TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY
MAS 3: FINANCIAL MANAGEMENT
CURRENT LIABILITIES MANAGEMENT
Spontaneous liabilities arise from the
normal course of business which normally
includes accounts payable and accruals.
There is normally no explicit cost attached
to either of these current liabilities,
although they do have certain implicit
costs.
In addition, both are forms of unsecured
short-term financing. The firm should take
advantage of these “interest-free” sources
of unsecured short-term financing
whenever possible.
ACCOUNTS PAYABLE MANAGEMENT
CASH CONVERSION CYCLE (CCC)
Measures the length of time required for a
company to convert cash invested in its
operations to cash received as a result of
operations.
CCC=( AAI + ACP ) −APP
A positive cash conversion cycle means the
firm must use negotiated liabilities to
support its operating assets.
Simply stated, the goal is to minimize the
length of the cash conversion cycle, which
minimizes current liabilities.
AVERAGE PAYMENT PERIOD (APP)
The average payment period has two parts:
(1) the time from the purchase of raw
materials until the firm mails the payment
and (2) payment float time (the time it
takes after the firm mails its payment until
the supplier has withdrawn spendable
funds from the firm’s account). The
formula for finding the average collection
period is,
360
Ave . Pay . Period= ¿
Payables ¿
Where,
Net credit purchases
Payables ¿=
Ave . Payables
Assuming receipt, processing, and
disbursement time is constant, the average
payment period tells the firm, on average,
when its customers pay their accounts.
CASH FLOAT MANAGEMENT
Float refers to funds that have been sent
by the payer but are not yet usable funds
to the payee. Float is important in the cash
conversion cycle because its presence
lengthens both the firm's average collection
period and its average payment period.
However, the goal of the firm should be to
shorten its average collection period and
lengthen its average payment period. Both
can be accomplished by managing float.
Float has three component parts:
1. Mail float is the time delay between
when payment is placed in the mail
and when it is received.
2. Processing float is the time between
receipt of the payment and its
deposit into the supplier's account.
3. Clearing float is the time between
deposit of the payment and when
spendable funds become available to
the supplier. This component of
float is attributable to the time
required for a check to clear the
banking system.
Cash Disbursements
Float is also a component of the firm's
average payment period. In this case, the
float is in the favor of the firm. The firm
may benefit by increasing all three of the
components of its payment float. Some
effective methods of cash outflow
management are:
 Use of checks and drafts
 Voucher system
 The 3 o’clock habit
 Thank God Its Friday (TGIF)
Syndrome
 Payroll management
In summary, a reasonable overall policy for
float management is to delay making
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 TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY
MAS 3: FINANCIAL MANAGEMENT
payment to suppliers because, once the
payment is mailed, the funds belong to the
supplier.
CREDIT TERMS
Cash Discount
Sometimes a supplier will offer a cash
discount for early payment. In that case,
the purchaser should carefully analyze
credit terms to determine the best time to
repay the supplier.
The purchaser must weigh the benefits of
paying the supplier as late as possible
against the costs of passing up the
discount for early payment.
The Nominal Discount Rate
The discount rate adjusted on an annual
basis. It is computed as follows:
Discount rate Days∈a year
x
100 %−discount rate Remaining credit time
Or, Discount time turnover x adjusted
discount rate per discount time
Decision Guide:
Buyer without available funds
EDR > cost of money Avail of the CD
EDR < cost of money Ignore the CD
Buyer with available funds
EDR < ROI if money is used Ignore the CD
EDR > ROI if money is used Avail of the CD
SAMPLE PROBLEM 1. Three suppliers of
PH Corp. offer different credit term.
Novavax Co. offers term of 1.5/15, net 30.
Sinovac Corp. offers terms of 1/10, net 30.
Sinopharm Inc. offers of 2/10, net 60.
PH Corp. would have to borrow from a
bank at an annual rate of 12% in order to
take any cash discounts.
Which one of the following would be the
most attractive for PH Corp.?
Effects of Stretching Accounts Payable
Stretching accounts payable reduces the
implicit cost of giving up a cash discount.
