CMA Part 2
Financial Decision Making
SU 4 - Managing Current Assets and
SU 4.1 – Working Capital
Concept
The basic components of an organization’s
working capital are cash, marketable securities,
accounts receivable, and inventory.
Working capital finance concerns the optimal
level, mix, and use of current assets and the
means used to acquire them, notably current
liabilities.
SU 4.1 – Working Capital
The objective is to minimize the cost of
maintaining liquidity while minimizing the risk of
insolvency.
In this section we will be looking at working
capital and the management of each of these
components.
SU- 6.1 – Working Capital
What is working capital and types of capital
policies?
1. What all is included in working capital?
Working capital (or current capital) generally refers to the
funds a company holds in current (short-term) asset
accounts, and includes cash, marketable securities,
receivables, and inventories.
SU 4.1 – Working Capital
2. What is “Net” working capital?
Net working capital provides a measure of immediate
liquidity and indicates how much cash a firm has available
to sustain and build its business, and refers specifically
(from an accounting perspective ) to the difference
between a firm’s current assets and its current liabilities.
Depending on a firm’s level of current liabilities, the
number may be positive or negative.
SU 4.1 – Working Capital
Working Capital policies include:
1. Conservative = minimize risk = Higher current ratio &
acid test ratio
A conservative working capital management policy focuses on
low-risk, low return working capital investment and financing. A
conservative policy places a greater proportion of capital in
liquid assets but at the sacrifice of some profitability.
Conservative policy uses higher-cost capital but postpones the
principal repayment of debt or avoids it entirely by using equity.
With a conservative policy, current assets will be much greater
than current liabilities.
So if you did not “conserve” current assets what would you do with them?
SU 4.1 – Working Capital
2. Aggressive = more (max) risk = Lower current ratio &
acid test ratio
An aggressive working capital management policy focuses on
high profitability potential, despite the cost of high risk and low
liquidity. Aggressive asset management results in capital being
minimized in current assets versus long-term investments.
Aggressive financing policies include higher levels of lower-cost
short-term debt and less long-term capital investments.
Although this lowers capital costs, it increases the risk of shortterm liquidity problems. With an aggressive policy, current
assets will be less than current liabilities.
You ultimately accept a higher risk of short-term cash-flow problems
SU 4.1 – Working Capital
3. Moderate = average risk =
A moderate (or matching) working capital management
policy uses risk and return and financing strategies that
match the maturity of the assets with the maturity of the
financing. The hedging approach to financing involves
matching maturities of debt with specific financing needs.
A moderate policy seeks a balance between current assets
and current liabilities.
SU 4.1 – Working Capital
• What is the optimal level of working capital?
– Varies with industry!
– Contrast a grocery chain which has to rotate its
inventory and probably has no receivables versus
a manufacturer
– Consequently ratios are only meaningful in terms
of norms and trends and relative its competitors
or the industry it which it operates
SU 4.1 – Working Capital
• Permanent and Temporary Working Capital
– Def. – The minimum level of current assets
maintained by a firm (which could fluctuate with
seasonality).
– It should increase as the company grows
– Permanent financed with long-term debt
• Why not short-term debt?
– Timing, incr. interest rates, uncertainty of loans
SU 4.1 – Working Capital
Remember!
– What is used to acquire working capital?
• Long-term vs. short-term sources
– What is the objective of having working capital?
• Minimize the cost of maintaining liquidity while
guarding against the risk of insolvency
SU 4.1 – Practice Question 1
Question 1 - CMA2 Study Unit 6:
Managing Current Assets
During the year, Mason Company’s
current assets increased by $120,000,
current liabilities decreased by
$50,000, and net working capital
A.
B.
C.
Increased by $70,000.
Did not change.
Decreased by $170,000.
D.
Increased by $170,000.
SU 4.1 – Practice Question 1 Answer
• Correct Answer: D
Net working capital is the excess of current assets over current liabilities.
An increase in current assets or a decrease in current liabilities increases
working capital. Thus, net working capital increased by $170,000
($120,000 + $50,000).
Incorrect Answers:
A: Both the increase in current assets and the decrease in current
liabilities increase working capital.
B: Net working capital did change.
C: Net working capital increased.
