Assume the firm can convince the bank to extend its line of credit to $45 million.
22. Sources and Uses of Cash. The accompanying tables show Dynamic Mattressâ€™s year-end
1998 balance sheet and its income statement for 1999. Use these tables (and Table 2.3) to
work out a statement of sources and uses of cash for 1999.
YEAR-END BALANCE SHEET FOR 1998
(figures in millions of dollars)
Current assets Current liabilities
Cash 4 Bank loans 4
Marketable securities 2 Accounts payable 15
Inventory 20 Total current liabilities 19
Accounts receivable 22 Long-term debt 5
Total current assets 48 Net worth (equity and retained earnings) 60
Gross investment 50
Less depreciation 14 Total liabilities and net worth 84
Net fixed assets 36
Total assets 84
INCOME STATEMENT FOR 1999
(figures in millions of dollars)
Operating costs â€“285
Pretax income 12
Tax at 50 percent â€“6
Net income 6
Note: Dividend = $1 million and retained earnings = $5 million.
23. Cash Budget. The following data are from the budget of Ritewell Publishers. Half the com-
panyâ€™s sales are transacted on a cash basis. The other half are paid for with a 1-month delay.
Problem The company pays all of its credit purchases with a 1-month delay. Credit purchases in Jan-
uary were $30 and total sales in January were $180.
Working Capital Management and Short-Term Planning 195
February March April
Total sales 200 220 180
Cash purchases 70 80 60
Credit purchases 40 30 40
Labor and administrative expenses 30 30 30
Taxes, interest, and dividends 10 10 10
Capital expenditures 100 0 0
Complete the following cash budget:
February March April
Sources of cash
Collections on current sales
Collections on accounts receivable
Total sources of cash
Uses of cash
Payments of accounts payable
Labor and administrative expenses
Taxes, interest, and dividends
Total uses of cash
Net cash inflow
Cash at start of period 100
+ Net cash inflow
= Cash at end of period
+ Minimum operating cash balance 100 100 100
= Cumulative short-term financing required
1 a. The new values for the accounts receivable period and inventory period are
Self-Test Days in inventory = = 25.9 days
Questions This is a reduction of 22.8 days from the original value of 48.7 days.
Days in receivables = = 27.6 days
This is a reduction of 16.2 days from the original value of 43.8 days
The cash conversion cycle falls by a total of 22.8 + 16.2 = 39.0 days.
b. The inventory period, accounts receivable period, and accounts payable period will all
fall by a factor of 1.10. (The numerators are unchanged, but the denominators are higher
by 10 percent.) Therefore, the conversion cycle will fall from 61 days to 61/1.10 = 55.5
2 a. An increase in the interest rate will increase the cost of carrying current assets. The ef-
fect is to reduce the optimal level of such assets.
b. The just-in-time system lowers the expected level of shortage costs and reduces the
amount of goods the firm ought to be willing to keep in inventory.
196 SECTION TWO
c. If the firm decides that more lenient credit terms are necessary to avoid lost sales, it must
then expect customers to pay their bills more slowly. Accounts receivable will increase.
3 a. This transaction merely substitutes one current liability (short-term debt) for another (ac-
counts payable). Neither cash nor net working capital is affected.
b. This transaction will increase inventory at the expense of cash. Cash falls but net work-
ing capital is unaffected.
c. The firm will use cash to buy back the stock. Both cash and net working capital will fall.
d. The proceeds from the sale will increase both cash and net working capital.
4 Quarter: First Second Third Fourth
Accounts receivable (Table 19.6)
Receivables (beginning period) 30.0 35.0 31.4 46.4
Sales 87.5 78.5 116.0 131.0
Collectionsa 82.5 82.1 101.0 125.0
Receivables (end period) 35.0 31.4 46.4 52.4
Cash budget (Table 19.7)
Sources of cash
Collections of accounts receivable 82.5 82.1 101.0 125.0
Other 1.5 0.0 12.5 0.0
Total 84.0 82.1 113.5 125.0
Payments of accounts payable 65.0 60.0 55.0 50.0
Labor and administrative expenses 30.0 30.0 30.0 30.0
Capital expenses 32.5 1.3 5.5 8.0
Taxes, interest, and dividends 4.0 4.0 4.5 5.0
Total uses 131.5 95.3 95.0 93.0
Net cash inflow â€“47.5 â€“13.2 18.5 32.0
Short-term financing requirements (Table 19.8)
Cash at start of period 5.0 â€“42.5 â€“55.7 â€“37.2
+ Net cash inflow â€“47.5 â€“13.2 18.5 32.0
= Cash at end of period â€“42.5 â€“55.7 â€“37.2 â€“5.2
Minimum operating balance 5.0 5.0 5.0 5.0
Cumulative short-term financing required 47.5 60.7 42.2 10.2
aSales in fourth quarter of the previous year totaled $75 million.
5 The major change in the plan is the substitution of the extra $5 million of borrowing via the
line of credit (bank loan) in the second quarter and the corresponding reduction in the
stretched payables. This substitution is advantageous because the bank loan is a cheaper
source of funds. Notice that the cash balance at the end of the year is higher under this plan
than in the original plan.
