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1. What are the 4 elements of a firm’s credit policy? To what extent can firms set their
own credit policies as opposed to having to accept policies that are dictated by “the
competition”? (15.6)

a. Discounts: Lowers price. Attracts new customers and reduces DSO.

b. Credit Period: How long to pay? Shorter period reduces DSO and average
A/R, but it may discourage sales.

c. Credit Standards: Tighter standards tend to reduce sales but reduce bad
debt expenses. Fewer bad debts reduce DSO.

a. Collection Policy: How tough? A tougher policy will reduce DSO but may
damage customer relationships.

2. Using a 360-day year, calculate the DSO for a firm with annual sales of $2,880,000
and accounts receivable of $312,000.

Is it true that if this firm sells on terms of (cash discount) 3/10 net 40, its customers
probably all pay on time? (15.8)

A. DSO = Receivables/(Sales/days)

39 = 312,000/ (2,880,000/360)

Therefore, DSO is 39 days.

B. Yes, the customers will because they are already paying within the 39
days.

It appears that most customers pay on time because they pay within 39 days, but
this does not mean that all customers are paying on time. In fact, it is likely that
some customers are not because some customers are taking the trade discount
and paying on the 10th day.
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7. Baker Brothers has a DSO of 40 days. The company’s annual sales are $7,300,000.

What is its level of accounts receivable? (Assume a year of 365 days)

a. Receivables/ ($7,300,000/ 365) = 40

Receivables/ $20,000 = 40

Receivables =$ 20,000 * 40 = $800,000

6. The Zocco corporation has an inventory conversion period of 75 days, a receivables

collection period of 38 days, and a payables deferral period of 30 days.

Assume 365 days/yr.

What is the length of the firm’s cash conversion cycle?

Its annual sales are $3,421,827 and all sales are on credit.

a. What is the firm’s accounts receivable?

b. How many times per year does it turn over its inventory? (15-8)

GIVEN: ICP = 75; DSO = 38 DYS; PDP = 30 DYS

Part A. Cash Conversion Cycle = ICP + DSO – PDP

= 75 days + 38 days – 30 days

= 83 days
Using 365 days a year
Average sales per day = 3,421,827 / 365 = $9,375

Accounts Receivables = 9,375 * 38 days

AR = $356,250

PART B. Inventory Turnover Ratio

= Number of days in a year/ Inventory conversion period

4.87 = 365/ 75

Therefore, ITR 4.87.

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4. ABC Manufacturing Co. makes 1500 automobile batteries/day, at a cost of $6/battery

for materials and labour. It takes 22 days to convert raw materials into a battery.

The firm gives its customers 40 days credit and pays its suppliers in 30 days.

(i) If it produces 1,500 batteries/day, how much working capital must it finance?

Cash Conversion Cycle = ICP + DSO – PDP

= 22 + 40 - 30
= 32 days

Working capital financing = batteries produced x CCC x Cost

= 1500 x 32 x $6 = $288,000

(ii) If its payables deferral period was extended to 35 days, by how much could it
reduce the working capital financing requirements? (15-7)

PDP Increased by 5 days so CCC would decrease by 5 days.

Decrease in WCF = 1500 x 5 x $6

= $45,000

New Working Capital Financing = batteries produce x new CCC x cost

= 1500 x 27 x $6 = $243,000

Old WCF - New WCF

$288,000 - $243,000 = $45,000

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1. Complete the following balance sheet using the given information: Debt ratio =50%.
Total assets turnover = 1.5, current ratio =1.8, DSO = 36.5 days, gross profit margin
on sales [(sales – cost of goods sold)/sales] = 25%, Inventory turnover ratio = 5.
(3.21)

ASSETS ($) LIABILITIES & EQUITY ($)

Cash Accounts Payable

Accounts Receivable Long Term Debt 60,000
Inventories Common Stock
Fixed Assets __________ Retained Earnings 97,500
Total Assets 300,000 Total Liabilities & Equity ………..
Sales Cost of Goods Sold