SU 4.1 – Practice Question 2
Question 2 - CMA2 Study Unit 6: Managing Current Assets
Mason Company’s board of directors has determined 4 options to
increase working capital next year. Option 1 is to increase current
assets by $120 and decrease current liabilities by $50. Option 2 is to
increase current assets by $180 and increase current liabilities by $30.
Option 3 is to decrease current assets by $140 and increase current
liabilities by $20. Option 4 is to decrease current assets by $100 and
decrease current liabilities by $75. Which option should Mason
choose to maximize net working capital?
A.
B.
C.
D.
Option 1.
Option 2.
Option 3.
Option 4.
SU 4.1 – Practice Question 2 Answer
• Net working capital is the excess of current assets over current
liabilities. An increase in current assets or a decrease in current
liabilities will increase net working capital. Option 1 maximizes
Mason Company’s net working capital, increasing it by $170 ($120 +
$50).
Incorrect Answers:
B: Option 2 increases net working capital by $150.
C: Option 3 decreases net working capital by $160.
D: Option 4 decreases net working capital by $25.
SU 4.1 – Practice Question 3
Question 3 - CMA2 Study Unit 6:
Managing Current Assets
Starrs Company has current assets
of $400,000 and current liabilities
of $300,000. Starrs could increase
its net working capital by the
A.
B.
C.
D.
Prepayment of $50,000 of next year’s
rent.
Refinancing of $50,000 of short-term
debt with long-term debt.
Acquisition of land valued at $50,000
through the issuance of common
stock.
Purchase of $50,000 of trading
securities for cash.
SU 4.1 – Practice Question 3 Answer
•
Correct Answer: B
Net working capital is defined as the excess of current assets over current
liabilities. Refinancing short-term debt with long-term debt decreases current
liabilities with no effect on current assets, resulting in an increase in working
capital.
Incorrect Answers:
A: A prepayment of expenses does not change current assets or current
liabilities. Cash decreases by the same amount that prepaid rent increases.
C: The acquisition of land (a noncurrent asset) for common stock (an equity
interest) does not affect either current assets or current liabilities.
D: The purchase of trading securities does not affect total current assets. Cash is
replaced by trading securities, another current asset.
SU 4.1 – Practice Question 4
Question 4 - CMA2 Study Unit 6:
Managing Current Assets
If a firm increases its cash balance by
issuing additional shares of common
stock, net working capital
A.
Remains unchanged and the current ratio
remains unchanged.
B.
Increases and the current ratio remains
unchanged.
C.
Increases and the current ratio decreases.
D.
Increases and the current ratio increases.
SU 4.1 – Practice Question 4 Answer
Correct Answer: D
Net working capital is the excess of current assets over current liabilities. The current
ratio equals current assets divided by current liabilities. Selling stock for cash increases
current assets and stockholders’ equity, with no effect on current liabilities. The result is
an increase in working capital and the current ratio.
Incorrect Answers:
A: Both working capital and the current ratio increase.
B: Both working capital and the current ratio increase.
C: Both working capital and the current ratio increase.
SU 4.2 – Cash Management
• Read Gleim Success Tip on page 160
SU 4.2 – Cash Management
Concept
Cash management describes the collective activities
by which a corporation administers and invests its
cash. The primary goal of cash management is to
use cash as efficiently as possible and in a manner
that is consistent with the firm’s strategic objectives
and risk management profile.
To maintain the firm’s optimal cash balance
SU 4.2 – Cash Management
• Managing the cash levels
– What are the motives for holding cash?
• Transactional
• Precautionary
• Speculative
– What is the firms optimal cash?
• Economic Order Quantity (EOQ) – As applied to cash (as
opposed to inventory)
• Questions you will have answer
– How much cash
– Transaction cost
– Return on marketable securities
SU 4.2 – Cash Management
• Review examples
– Forecasting future cash flows (see examples on
page 161, very typical test questions!)
SU 4.2 – Cash Management
Cash management techniques
1.
Speeding up cash collections
A collection system is the set of banking arrangements and processing procedures
used to process customer payments and gather incoming cash. A firm’s collection
system affects the timing of cash inflows. Firms generally attempt to speed up
cash collections by reducing collection float. Collection float is the time interval
between when the maker mails a check and when the funds are available for the
receiving firm to use.
