Current Asset Managemen Part 6

Short Answer Questions 137. Explain what a float is and what causes it to occur. There are two cash balances of importance: • Corporation's recorded amount • Amount available for use by the corporation at the bank The difference between the two is float. Float exists as a result of the time lag between when a payment or receipt is recorded in the corporation's ledgers and the eventual acknowledgement that it has altered the corporate bank account. Float arises from payments or receipts that are • In the mail • Clearing the banking system • Being processed • Slow to be acknowledged by the firm's (bank's) information system 7-45 Chapter 07 - Current Asset Management Accessibility: Keyboard Navigation Blooms: Remember Difficulty: Medium Learning Objective: 07-02 Examine cash management as the control of receipts and disbursements to minimize nonearning cash balances while providing liquidity; and compare techniques to make cash management more efficient. Topic: 07-05 Float 138. How can a firm achieve faster collection times? Why is this desirable? A firm must be diligent in collecting monies owed to it, in depositing those monies into a bank account, and in holding on to monies as long as possible, so that the funds can be utilized efficiently by the corporate treasurer. Having monies in a bank account even one day longer can make a significant difference to the firm. Faster collections can be achieved by: • Encouraging customers to pay on a timely basis • Cutting down on the time monies take to arrive in the firm's possession • Accounting for and processing monies quickly upon receipt • Depositing monies quickly into the firm's bank accounts Once concentrated and administered centrally in the firm's bank accounts, the funds can be more efficiently deployed, because: • Treasury has better control of the funds. • Transaction and administration costs are lower. • Concentrated sums can earn better returns invested in marketable securities (e.g., $100,000 receives a higher rate than 20 $5,000). Accessibility: Keyboard Navigation Blooms: Understand Difficulty: Medium Learning Objective: 07-02 Examine cash management as the control of receipts and disbursements to minimize nonearning cash balances while providing liquidity; and compare techniques to make cash management more efficient. Topic: 07-06 Improving Collections and Extending Disbursements 139. What factors should a financial manager consider when choosing appropriate short-term securities? The financial manager in choosing short-term securities considers such factors as yield, maturity, minimum investment required, safety of the security, and marketability of the security. 7-46 Chapter 07 - Current Asset Management Accessibility: Keyboard Navigation Blooms: Remember Difficulty: Easy Learning Objective: 07-03 Define the various marketable securities available for investment by the firm; and calculate the yield on these instruments. Topic: 07-10 Marketable Securities 140. Describe the 7 characteristics of most market securities. Most money market securities are: • Unsecured (no physical asset backing up pledge of payment) promissory notes. • Highly liquid with high trading volumes. • In either bearer (ownership resides with individual in possession) or street (investment dealer's name) form. This facilitates ease of trading. • Short-term (maturity or payback occurs in less than one year) and most commonly issued for periods of 1, 2, 3, 6 months, or 1 year. • Traded continuously, producing maturities of any period desired (a 3-month security sold one month later becomes a 2-month security). • Sold on a discount basis. The instrument is sold at less than the maturity value. The return (considered interest, not a capital gain, by the tax department) is the gain from the discounted price to the maturity value. • Bought and sold on the basis of their promised yield (price) with the best rates for transactions of $1,000,000 or more. Lower yields accompany lower-sized investments. 7-47 Chapter 07 - Current Asset Management Accessibility: Keyboard Navigation Blooms: Remember Difficulty: Hard Learning Objective: 07-03 Define the various marketable securities available for investment by the firm; and calculate the yield on these instruments. Topic: 07-10 Marketable Securities 141. List and explain the "4C's of credit" as discussed by the author. To establish the degree of credit risk of a potential customer, a firm should develop a credit profile. This profile establishes the customer's strengths and weaknesses. Most importantly, it questions if customers are able to pay and if they can buy enough. Companies that analyze credit risk tend to develop a system in some way related to the 4 Cs of credit. Character: An analyst attempts to determine the customer's willingness to pay. If things get rough, does the customer go into hiding or attempt to work things out? Clues as to the