Complete the following balance sheet using the given information:

Debt ratio =50%

Total assets turnover = 1.5,
Current Ratio =1.8, DSO = 36.5 days,
Gross profit margin on sales [(sales – cost of goods sold)/sales] = 25%,
Inventory turnover ratio = 5. (3.21)

ASSETS ($) LIABILITIES & EQUITY ($)

Cash 49,500 Accounts Payable 90,000

Accounts Receivable 45,000 Long-Term Debt 60,000
Inventories 67,500 Common Stock 52,500
Fixed Assets 138,000 Retained Earnings 97,500
Total Assets 300,000 Total Liabilities & Equity 300,000
Sales 450,000 Cost of Goods Sold 337,500

Total Debt
Debt Ratio = Total Debt / Total Asset = 50%
Total Debt/ 300,000 = 50%
Total Debt = 300,000 x 50%
Total Debt = 150,000

Accounts Payable
Total Debt = Account Payable + Long Term Debt
150,000 = Accounts Payable + 60,000
Account Payable = 90,000
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Current Assets
Current Ratio = Current Assets/ Current Liabilites = 1.8
Current Assets/ 90,000 = 1.8
Current Assets = 90,000 x 1.8
Current Assets = 162,000

Sales
Asset Turnover = Sales/ Total Assets = 1.5
TAT = Sales/ TA =1.5
Sales/ 300,000 = 1.5
Sales = 300,000 x 1.5
Sales = 450,000

Receivables
DSO = AR / (AVG. DAILY SALES/365) = 36.5 DAYS
Receivables/ 450,000/ 365) = 36.5
Receivables/ 1,232.88 = 36.5
Receivables = 1,232.88 x 36.5
Receivables = 45,000

GPM = 25%
(Sales – Cost of Goods Sold) / Sales = 25%
450,000 – Cost of Goods Sold / 450,000 = 25%
450,000 – Cost of Goods Sold = 450,000 x 25%
450,000 – COGS = 112,500
COGS = 337,500

Inventory
Inventory Turnover = COGS / Inventories = 5
Inventory = 337,500 / Inventory = 5
Inventory = 337,500/ 5
Inventory = 67,500

Current Assets
Current Assets = Cash + Inventory + Accounts Receivables = 162,000
Cash + 67,500 + 45,000 = 162,000
Cash = 162,000 – 113,125
Cash = 49,500
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3. The Ace Co. Ltd is trying to establish a current assets policy. It has fixed assets of
$600,000 and the firm plans to maintain a debt ratio of 50%. The interest rate on its
debt is 10%. Three alternative current asset policies are under review: 40% 50% and
60% of projected sales. The firm expects to earn 15% before interest and taxes on
sales of $3 million. Its tax rate is 40%.

What is the expected ROE for each alternative? (Ch.16 ST-2)

1. Current Asset policy at 40%:

Step 1: Sales = $3,000,000

Step 2: Current assets = 0.40 * $3,000,000 = $1,200,000

Fixed Assets = $600,000, Therefore Total assets = $1,800,000

Debt Ratio = .50

Step 3: Debt = .50 * $1,800,000 = $900,000
Step 4: Interest on debt = $900,000 * .10 = $90,000
Step 5: Earnings before interest and tax = .15 * $3,000,000 = $450,000
Step 6: Earnings before interest = $450,000 - $90,000 = $360,000

Step 7: Earnings after tax = $216,000 (TAX RATE 40%)

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Return on Equity = Net Income/ Equity

ROE = 216,000/900,000 = 0.24 or 24%

Question 3 continued

2. Current Asset policy at 50%:

Step 1: Sales = 3,000,000

Step 2: Current assets = 0.50*3,000,000 = $1,500,000
Fixed Assets = $600,000, Therefore Total assets = $2,100,000

Debt Ratio = .50

Step 3: Debt = .50 * 2,100,000 = $1,050,000
Step 4: Interest on debt = 1,050,000* .10 = $105,000
Step 5: Earnings before interest and tax = .15 * $3,000,000 = $450,000
Step 6: Earnings before interest = $450,000 - 105,000 = $345,000