Collection float has three components:
1. Mail float. The time between when a check is mailed and when it is received by
the payee or a processing site
2. Processing float. The time between when the payee or processing site receives
a check and when it is deposited at a financial institution
3. Availability float. The time interval between when the check is deposited and
when the firm’s account is credited with the collected funds
SU 4.2 – Cash Management
In attempting to reduce collection float,
important considerations include the optimal
number and location of collection points,
whether to use a lockbox system or an
electronic payment system, and how to manage
the concentration banking system.
SU 4.2 – Cash Management
• Collections Points - The more collection points
available, the shorter the collection float,
especially if collection points are closer to
customers or near Federal Reserve banks (for
faster check-clearing purposes).
• Lockbox System - A lockbox system is an
arrangement between a firm and a banking
institution in which all deposits are received
directly by the bank and immediately deposited
into the firm’s account.
SU 4.2 – Cash Management
• Lockbox benefit analysis
Net Benefit from Lockbox = Reduction in Float
Opportunity Cost + Reduction in Internal Processing Costs
- Lockbox Processing Costs
See example question #7 on page 179
SU 4.2 – Cash Management
• An electronic payment system – Will facilitate
a payment or a transfer in an electronic
format. Because electronic systems bypass
mail and manual processing, they can
guarantee funds availability on the payment
date. In the United States, two of the primary
electronic payment methods are the
automated clearing house system and
Fedwire.
SU 4.2 – Cash Management
• Review examples
– See examples of how to speed up cash flows (see example 1 & 2 page
162)
SU 4.2 – Cash Management
2. Slowing cash Payments through a disbursement system
– A disbursement system is the set of banking arrangements,
payment mechanisms, and processing procedures used to
disburse funds to employees, vendors, suppliers, tax agencies,
and other payees (e.g., shareholders and/or bondholders).
– A firm’s disbursement system affects the timing of cash outflows
and disbursement float. Disbursement float is the time interval
between when the maker mails a check and when funds are
deducted from the maker’s account.
– Disbursement float has three components.
1.
2.
3.
Mail float
Processing float
Clearing float
SU 4.2 – Cash Management
1. Mail float – How and by which means can we
slow down receipt of the check?
2. Processing float – How by which means can
we slow down the processing of a pmt
a) Draft
b) PTD – Payable through draft
3. Clearing float - the time interval between
when the check is deposited by the payee
and when the firm’s account is debited
Cash Management Question 1
Question 1 - CMA2 Study Unit 6:
Managing Current Assets
The economic order quantity
(EOQ) formula can be adapted in
order for a firm to determine the
optimal split between cash and
marketable securities. The EOQ
model assumes all of the
following except that
A.
The cost of a transaction is independent of the
dollar amount of the transaction.
B.
Interest rates are constant over the short run.
C.
D.
There is an opportunity cost associated with
holding cash, beginning with the first dollar.
Cash flow requirements are random.
Cash Management Answer 1
•
Correct Answer: D
The EOQ formula is a deterministic model that requires a known demand for
inventory or, in this case, the amount of cash needed. Thus, the cash flow
requirements cannot be random. The model also assumes a given carrying
(interest) cost and a flat transaction cost for converting marketable securities to
cash, regardless of the amount withdrawn.
Incorrect Answers:
A: Use of the EOQ model assumes that the cost of a transaction is independent
of the dollar amount of the transaction.
B: Use of the EOQ model assumes that interest rates are constant over the short
run.
C: Use of the EOQ model assumes that there is an opportunity cost associated
with holding cash, beginning with the first dollar.
Cash Management Question 2
Question 2 - CMA2 Study Unit 6:
Managing Current Assets
What is the benefit for a firm with daily
cash receipts of $15,000 to be able to
speed up collections by 2 days, assuming
an 8% annual return on short-term
investments and no cost to the company
to speed up collections?
A.
B.
C.
D.
$2,400 daily benefit.
$2,400 annual benefit.
$15,000 annual benefit.
$30,000 annual benefit.