strength of corporate character come from information on fraudulent activities, legal disputes, union problems, dealings with other suppliers, and even the willingness to supply credit information. Capacity: The ability to pay. Capacity is built on marketing abilities, experience in the business, the management team, and overall, the ability to generate profits. To judge a customer's ability to generate profits is a difficult process. Financial ratio analysis can be of considerable assistance, as is an investigation of the customer's abilities based on past experience. Capital: Assets and net worth. Strong net worth is evidence of past success and a commitment by shareholders to the firm. Growing assets demonstrate an ongoing successful business. In difficult economic times when its ability to generate profits is diminished, a strong net worth helps a company survive. Conditions: The state of the economy and the industry in general. One's experience and knowledge best help an analyst in getting a fix on conditions. One tries to foresee how existing conditions affect the potential credit customer. How the customer adapts to changing conditions in the marketplace is also a consideration. 7-48 Chapter 07 - Current Asset Management Accessibility: Keyboard Navigation Blooms: Remember Difficulty: Hard Learning Objective: 07-04 Characterize accounts receivable as an investment resulting from the firm's credit policies; outline the considerations in granting credit; and evaluate a credit decision that changes credit terms to stimulate sales. Topic: 07-14 Credit Policy Administration 142. Describe the 3 basic requirements of Just-in-Time inventory management. Just-in-time inventory management is part of a total production concept that often interfaces with a total quality control program. A JIT program has several basic requirements: 1) quality production that continually satisfies customer requirements 2) close ties between suppliers, manufacturers, and customers 3) minimization of the level of inventory. 7-49 Chapter 07 - Current Asset Management Accessibility: Keyboard Navigation Blooms: Remember Difficulty: Hard Learning Objective: 07-05 Assess inventory as an investment and apply techniques to reduce the costs of this investment. Topic: 07-22 Just-in-Time Inventory Management 143. Describe and explain several benefits and downsides of a Just-in-Time inventory program. Benefits of JIT: 1) Cost savings from lower levels of inventory and reduced financing cost are expected. 2) A JIT plant may use much less space than the standard plant and therefore saves construction costs and reduces its overhead expenses for utilities and manpower. 3) Computerized ordering systems and EDI systems between suppliers, production, and manufacturing reduce rekeying errors and duplication of forms for the accounting and finance functions. 4) Supplier lists may be reduced, creating savings in quality control programs. 5) JIT can reduce quality control costs as much as 60%, but these costs can often be overlooked by financial analysts because JIT prevents defects rather than detecting poor quality (therefore no cost savings are recognized). 6) Elimination of waste—one of the side benefits of a total quality control system coupled with JIT. The Downside of JIT: 1) Some JIT management systems allow for inventory levels as low as 1 hour's worth of parts. The discipline of these levels and the required process has imposed an extraordinary rigour on firms. Such a system requires a substantial expenditure on computer systems to coordinate the delivery activity. 2) May be forced to shut down manufacturing plants if parts cannot be delivered by suppliers due to weather or other disruptions. The cost is lost business. 7-50 Chapter 07 - Current Asset Management Accessibility: Keyboard Navigation Blooms: Understand Difficulty: Hard Learning Objective: 07-05 Assess inventory as an investment and apply techniques to reduce the costs of this investment. Topic: 07-22 Just-in-Time Inventory Management 144. Mountain Home Systems, Inc. is a well-known and reputable supplier of integrated circuits to manufacturers of telecommunications devices. The firm is currently debating whether to expand its sales to car-telephone manufacturers. While the firm expects an extra $2 million in sales if it enters this market, it also knows that 15% of its sales will ultimately be uncollectible. In addition, collection costs will be 2% on all new sales and the firm's production costs are 72% of sales. Selling expenses are 8% of sales and Mountain Home has an opportunity cost of funds (before tax) of 20%. Mountain Home can turn its receivables 4 times per year. Should Mountain Home Systems Co. enter the car telephone manufacturer market? Incremental sales Incremental contribution margin (100 – 72) % Incremental selling expense Incremental bad debts (uncollectables) 15% Incremental collection costs 2% Incremental accounts receivable $2,000,000 $560,000 (160,000) (300,000) (40,000) $2,000,000/4 $500,000 Incremental opportunity cost on investment in accounts receivable 20% Total incremental change No, Mountain Home Systems should not enter this market. 