Step 7: Earnings after tax = $207,000 (TAX RATE 40%)

Return on Equity = Net income/ Equity

ROE = 207,000/1,050,000 = 0.197 or 19.7%

Question 3 continued

3. Current Asset policy at 60%:

Step 1: Sales = $3,000,000

Step 2: Current assets = 0.60 * $3,000,000 = $1,800,000

Fixed Assets = $600,000, Therefore Total assets = $2,400,000

Debt Ratio = .50

Step 3: Debt = .50 * $2,400,000 = $1,200,000
Step 4: Interest on debt = $1,200,000 * .10 = $120,000
Step 5: Earnings before interest and tax = .15 * $3,000,000 = $450,000
Step 6: Earnings before interest = $450,000 - $120,000 = $330,000

Step 7: Earnings after tax = $198,000 (TAX RATE 40%, therefore find 60% of earnings)

Return on Equity = Net income/Equity

ROE = 198,000/1,200,000 = 0.165

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1. Harrelson Inc. currently has $750,000 in accounts receivable. Its days sales outstanding
(DSO) is 55 days. It wants to reduce its DSO to the industry average of 35 days by
pressuring customers to pay on time. The Chief Financial Officer (CFO) estimates that
average sales will fall by 15% if the policy is adopted. Assuming the firms achieves the
DSO of 35 days and suffers the 15% sales decline, what will be the new level of accounts
receivable? Assume 1 year =365 days

Given:
# of days in years = 365,
Current – Accounts Receivable $750k
Current DSO = 55 days DSO = Accounts Receivable/ Sales per day
New DSO 35 days
Sales – Decrease by 15%

Accounts Receivable NEW?

STEP 1
DSO = Accounts Receivable/ (Sales per day/365)
55 days = $750,000 / (Sales/ 365)
55 sales = $750,000 * 365
Sales = ($750,000 * 365) / 55 or AS = 750,000/55 = $13,636.40 x 365 days
Annual Sales = $4,977,273
NEW:
15% SALE DECLINE = $4,977,273 * (1-0.15) = $4,230,682
Average sales = $4,230,682/ 365 = $11,591

STEP 2
35 days = Accounts Receivables/ 4,230,682/ 365
35 days = AR/ 11,591
AR = 11,591 x 35
AR = $405,685
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Give two reasons why pressuring customers to pay before the expiry of their credit period is
not a good idea.
______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

(c) What other approaches could the company use to achieve its objective of reducing DSO? What
impact would this have on the company’s financials?

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________
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Seats ‘R’ Us has seen a demand for executive office chairs is 50,000 units per year, at a
steady rate. It costs $25 to place an order, and $0.50 to hold a unit per year. Assume a 52-
week year. The company now wants you to:
(a) find the order size to minimise inventory costs
(b) the number of orders to be placed each year (
c) the length of the inventory cycle
(d) the total cost of holding inventory each year.

SEATS R US – ANSWER

(a) √ (2 x D x Co)/ Ch
√ (2 x 50,000 x 25)/ 0.50
√2,500,000/ 0.50
√5,000,000

EOQ = 2,236 units

(b) the number of orders to be placed each year

 R/q0 = 50,000/ 2236 = 22.36 orders per year (times in year)

(c) the length of the inventory cycle

 q0/R 52 weeks/ 22.36 orders = 2.3 weeks or 0.04 year or 2.33 weeks

(d) the total cost of holding inventory each year. (carrying + ordering)

 carrying cost = q0/2 x C1 2236/ 2 x 0.5 = $559

 ordering cost = R/q0 x C3 50,000/ 2236 x 25 = $559.03

 Total Cost = 559 + 559.03 = $1,118.03

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1. How does collection policy influence sales, the collection period, and bad debt losses?