Cash Management Answer 2
• Correct Answer: B
Speeding up collections by 2 days will raise the firm’s average cash
balance by $30,000. At 8% interest, the benefit will be $2,400
annually [($15,000 × 2 days) × .08].
Incorrect Answers:
A: This figure is the annual, not the daily, benefit.
C: This figure is the amount of daily cash receipts.
D: This figure is the reduction in receivables.
Cash Management Question 3
Question 3 - CMA2 Study Unit 6: Managing Current Assets
DLF is a retail mail order firm that currently uses a central
collection system that requires all checks to be sent to its
Boston headquarters. An average of 6 days is required for
mailed checks to be received, 3 days for DLF to process
them, and 2 days for the checks to clear through its bank. A
proposed lockbox system would reduce the mailing and
processing time to 2 days and the check clearing time to 1
day. DLF has an average daily collection of $150,000. If DLF
adopts the lockbox system, its average cash balance will
increase by
A.
B.
C.
D.
$1,200,000
$750,000
$600,000
$450,000
Cash Management Answer 3
• Correct Answer: A
Checks are currently tied up for 11 days (6 for mailing, 3 for processing,
and 2 for clearing). If that period were reduced to 3 days, DLF’s cash
balance would increase by $1,200,000 ($150,000 per day × 8 days).
Incorrect Answers:
B: The decrease is 8 days, not 5.
C: The amount of $600,000 represents only a 4-day savings.
D: The lockbox system will result in an additional 8 days of savings, not 3
Cash Management Question 4
Question 4 - CMA2 Study Unit 6: Managing Current Assets
A firm has daily cash receipts of $300,000. A commercial
bank has offered to reduce the collection time by 2 days.
The bank requires a monthly fee of $3,000 for providing
this service. If the money market rates will average 11%
during the year, the annual pretax income (loss) from using
the service is
A.
B.
C.
D.
$(30,000)
$30,000
$66,000
$63,000
Cash Management Answer 4
Correct Answer: B
The additional annual income (loss) from using the
bank’s proposed service is the excess (deficit) of
interest earned on the early deposits over (under)
the cost of the service. If the plan is adopted, the
firm’s average cash balance will increase by
$600,000 ($300,000 × 2 days).
Benefit (loss) = Interest earned – Cost
= ($600,000 × 11%) – ($3,000 × 12 months)
= $66,000 – $36,000
= $30,000
Incorrect Answers: A: This figure results
from subtracting the interest earned
from the cost. C: This figure results
from failing to subtract the $36,000 cost
of the service. D: This figure results
from subtracting the service charge for
only a single month.
SU 4.3 – Marketable Securities
Management
• Corporations need cash to meet their ongoing
financial obligations. Although some amount of
cash reserves is prudent, holding an excessive
level involves several costs.
• Holding too much cash idle in bank accounts not
only incurs maintenance costs but also results in
a loss of potential interest income. That is why
companies hold a short-term investment
portfolio of interest-earning marketable
securities.
SU 4.3 – Marketable Securities
Management
• Definition – Marketable securities are
investments that mature in a year or less.
They generally are classified as short-term
investments (although balance sheet
accounting differentiates securities with
original maturities of three months or less as
cash equivalents and those maturing in a year
or less as short-term investments).
SU 4.3 – Marketable Securities
Management
• Consideration in Marketable Securities
1.
2.
3.
4.
5.
Safety
Marketability
Yield
Maturity
Taxability
SU 4.3 – Marketable Securities
Management
• Types of Marketable Securities
– U.S. Treasury obligations
• T-bills - do not bear interest; sold at a discount and
mature to face value in one year or less.
• T-notes - bear interest semiannually; mature within one
to ten years.
• T-bonds - similar to T-notes but have maturities longer
than ten years; generally not purchased for a shortterm portfolio except when the bond is close to
maturity.
SU 4.3 – Marketable Securities
Management
– Repos
• Purchase of a security from another party, usually a bank or
security dealer who agrees to buy it back at a specified date
for a fixed price.
• Commonly involve U.S. Treasury securities as the underlying
security to be repurchased at a rate slightly less than the U.S.
Treasury securities offer.
• Varying maturity, starting with overnight repurchase
agreements.
• Generally considered a relatively safe investment (because
of the government underlier).