7-51 (100,000) $(40,000) Chapter 07 - Current Asset Management Accessibility: Keyboard Navigation Blooms: Apply Difficulty: Medium Learning Objective: 07-04 Characterize accounts receivable as an investment resulting from the firm's credit policies; outline the considerations in granting credit; and evaluate a credit decision that changes credit terms to stimulate sales. Topic: 07-15 An Actual Credit Decision 145. Tanner Co. is a highly successful supplier of leather to manufacturers of leather goods. Tanner is considering expanding into the luxury auto seat market. It is estimated that although selling leather to auto manufacturers will bring additional annual sales of $700,000, a high 12% of those accounts will be uncollectible. The cost of conditioning and selling the leather is 70% of sales. Tanner has a receivables turnover of 5 times a year and its opportunity cost of funds (before-tax) is 15%. Should Tanner expand into the auto market? Incremental sales Incremental contribution margin (100 – 70) % Incremental selling expense Incremental bad debts (uncollectables) 15% Incremental collection costs 2% Incremental accounts receivable Incremental opportunity cost on investment in accounts receivable 20% Total incremental change Tanner Co. should expand into this market. 7-52 $2,000,000 $560,000 (160,000) (300,000) (40,000) $2,000,000/4 $500,000 (100,000) $(40,000) Chapter 07 - Current Asset Management Accessibility: Keyboard Navigation Blooms: Apply Difficulty: Hard Learning Objective: 07-04 Characterize accounts receivable as an investment resulting from the firm's credit policies; outline the considerations in granting credit; and evaluate a credit decision that changes credit terms to stimulate sales. Topic: 07-15 An Actual Credit Decision 7-53 Chapter 07 - Current Asset Management 146. Novelty Gifts, Inc. is experiencing some inventory control problems. The manager, Wanda LaRue, currently orders 5,000 units four times each year to handle annual demand of 20,000 units. Each order costs $15 and each unit costs $1.50 to carry. Ms. LaRue maintains a safety stock of 200 units. A) What is Novelty Gifts' current total annual inventory cost? B) Calculate the economic ordering quantity (EOQ). C) What is average inventory under EOQ if Ms. LaRue maintains a safety stock of 200 units? D) Calculate total annual inventory cost under EOQ. A) B) C) D) 7-54 Chapter 07 - Current Asset Management Blooms: Apply Difficulty: Hard Learning Objective: 07-05 Assess inventory as an investment and apply techniques to reduce the costs of this investment. Topic: 07-20 The Inventory Decision Model 147. The Milling Corp. has developed a new type of widget. The local distributor expects to increase his sales by 20% over the past year due to this new development. Last year's sales were $50,000 at a selling price of $100 per unit. The manager would like to cut costs as much as possible and comes to you for advice. Relevant cost information includes: Warehouse space Material handling expense Insurance premium Total ordering cost $.50/unit $1.50/unit $1.00/unit $100.00/per order 7-55 Chapter 07 - Current Asset Management A) What is the economic order quantity? B) What is the amount of average inventory? C) How many orders will be made per year? D) What is the total cost of this inventory decision? A) B) 155/2 = 77.5 units C) D) 7-56 Chapter 07 - Current Asset Management Blooms: Apply Difficulty: Hard Learning Objective: 07-05 Assess inventory as an investment and apply techniques to reduce the costs of this investment. Topic: 07-20 The Inventory Decision Model 148. Linkup Systems, which provides investors with computerized information about stock prices, is considering the establishment of a lockbox system with its bank. The firm receives daily remittances of $1.5 million, and could earn 9% on any funds freed up through faster collections. If the lockbox system can save 2 days in the collection process, and the firm's bankers will charge $200,000 per year to operate the lockbox system, is it worth it to establish the system? Average daily remittances X days saved in collection Freed-up cash balance X earnings on cash balances Additional earnings from establishing lockbox system Less: operating costs Net gain from lockbox system $1,500,000 x2 3,000,000 x 9% 270,000 200,000 $70,000 It will be worthwhile to establish the lockbox system. Accessibility: Keyboard Navigation Blooms: Apply Difficulty: Medium Learning Objective: 07-02 Examine cash management as the control of receipts and disbursements to minimize nonearning cash balances while providing liquidity; and compare techniques to make cash management more efficient. Topic: 07-05 Float 7-57