Quarter: First Second Third Fourth
1. Cash required for operations 45 15 â€“26.0 â€“35
2. Interest on line of credit 0 0.8 0.9 0.6
3. Interest on stretched payables 0 0 0.5 0
4. Total cash required 45 15.8 â€“24.6 â€“34.4
Working Capital Management and Short-Term Planning 197
5. Bank loan 40 5 0 0
6. Stretched payables 0 10.8 0 0
7. Securities sold 5 0 0 0
8. Total cash raised 45 15.8 0 0
9. Of stretched payables 0 0 10.8 0
10. Of bank loan 0 0 13.8 31.2
Increase in cash balances
11. Addition to cash balances 0 0 0 3.2
12. Beginning of quarter 0 40 45 31.2
13. End of quarter 40 45 31.2 0
6 Bank A: The interest paid on the $20 million loan over the 6-month period will be $20 mil-
lion Ã— .07/2 = $.7 million. With a 20 percent compensating balance, $16 million is available
to the firm. The effective annual interest rate is
Effective annual rate on a actual interest paid m
= 1+ â€“1
loan with compensating balances borrowed funds available
$.7 million 2
= 1+ â€“ 1 = .0894, or 8.94%
Bank B: The compound annual interest rate on the simple loan is
quoted interest rate m
Effective annual rate = 1 + â€“1
= 1+ â€“ 1 = 1.042 â€“ 1 = .0816, or 8.16%
Bank C: The compound annual interest rate is
Effective annual rate 1 m
on a discount loan = â€“1
annual interest rate
1 2 1 2
= â€“1= â€“ 1 = .0794, or 7.94%
Capstan Autos operated an East Coast dealership for a major ness, as well as providing Sidney Capstan with a good return on
Japanese car manufacturer. Capstanâ€™s owner, Sidney Capstan, at- his equity investment.
tributed much of the businessâ€™s success to its no-frills policy of By the fourth quarter of 2004 sales were running at 250 cars
competitive pricing and immediate cash payment. The business a quarter. Since the average sale price of each car was about
$20,000, this translated into quarterly revenues of 250 Ã— $20,000
was basically a simple oneâ€”the firm imported cars at the begin-
ning of each quarter and paid the manufacturer at the end of the = $5 million. The average cost to Capstan of each imported car
quarter. The revenues from the sale of these cars covered the pay- was $18,000. After paying wages, rent, and other recurring costs
ment to the manufacturer and the expenses of running the busi- of $200,000 per quarter and deducting depreciation of $80,000,
198 SECTION TWO
Sidney Capstan was first and foremost a superb salesman and
the company was left with earnings before interest and taxes
always left the financial aspects of the business to his financial
(EBIT) of $220,000 a quarter and net profits of $140,000.
manager. However, there was one feature of the financial state-
The year 2005 was not a happy year for car importers in the
ments that disturbed Sidney Capstanâ€”the mounting level of
United States. Recession led to a general decline in auto sales,
debt, which by the end of the first quarter of 2006 had reached
while the fall in the value of the dollar shaved profit margins for
$9.7 million. This unease turned to alarm when the financial
many dealers in imported cars. Capstan more than most firms
manager phoned to say that the bank was reluctant to extend fur-
foresaw the difficulties ahead and reacted at once by offering 6
ther credit and was even questioning its current level of exposure
monthsâ€™ free credit while holding the sale price of its cars con-
to the company.
stant. Wages and other costs were pared by 25 percent to
Capstan found it impossible to understand how such a suc-
$150,000 a quarter and the company effectively eliminated all
cessful year could have landed the company in financial difficul-
capital expenditures. The policy appeared successful. Unit sales
ties. The company had always had good relationships with its
fell by 20 percent to 200 units a quarter, but the company contin-
bank, and the interest rate on its bank loans was a reasonable 8
ued to operate at a satisfactory profit (see table).
percent a year (or about 2 percent a quarter). Surely, Capstan rea-
The slump in sales lasted for 6 months, but as consumer con-
soned, when the bank saw the projected sales growth for the rest
fidence began to return, auto sales began to recover. The com-
of 2006, it would realize that there were plenty of profits to en-
panyâ€™s new policy of 6 monthsâ€™ free credit was proving suffi-
able the company to start repaying its loans.
ciently popular that Sidney Capstan decided to maintain the
policy. In the third quarter of 2005 sales had recovered to 225
units; by the fourth quarter they were 250 units; and by the first
quarter of the next year they had reached 275 units. It looked as
1. Is Capstan Auto in trouble?
if by the second quarter of 2006 that the company could expect to
2. Is the bank correct to withhold further credit?
sell 300 cars. Earnings before interest and tax were already in ex-
3. Why is Capstanâ€™s indebtedness increasing if its profits are
cess of their previous high and Sidney Capstan was able to con-
higher than ever?
gratulate himself on weathering what looked to be a tricky period.
Over the 18-month period the firm had earned net profits of over
half a million dollars, and the equity had grown from just under
$1 million to about $2 million.
Working Capital Management and Short-Term Planning 199