• Often transferred to a third party to ensure that securities
are available for sale if the issuer defaults.
SU 4.3 – Marketable Securities
Management
– Federal agency securities
• Interest-bearing securities usually offered and
redeemed at face value.
• Generally not backed by the full faith and credit of the
U.S. government but still considered relatively safe
investments and free of default risk.
• Typically smaller issues than treasury securities; not
quite as marketable but still highly liquid.
• Limited tax exposure; many are exempt from state/local
income taxes but not state franchise taxes.
SU 4.3 – Marketable Securities
Management
– Bankers’ acceptances
• Essentially time drafts that result from commercial
trade financing; frequently involve international
transactions.
• Involve a letter of credit “accepted” by a bank; typically
implies the BA is backed by that bank.
• Varying maturities and denominations.
• Liquidity is provided by an active secondary market of
dealers.
SU 4.3 – Marketable Securities
Management
– Commercial paper
• Unsecured short-term loan issued by a corporation.
• Negotiable instrument but typically held to maturity
because of a weak secondary market; typically higher
yield than similar securities because of its low
marketability.
• Maturity ranges from 1 to 270 days.
• May be interest bearing or discounted; usually are
discounted.
• Generally rated by credit rating agencies (e.g., Moody’s
or Standard & Poor’s) to help investors assess risk.
SU 4.3 – Marketable Securities
Management
– CD’s
• Interest-bearing deposits issued by banks or saving and
loan institutions that can be traded in money markets;
generally sold at face value in denominations of $1
million.
• Most mature between one and three months; some
can be for several years.
• Offer fixed and variable interest rates.
• Not guaranteed by the Federal Deposit Insurance
Corporation if in excess of $100,000; therefore, issuing
bank should be investigated carefully.
• Highly marketable if issued by a large, established bank.
SU 4.3 – Marketable Securities
Management
– Others
• Money-market mutual funds – invest in short-term,
low-risk securities
• Short-term securities – by State and local governments
SU 4.3 – Marketable Securities
Management
Remember!
Companies invest in marketable securities for three main
reasons:
1.
2.
3.
Reserve liquidity. To provide a source of near cash (or instant
cash) and cover any working capital imbalances resulting from
insufficient cash inflows or unforeseen cash needs
Controllable outflows. To earn interest on funds that are being
held for predictable downstream cash outflows (such as
interest payments, taxes, dividends, or insurance policies)
Income generation. To earn interest on surplus cash for which
the company has no immediate use
SU 4.3 – Marketable Securities
Management Practice Question 1
Which one of the following is not a
characteristic of a negotiable
certificate of deposit? Negotiable
certificates of deposit
A.
B.
C.
D.
Have a secondary market for investors.
Are regulated by the Federal Reserve
System.
Are usually sold in denominations of a
minimum of $100,000.
Have yields considerably greater than
bankers’ acceptances and commercial
paper.
SU 4.3 – Marketable Securities
Management Practice Question 1 Answer
Correct Answer: D
A certificate of deposit (CD) is a form of savings deposit that cannot be withdrawn
before maturity without incurring a high penalty. A negotiable CD can be traded. CDs
usually have a fairly high rate of return compared with other savings instruments
because they are for fixed, usually long-term periods. However, their yield is less than
that of commercial paper and bankers’ acceptances because they are less risky.
Incorrect Answers:
A: Negotiable CDs do have a secondary market (i.e., they are negotiable).
B: Negotiable CDs are regulated.
C: Negotiable CDs are typically issued in a denomination of $100,000.
SU 4.3 – Marketable Securities
Management Practice Question 2
Hendrix, Inc., is interested in
purchasing a $100 U.S. Treasury bill
and was presented with the following
options:
Due Date
Discount Rate
Option 1
180 days
6%
Option 2
360 days
3.5%
Option 3
120 days
8%
Option 4
240 days
4.5%
If Hendrix wishes to buy the Treasury bill at the lowest
purchasing price, which option should be chosen, assuming
a 360-day year?
A.
Option 1.
B.
Option 2.
C.
Option 3.
D.
Option 4.
