RMIT Classification: Trusted

$ Accounts Receivable
Average collection period (ACP)= $ Annual credit sales
365 days

$ Inventory
Average age of inventory (AAI) = $ Cost of good sold
365 days

$ Accounts Payable
Average payment period (APP) = $ Annual credit purchases
365 days

Week 3 Lecture Illustrations

Q1 Lecture Illustration -2 Working Capital (Risk-return trade-off)
The balance sheet from 2014 to 2017 for Block-Chain Ltd, a consultancy firm, has been provided
(figures in thousands):

2014 2015 2016 2017

Current assets $150 $140 $100 $200
Fixed assets 100 100 150 165
Total $250 $240 $ 250 $365
Current liabilities $ 30 $ 60 $ 100 $120
Long-term liabilities 50 40 80 60
Owner’s equity 170 140 70 185
Total $250 $240 $ 250 $365
a. Complete current and debt ratios for 4 years.
b. What is your opinion of the company’s liquidity and leverage? (Leverage usually shows the
share of liabilities in assets). Please note that in all 4 years, the company experienced an
increase in net profit.
c. What conclusions can you draw from the company’s financial decisions in the last year?

a.
2014 2015 2016 2017

Current ratio 150/30=5.00 140/60=2.33 1.00 1.67

5:1
 RMIT Classification: Trusted

Debt ratio= Total 80/250=32% 100/240=42% 72% 49%

Liability/ Total
Assets

b. During 2014–2016, current ratio declined dramatically, and debt ratio increased
substantially. The company experienced net profit; however, the owner’s equity
also decreased in the mentioned years. The latest is most likely to pay out
dividends. The company made investments in the long-term assets, this may
partially explain the declining current ratio, but it is mostly due to the collection of
receivables and dividend payouts. In 2016, there is a huge increase in debt ratio
which is mostly due to increase in both current and long-term liabilities and the
decreasing of cash. So, we can see that the financial situation was getting riskier
during the years 2015–2016.

c. The last year’s tendency is better, there is an increase in current ratio, quite a
drop-in debt ratio, and an increase in equity. This is mostly due to better cash
management as well as improved dividend policy.

Q2 Lecture Illustration -3 Working Capital (Hedging Principle)

A popular theory for managing risk to the firm that arises out of its management of working capital
(that is, current assets and current liabilities) involves following the principle of self-liquidating debt.
How would this principle be applied in each of the following situations? Explain your responses to
each alternative.

a. Longleaf Homes owns a chain of senior housing complexes in the Seattle, Washington, area.
The firm is presently debating whether it should borrow short or long term to raise $10
million in needed funds. The funds are to be used to expand the firm’s care facilities, which
are expected to last 20 years.
b. Arrow Chemicals needs $5 million to purchase inventory to support its growing sales
volume. Arrow does not expect the need for additional inventory to diminish in the future.
c. Blocker Building Materials, Inc. is reviewing its plans for the coming year and expects that
during the months of November through January it will need an additional $5 million to
finance the seasonal expansion in inventories and receivables.
 RMIT Classification: Trusted

a. The principle of self-liquidating debt (hedging principle) suggests that the long-
term care facilities, which are expected to be productive for 20 years, should be
financed with a source of financing that has a similar maturity. Thus, Longleaf
should use long-term debt for its expansion.
b. This example is a “permanent” increase in the firm’s needs for inventory.
Consequently, this financing would be best raised using a permanent source of
financing such as intermediate-term loans, long-term debt, preferred stock, or
common equity.
c. Seasonal expansions in working capital are followed by seasonal contractions.
Therefore, this need for financing would best be provided by a short-term loan or
temporary source of financing such as unsecured bank loans, commercial paper or
loans secured by accounts receivable or inventory.
 RMIT Classification: Trusted

Q3 Working Capital (Cash Conversion Cycle)

The data for Sharm trading Company across the last 6 years have been provided:

2012 2013 2014 2015 2016 2017

$ $ $ $ $ $
Sales 2900 3100 3400 3500 4100 4900
Receivable 511 677 752 765 801 908
Accounts Payable 287 309 509 573 675 566
Inventory 230 300 390 459 597 609

Since Sharm trading shows an increase in sales, the management decided to hold more inventories.
Assuming the cost of goods sold and purchase are assumed to be 60 percent of sales.

a. Calculate the number of days of sales outstanding in receivables, days of sales in inventory,
and days- payable outstanding for each year. What patterns do you note?
b. Evaluate the company’s strategy in holding more inventories and its overall working capital
management.

2012 2013 2014 2015 2016 2017

Days of sales (511/2900/365) 79.71 80.73 79.78 71.31 67.64

outstanding(ACP) 64.32

Cost of goods 2900x60%=1,740 1,860 2,040 2,100 2,460 2,940

sold=purchases =
60% sales

Days sales in 48.25 58.87 69.78 79.78 88.58 75.61

inventory(AAI)

Days payables 60.20 60.63 91.07 99.59 100.15 70.26

outstanding(APP)
 RMIT Classification: Trusted

Cash conversion 52.37 77.95 59.44 59.97 59.74 72.99

cycle

In general, the tendency is towards increasing sales as well as towards an increase in

days of sales in inventory, day’s payable outstanding, and cash conversion cycle. The
data provided show that the only positive is increase in sales. However, we cannot
conclude that this led to improved current asset and working capital management.

b. The company’s strategy to hold more inventories since sales increased did not do well as
it did not lead to working capital improvement; instead, days of sales in inventory
increased. It was a small decrease only in the last year. Moreover, cash conversion cycle
increased as well as days payable outstanding. So, in general, unfortunately even with
increased sales, the company could not improve the situation with working capital.

Inventory
1. Inventory Conversion Period (AAI) = Cost of goods sold perday

Inventory
= Cost of good sold
÷ 365 days
Receivable s
2. Receivable Collection Period(ACP) = Daily Credit Sales

Receivables
¿
= Annual Credit Sales
¿
÷ 365 days

Accounts payable
3. Payables Deferral Period(APP) = Credit purshases per day

Accounts pyables
¿
= Cost of goods sold
¿
÷ 365 days

4. CCC= ICP+ DSO-DPO

RMIT Classification: Trusted