SAMPLE PROBLEM 2. Moderna Industries
was extended credit terms of 2/10, net 30.
If the firm were able to stretch its account
payable to 70 days without damaging its
credit rating, what would be the cost of
giving up the cash discount?
ACCRUALS
The most common items accrued by a firm
are wages and taxes. Because taxes are
payments to the government, their accrual
cannot be manipulated by the firm.
However, the accrual of wages can be
manipulated to some extent. This is
accomplished by delaying payment of
wages, thereby receiving an interest-free
loan from employees who are paid
sometime after they have performed the
work.
SAMPLE PROBLEM 3. AstraZeneca
Company currently pays its employees at
the end of each work week. The weekly
payroll totals P400,000.
If the firm were to extend the pay period so
as to pay its employees 1 week later
throughout an entire year, assuming the
firm could earn 10% annually on invested
funds, such a strategy would be give the
firm an annual income of how much?
UNSECURED SOURCES OF SHORT-
TERM LOANS
BANK LOANS
The major type of loan made by banks to
businesses is the short-term, self-
liquidating loan. These loans are intended
merely to carry the firm through seasonal
peaks in financing needs that are due
primarily to buildups of inventory and
accounts receivable.
Loan Interest Rates
1. Fixed Rate - the rate of interest
determined at a set increment above
the prime rate on the date of the
loan and remains unvarying at that
fixed rate until maturity.
2. Variable Rate - the increment above
the prime rate is initially
established, and the rate of interest
is allowed to “float,” or vary, above
prime as the prime rate varies until
maturity.
Methods of Computing Interest
1. When interest is paid at maturity,
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 TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY
MAS 3: FINANCIAL MANAGEMENT
Interest
Amount borrowed
2. When interest is paid in advance,
Interest
Amount borrowed−Interest
SAMPLE PROBLEM 4. Pfizer Company, a
manufacturer of athletic apparel, wants to
borrow P10,000 at a stated annual rate of
10% interest for 1 year. Compute for the
effective annual rate if, (1) interest is paid
at maturity, (2) interest is paid in advance.
SINGLE-PAYMENT NOTES
SAMPLE PROBLEM 5. Johnson & Johnson
Co. recently borrowed P100,000 from a
bank when the prime rate was 6% and
issued a 90-day note with a fixed interest
rate set at 1% above the prime rate payable
at maturity.
Compute for the, (1) interest paid on the
note, (2) effective annual interest rate.
SAMPLE PROBLEM 6. Inovio Corp.
recently borrowed P100,000 from a bank
when the prime rate was 6% and issued a
90-day note with a variable interest rate
set at 1.5% above the prime rate payable at
maturity.
Assuming after 30 days the prime rate
rises to 6.5%, and after another 30 days it
drops to 6.25%, compute for the, (1)
interest paid on the note, (2) effective
annual interest rate.
LINES OF CREDIT
Interest Rates. The interest rate on a line of
credit is normally stated as a floating rate.
Operating-Change Restrictions. In a line-of-
credit agreement, a bank may impose
operating-change restrictions, which give it
the right to revoke the line if any major
changes occur in the firm’s financial
condition or operations.
Compensating Balances. Banks frequently
require compensating balances of 10 to 20
percent. A compensating balance not only
forces the borrower to be a good customer
of the bank but may also raise the interest
cost to the borrower.
SAMPLE PROBLEM 7. Viral Vector
Company has a P2,000,000 line of credit
agreement with its bank.
It must pay a stated interest rate of 10%
and maintain, in its checking account, a
compensating balance equal to 10% of the
amount borrowed.
Compute for the effective annual interest
rate.
Annual Cleanups. This means that the
borrower must have a loan balance of zero
—that is, owe the bank nothing—for a
certain number of days during the year.
This ensures that short-term loans do not
turn into long-term loans.
REVOLVING CREDIT AGREEMENTS
SAMPLE PROBLEM 8. Viral Vector
Company has a P2,000,000 revolving
credit agreement with its bank. Its average
borrowing under the agreement for the
past year was P1.5 million.
The bank charges a commitment fee of
0.5% on the average unused balance. Viral
Vector also had to pay interest of 10%.