SU 4.3 – Marketable Securities
Management Practice Question 2 Answer
Correct Answer: B
To determine the amount of interest the lender will earn, the 3.5%
discount rate is multiplied by the face amount of the Treasury bill. The
interest on this Treasury bill is $3.50 ($100 × 3.5% × 1 year). Thus, the
purchase price is $96.50 ($100 – $3.5).
Incorrect Answers:
A: Option 1 has a purchase price of $97.00.
C: Option 3 has a purchase price of $97.33.
D: Option 4 has a purchase price of $97.00.
SU 4.3 – Marketable Securities
Management Practice Question 3
Assuming a 360-day year, the current
price of a $100 U.S. Treasury bill due
in 180 days on a 6% discount basis is
A.
$97.00
B.
$94.00
C.
$100.00
D.
$93.00
SU 4.3 – Marketable Securities
Management Practice Question 3 Answer
Correct Answer: A
The 6% discount rate is multiplied times the face amount of the Treasury bill to
determine the amount of interest the lender will earn. The interest on this Treasury
bill is $3 ($100 × 6% × .5 year). Thus, the purchase price is $97 ($100 – $3).
Incorrect Answers:
B: The interest is for 180 days, not a full year.
C: The purchase price will always be less than the face value when the Treasury bill
is sold at a discount.
D: The interest rate is 6% per year. The question is based on 180 days or half a year.
SU 4.5 – Receivable Management
• Overview
– A firm must balance default risk and sales
maximization
• Basic Receivable Formulas
– Average collection period (see example on page 224)
– Accounts Rec. – days vs. dollars (see page 224)
• Assessing impact of a credit term change (see
example page 225)
SU 4.5 – Receivable Management
Practice Question 1
Question 1 - CMA2 Study Unit 6: Managing Current
Assets
A change in credit policy has caused an increase in
sales, an increase in discounts taken, a reduction in
the investment in accounts receivable, and a reduction
in the number of doubtful accounts. Based upon this
information, we know that
A.
B.
C.
D.
Net profit has increased.
The average collection
period has decreased.
Gross profit has declined.
The size of the discount
offered has decreased.
SU 4.5 – Receivable Management
Practice Question 1 Answer
An increase in discounts taken accompanied by declines in receivables balances and
doubtful accounts all indicate that collections on the increased sales have been
accelerated. Accordingly, the average collection period must have declined. The
average collection period is a ratio calculated by dividing the number of days in a
year (365) by the receivable turnover. Thus, the higher the turnover, the shorter the
average collection period. The turnover increases when either sales (the numerator)
increase or receivables (the denominator) decrease. Accomplishing both higher sales
and a lower receivables increases the turnover and results in a shorter collection
period.
Incorrect Answers:
A: No statement can be made with respect to profits without knowing costs.
C: No statement can be made with respect to profits without knowing costs.
D: The discount may have been increased, which has led to quicker payments.
SU 4.5 – Receivable Management
Practice Question 2
Question 2 - CMA2 Study Unit 6:
Managing Current Assets
A change in credit policy has caused an
increase in sales, an increase in discounts
taken, a decrease in the amount of bad
debts, and a decrease in the investment
in accounts receivable. Based upon this
information, the company’s
A.
B.
C.
D.
Average collection period has decreased.
Percentage discount offered has
decreased.
Accounts receivable turnover has
decreased.
Working capital has increased.
SU 4.5 – Receivable Management
Practice Question 2 Answer
Correct Answer: A
An increase in discounts taken accompanied by declines in receivables balances and doubtful
accounts all indicate that collections on the increased sales have been accelerated. Accordingly,
the average collection period must have declined. The average collection period is a ratio
calculated by dividing the number of days in a year (365) by the receivable turnover. Thus, the
higher the turnover, the shorter the average collection period. The turnover increases when
either sales (the numerator) increase, or receivables (the denominator) decrease.
Accomplishing both higher sales and a lower receivables increases the turnover and results in a
shorter collection period.
Incorrect Answers:
B: A decrease in the percentage discount offered provides no incentive for early payment.
C: Accounts receivable turnover (sales ÷ average receivables) has increased.
D: No information is given relative to working capital elements other than receivables. Both
receivables and cash are elements of working capital, so an acceleration of customer payments
will have no effect on working capital.
