed by the end user
• Inventory reductions = production and purchasing occur only as needed - inventory reduced or eliminated
• Production in work center (or cells) - workers operate multiple pieces of equipment or robotics are used
• Close working relationships with a limited number of suppliers located physically close to production facilities
• Quality is critical, including inputs to the production process
• Simplified cost accounting with fewer accounts - more items considered direct cost and reducing allocations

Question 18

Inventory Management: Financial benefits of JIT and related production processes?

Answer 18

• Reduced investment in inventory
• Lower cost of inventory transportation, warehousing, insurance, property taxes and related costs
• Reduced lead time in replenishing production inputs
• Less complex and more relevant accounting and performance measures

Question 19

Inventory Management: Can JIT be used by every firm?

Answer 19

No

Question 20

Inventory Management: Regardless of methods, what are 2 elements a firm is concerned?

Answer 20

• The economic order quantity

* The reporter point for its inventory

Question 21

Inventory Management: The economic order qty: what are the trade off of inventory ordering cost and carrying cost?

Answer 21

Larger the qty ordered, the lower per unit order cost

Larger the qty ordered, the higher the carrying cost

Question 22

Inventory Management: what is total inventory administrative cost?

Answer 22

Total order costs + Total carrying costs

Question 23

Inventory Management: what does the economic order qty (EOQ) model determines?

Answer 23

The order size that minimize total inventory administrative costs.

Question 24

Inventory Management: what is the formula for total order cost? no need to remember

Answer 24

= (Total units / Order size qtry) x Per order cost

= (T/Q) x O

Question 25

Inventory Management: what is the formula for total carrying cost? no

Answer 25

= (Order size qty / 2) x Per unit carrying cost

= (Q/2) x C

Question 26

Inventory Management: Formula for total cost? no

Answer 26

TC = [(T/Q) x O] + [(Q/2) x C] or
TC = (T x O) / Q + (Qx C) / 2

Question 27

Inventory Management: Formula for EOQ?

Answer 27

2 TO/C square root.
T = total demand
O = Per order cost
C = Per unit carrying cost

Question 28

Inventory Management: EOQ EX:

Total demand = 10,000 units, per order cost = $100, Per unit carrying cost = $2.00.

Answer 28

square root of 2 x 10,000 x 100 / 2 = 1,000 units = optimum order qty

Question 29

Inventory Management: what are assumptions for EOQ?

Answer 29

• Demand is constant during period
• Unit cost and carrying costs are constant during the period
• Delivery is instantaneous

Question 30

Inventory Management: What is inventory reorder point? Formula?

Answer 30

Determine the inventory qty at which goods should be reordered.
Reorder point = Delivery time stock + Safety stock

Question 31

Inventory Management: Reorder point ex:

Annual use equally over 50 wks = 300,000 units, delivery time = 2 wks, safety stock = 1,000 units.

Answer 31

[(300,000 / 50) x 2 wks] + 1,000 = 13,000 units = reorder point

Question 32

Current Liabilities Management: What is the guideline?

Answer 32

• Should be used to finance assets which generate cash in the short-term; the principle of self-liquidating debt.
• Some amount provide a permanent amount of financing
• Normally do not require collateral or impose restrictive covenants
• If requires a compensating balance, the effective cost is greater than the stated cost
• A line of credit, revolving credit and letter of credit provide “stand by” financing

Question 33

Current Liabilities Management: computing the value of discount ex:
A: 1.5/15, net 30
B: 1/10, net 30
C: 2/10, net 60
A firm must borrow from a bank to take the discount at annual rate of 10%.

Answer 33

Discount% / (100% - discount%) x 360 days / (Total pay period - Discount period).

A: 0.015 / (1 - 0.015) x 360 / (30-15) = 0.3648 - Annual cost of not taking discount. By borrowing from the bank at 10% and taking advantage of the discount, Ruby would benefit by .3653 annual rate saved less .10 annual cost of borrowing = .2653.