2. How can cash discounts be used to influence sales volume and the DSO?

3. What are the 4 credit policy variables?

4. Explain Just in Time and Outsourcing as inventory management systems

PREVIOUS SLIDE Q: 1,2,3,4

1. How does collection policy influence sales, the collection period, and bad debt
losses?

a. Collecting payment is arguably more important than making the sale.

Management can reinforce this concept by basing sales commissions on
payments collected rather than invoiced amounts. This also aids the company in
guaranteeing they only pay out bonuses based on what they actually received
during the quarter. Strict collection policies and procedures that encourage
customers to pay can result in fewer bad debts, better cash flows and an increase
in business profitability.

2. How can cash discounts be used to influence Sale Volume (SV) and the Days Sales
Outstanding (DSO)?

a. Cash discounts benefit the seller because they increase the likelihood that a
buyer will pay quickly. Cash discounts therefore provide the seller with
cash faster; at times, it can be better to receive 95% of an invoice within a
few days for example, rather than wait 30 or more days to receive the full
amount.

3. What are the 4 credit policy variables?

1. Cash Discounts,
2. Credit Period,
3. Credit Standards and
4. Collection Policy
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4. Explain Just in Time and Outsourcing as inventory management systems?

a. A just-in-time (JIT) inventory system is a management strategy that has

a company receive goods as close as possible to when they are actually
needed. So, if a car assembly plant needs to install airbags, it does not
keep a stock of airbags on its shelves but receives them as those cars
come onto the assembly line, while Outsourcing is a system of buying the
products or components from outside vendors rather than
manufacturing internally.

1. Maco Ltd stocks a single item and has an inventory management policy which involves
ordering 50,000 units when inventory levels fall to 15,000 units. Forecast demand to
meet production requirements during the next year is 310,000 units. Demand is constant
throughout the year and orders are received 2 weeks after being placed with its suppliers.
Assume a 50-week year.

(a) Maco has now commissioned you to forecast its average inventory level.
The demand per week is 310,000 / 50 = 6,200 units.

Given that it takes two weeks for an order to arrive, during this time they will sell 2
x 6,200 = 12,400 units.

They place an order when they have 15,000 units in inventory, and so immediately
before the new order arrives, they will have 15,000 – 6,200 = 8,800 units.

The new order then arrives and so they will then have 8,800 + 50,000 = 58,800 units,
and this is the maximum inventory level (because from then on they will be selling
units and the inventory level will fall until it gets to 15,000 when they will then
places another order).
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2. SAME AS THE HARRELSON INC. QUES.

Cosoom Ltd currently has $750,000 in accounts receivables. Its DSO is 55 days. It
wants to reduce its DSO to an industry average of 35 days by pressuring customers to
pay on time. The Chief Financial Officer (CFO) estimates that average sales will fall by
15% if the policy is adopted.

Assuming that the firm achieve its DSO target and consequently suffers the 15%
decline in sales.

Assume a 365-day year.

(a) What will be the new level of accounts receivable?
(b) Give two reasons why pressuring customers to pay before the expiry of their
credit period is not a good idea.
(c) What other approaches could the company use to achieve its objective of
reducing DSO? What impact would this have on the company’s financials?
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3. Emblem Manufacturing Company Ltd has

$6,000,000 in sales, an
ROE of 12% and
total asset turnover of 3.2 times.
The company is 50% equity financed.
(a) What is the company’s debt ratio?
Debt Ratio = Total Dedt / Total Assets = 50%
$6,000,000 x .50 = ?
(b) What is its net income?
TATO = Sales/ TA
3.2 = $6,000,000/ TA
TA = $1,875,000

Equity= $1,875,000 * .50 = $937,500

ROE = (NI/S) TATO (TA/E)
0.12 = (NI / $6,000,000) 3.2 ($1,875,000/ $937,500)
0.12 = (NI / $6,000,000) * 6.4
NI = $112,500

We can use the following formula to compute the net income of Ebersoll Mining:

 net income = total equity * ROE

The formula can be further expanded as

 net income = (sales / asset turnover ratio) * equity ratio * ROE

 net income = (6,000,000 / 3.2) * 50% * 12%
 net income = $112,500