Compute for the effective annual interest
rate.
COMMERCIAL PAPERS
A form of financing that consists of short-
term, unsecured promissory notes issued
by firms with a high credit standing.
Commercial paper is sold at a discount
from its par, or face value. The size of the
discount and the length of time to maturity
determine the interest paid by the issuer of
commercial paper.
An interesting characteristic of commercial
paper is that its interest cost is normally 2
percent to 4 percent below the prime rate.
In other words, firms are able to raise
funds more cheaply by selling commercial
paper than by borrowing from a
commercial bank.
SAMPLE PROBLEM 9. Oxford U
Corporation has just issued P1,000,000
worth of commercial paper that has a 90-
day maturity and sells for P990,000.
Compute for the, (1) interest paid on the
note, (2) effective annual interest rate.
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 TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY
MAS 3: FINANCIAL MANAGEMENT
SECURED SOURCES OF SHORT-TERM
LOANS
Secured short-term financing has specific
assets pledged as collateral. The collateral
commonly takes the form of an asset, such
as accounts receivable or inventory.
The lender obtains a security interest in
the collateral through the execution of a
security agreement filed in a public office.
Note that the presence of collateral has no
impact on the risk of default.
The primary sources of secured short-term
loans to businesses are commercial banks
and commercial finance companies.
USE OF ACCOUNTS RECEIVABLE AS
COLLATERAL
Two commonly used means of obtaining
short-term financing with accounts
receivable are pledging accounts receivable
and factoring accounts receivable.
PLEDGING ACCOUNTS RECEIVABLE
The Pledging Process.
Pledging Cost. The stated cost of a pledge
of accounts receivable is normally 2%-5%
above the prime rate. In addition to the
stated interest rate, a service charge of up
to 3 percent may be levied by the lender to
cover its administrative costs.
FACTORING ACCOUNTS RECEIVABLE
Factoring Agreement.
Factoring Cost. Factoring costs include
commissions, interest levied on advances,
and interest earned on surpluses.
The commissions are typically stated as a
1 to 3 percent discount from the book
value of factored accounts receivable. The
interest levied on advances is generally 2 to
4 percent above the prime rate. It is levied
on the actual amount advanced. The
interest paid on surpluses is generally
between 0.2 percent and 0.5 percent per
month.
USE OF INVENTORY AS COLLATERAL
The most important characteristic of
inventory being evaluated as loan collateral
is marketability.
FLOATING INVENTORY LIENS
A claim on inventory in general as extra
security on what would otherwise be an
unsecured loan.
This arrangement is most attractive when
the firm has a stable level of inventory that
consists of a diversified group of relatively
inexpensive merchandise.
The interest charge on a floating lien is
3%-5% above the prime rate.
TRUST RECEIPT INVENTORY LOANS
Made against relatively expensive
automotive, consumer durable, and
industrial goods that can be identified by
serial number.
Under this agreement, the borrower keeps
the inventory, and the lender may advance
80%-100% of its cost.
The interest charge to the borrower is
normally 2% or more above the prime rate.
WAREHOUSE RECEIPT LOAN
An arrangement whereby the lender, which
may be a commercial bank or finance
company, receives control of the pledged
inventory collateral, which is stored by a
designated agent on the lender’s behalf.
After selecting acceptable collateral, the
lender hires a warehousing company to act
as its agent and take possession of the
inventory.
Two types of warehousing arrangements
are:
1. Terminal Warehouse
A central warehouse that is used to
store the merchandise of various
customers.
2. Field Warehouse
The lender hires a field-warehousing
company to set up a warehouse on the
borrower’s premises or to lease part of
the borrower’s warehouse to store the
pledged collateral.
Generally, the lender advances 75%-90%
of the collateral’s value and charges a basic
interest ranging from 3%-5% above the
prime rate.
In addition to interest, the borrower must
absorb the costs of warehousing which is
generally between 1%-3% of the amount of
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 TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY
MAS 3: FINANCIAL MANAGEMENT

the loan. Normally, the borrower is also

required to pay the insurance costs on the
warehoused merchandise.

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