SU 4.5 – Receivable Management
Practice Question 3
Question 3 - CMA2 Study Unit 6:
Managing Current Assets
Clauson, Inc., grants credit terms of
1/15, net 30 and projects gross sales for
next year of $2,000,000. The credit
manager estimates that 40% of their
customers pay on the discount date,
40% on the net due date, and 20% pay
15 days after the net due date. Assuming
uniform sales and a 360-day year, what
is the projected days’ sales outstanding
(rounded to the nearest whole day)?
A.
B.
C.
D.
20 days.
24 days.
27 days.
30 days.
SU 4.5 – Receivable Management
Practice Question 3 Answer
Correct Answer: C
The days’ sales outstanding can be determined by weighting the collection
period for each group of receivables by its collection percentage. Hence, the
projected days’ sales outstanding equal 27 days [(15 days × 40%) + (30 days ×
40%) + (45 days × 20%)].
Incorrect Answers:
A: Average receivables are outstanding for much more than 20 days.
B: Twenty-four days assumes 40% of receivables are collected after 15
days and 60% after 30 days.
D: More receivables are collected on the 15th day than on the 45th day;
thus, the average must be less than 30 days.
SU 4.5 – Receivable Management
Practice Question 4
Question 4 - CMA2 Study Unit 6:
Managing Current Assets
A firm averages $4,000 in sales per day
and is paid, on an average, within 30
days of the sale. After they receive their
invoice, 55% of the customers pay by
check, while the remaining 45% pay by
credit card. Approximately how much
would the company show in accounts
receivable on its balance sheet on any
given date?
A.
B.
C.
D.
$4,000
$48,000
$54,000
$120,000
SU 4.5 – Receivable Management
Practice Question 4 Answer
Correct Answer: D
The average balance of receivables is $120,000 ($4,000 × 30 days). Whether
customers pay by credit card or check, collection requires 30 days.
Incorrect Answers:
A: The amount of $4,000 is only 1 day’s sales.
B: Invoices are outstanding for 30 days, not 12 days.
C: The amount of $54,000 is based on the 45% of collections via credit
card.
SU 4.6 Inventory Management
• Overview
– Understanding inventory management requires an
understanding of these basic inventory control terms:
– Stock – All the goods a company stores and represents
a supply that is kept for future use.
– Inventory – List of all the items held in stock.
– An item is a single type of product kept in stock or one
entry in the inventory.
– A unit is the standard size or quantity of a stock item.
SU 4.6 Inventory Management
• Inventory management refers to the process
of determining and maintaining the required
level of inventory that will ensure that
customer orders are properly filled on time.
Inventory management requires that the
organization answer three additional
questions. They are:
1. What to order (or make)?
2. When to order (or make)?
3. How much to order (or make)?
SU 4.6 Inventory Management
• Reasons for carrying inventory include:
– Hedging against supply uncertainty
– Hedging against demand uncertainty
– Ensuring that operations are not interrupted (ref.
JIT)
SU 4.6 Inventory Management
• Inventory control (or stock control) refers to
the collective activities and procedures that
ensure that the right amount of each item is
held in stock.
– Inventory control requires that the organization be
able to answer three questions.
They are:
1. What do we have?
2. How much do we have?
3. Where is it?
SU 4.6 Inventory Management
• Inventory costs
– Purchase cost – actual invoice amounts
– Carrying cost incl.
•
•
•
•
•
•
•
•
Storage
Insurance
Security
Inventory taxes
Depreciation or rent
Interest
Obsolescence and/or spoilage
Opportunity cost
Continued
SU 4.6 Inventory Management
• Inventory costs
– Ordering costs - include the marginal costs of placing a
purchase or production order. They are the marginal cost
of computer time to prepare orders and the cost of the
supplies used to generate an order. Fixed costs of ordering,
such as salaries, are irrelevant.
– Stockout costs are the opportunity cost of missing a
customer order, which could include expediting a special
shipment.
See example on page 226
SU 4.6 Inventory Management
• Inventory Replenishment Models
– With Certainty
Average daily demand X Lead time in days
– Without Certainty
Average daily demand X Lead time in days) + Safety Stock
Cost of Safety Stock = Expected stockout cost + Carrying Cost
See example on page 168
SU 4.6 Inventory Management
Economic order quantity (EOQ) – Represents the
optimum order size—the quantity of a regularly
ordered item to be purchased at a point in time
that results in minimum total cost (i.e., the sum
of ordering costs and carrying costs).
SU 4.6 Inventory Management
• Determining the Order Quantity
Square root of ((2x VC/purchase X periodic demand in
units)/periodic carrying cost)
– Assumptions of EOQ
•
•
•
•
•
Demand is uniform
Order (setup) costs and carrying costs are constant
No quantity discounts are allowed
Sales are perfectly predictable
Deliveries are always on time
SU 4.6 Inventory Management
• Just-in-Time and Kanban Systems
– JIT – The underlying objective of JIT systems is to
minimize all waste in manufacturing operations by
meeting production targets with the minimum
amount of materials, equipment, operators, and so
on. This is accomplished by completing all operations
just at the time they are needed. It ultimately
considers inventory as a nonvalue-adding activity
– Kanban = Kanban is the simple manual method of
control used in conjunction with JIT to ensure that all
materials actually do arrive just as they are needed.
SU 4.6 Inventory Management Practice
Question 1
The optimal level of inventory is
affected by all of the following except
the
A.
Usage rate of inventory per time
period.
B.
Cost per unit of inventory.
C.
Current level of inventory.
D.
Cost of placing an order for
merchandise
SU 4.6 Inventory Management Practice
Question 1 Answer
Correct Answer: C
The optimal level of inventory is affected by the factors in the economic order quantity (EOQ) model
and delivery or production lead times. These factors are the annual demand for inventory, the carrying
cost, which includes the interest on funds invested in inventory, the usage rate, and the cost of placing
an order or making a production run. The current level of inventory has nothing to do with the optimal
inventory level.
Incorrect Answers:
A: The usage rate of inventory is a factor in determining how much inventory to carry.
B: The cost of inventory affects carrying costs and a firm wants to minimize its inventory carrying
costs.
D: The cost of placing an order affects how often orders are placed. A firm wants to minimize its
ordering costs.
SU 4.6 Inventory Management Practice
Question 2
A major supplier has offered Alpha
Corporation a year-end special
purchase whereby Alpha could
purchase 180,000 cases of sport drink
at $10 per case. Alpha normally
orders 30,000 cases per month at $12
per case. Alpha’s cost of capital is 9%.
In calculating the overall opportunity
cost of this offer, the cost of carrying
the increased inventory would be
A.
B.
C.
D.
$32,400
$40,500
$64,800
$81,000
SU 4.6 Inventory Management Practice
Question 2 Answer
Correct Answer: A
If Alpha makes the special purchase of 6 months of inventory (180,000 cases ÷ 30,000 cases per
month), the average inventory for the 6-month period will be $900,000 [(180,000 × $10) ÷ 2]. If
the special purchase is not made, the average inventory for the same period will be the average
monthly inventory of $180,000 [(30,000 × $12) ÷ 2]. Accordingly, the incremental average
inventory is $720,000 ($900,000 – $180,000), and the interest cost of the incremental 6-month
investment is $32,400 [($720,000 × 9%) ÷ 2].
Incorrect Answers:
B: The amount of $40,500 is the result of assuming an incremental average inventory of
$900,000.
C: The interest cost for 12 months is $64,800.
D: The amount of $81,000 is the result of assuming an incremental average inventory of
$900,000 and a 12-month period.
SU 4.6 Inventory Management Practice
Question 3
The following information regarding
inventory policy was assembled by
the JRJ Corporation. The company
uses a 50-week year in all
calculations.
Sales
10,000 units per year
Order quantity
2,000 units
Safety stock
1,300 units
Lead time
A.
B.
C.
D.
4 weeks
The reorder point is
3,300 units.
2,100 units.
1,300 units.
800 units.
SU 4.6 Inventory Management Practice
Question 3 Answer
Correct Answer: B
The reorder point is the
inventory level at which
an order should be placed.
It can be quantified using
the following equation:
Reorder point = (Average weekly demand × Lead time) + Safety stock
= [(10,000 units ÷ 50 weeks) × 4 weeks] + 1,300 units
= 800 units + 1,300 units
= 2,100 units