Managing Current Liabilities (Gitman)

Copyright © 2009 Pearson Prentice Hall. All rights reserved.
Chapter 15
Current
Liabilities
Management

Copyright © 2009 Pearson Prentice
Hall. All rights reserved. 15-2
Learning Goals
1. Review the key components of credit terms,
accounts payable, and the procedures for
analyzing them.
2. Understand the effects of stretching accounts
payable on their cost and the use of accruals.
3. Describe interest rates and the basic types of
unsecured bank sources of short-term loans.

Spontaneous Liabilities
• Spontaneous liabilities arise from the normal course of
business.
• The two major spontaneous liability sources are
accounts payable and accruals.
• As a firm’s sales increase, accounts payable and
accruals increase in response to the increased
purchases, wages, and taxes.
• There is normally no explicit cost attached to either of
these current liabilities.

Spontaneous Liabilities: Accounts
Payable Management
• Accounts payable are the major source of unsecured
short-term financing for business firms.
• The average payment period has two parts:
– The time from the purchase of raw materials until the firm
mails the payment
– 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payment until the supplier has withdrawn spendable funds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

In the demonstration of the cash conversion cycle in Chapter 14,
MAX Company had an average payment period of 35 days, which
resulted in average accounts payable of $467,466. Thus, the daily
accounts payable generated is $13,356. If MAX were to mail its
payments in 35 days instead of 30, it would reduce its investment in
operations by $66,780. If this did not damage MAX’s credit rating, it
would clearly be in its best interest to pay later.
• The firm’s goal is to pay as slowly as possible without
damaging its credit rating.
Spontaneous Liabilities: Accounts
Payable Management (cont.)

Spontaneous Liabilities: Analyzing Credit
Terms
• Credit terms offered by suppliers allow a firm to delay
payment for its purchases.
• However, the supplier probably imputes the cost of
offering terms in its selling price.
• Therefore, the firm should analyze credit terms to
determine its best credit strategy.
• If a cash discount is offered, the firm has two options
—to take the cash discount or to give it up.

Lawrence Industries, operator of a small chain of video stores,
purchased $1,000 worth of merchandise on February 27 from a
supplier extending terms of 2/10 net 30 EOM. If the firm takes the
cash discount, it will have to pay $980 [$1,000 - (.02 x $1,000)] on
March 10th saving $20.
• Taking the Cash Discount
– If a firm intends to take a cash discount, it should pay on the
last day of the discount period.
– There is no cost associated with taking a cash discount.
Terms (cont.)

If Lawrence gives up the cash discount, payment can be made on
March 30th
. To keep its money for an extra 20 days, the firm must
give up an opportunity to pay $980 for its $1,000 purchase, thus
costing $20 for an extra $20 days.
• Giving Up the Cash Discount
– If a firm chooses to give up the cash discount, it should pay
on the final day of the credit period.
– The cost of giving up a cash discount is the implied rate of
interest paid to delay payment of an account payable for an
additional number of days.
Terms (cont.)

Terms (cont.)
Figure 15.1
Payment
Options

Hall. All rights reserved.
15-
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Terms (cont.)
Cost = 2% x 365 = 37.24%
100% - 2% 30 - 10

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Terms (cont.)
The preceding example suggest that the firm should take the cash
discount as long as it can borrow from other sources for less than
37.24%. Because nearly all firms can borrow for less than this (even
using credit cards!) they should always take the terms 2/10 net 30.

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• Using the Cost of Giving Up the Cash Discount
Terms (cont.)
Mason Products, a large building-supply company, has four possible
suppliers, each offering different credit terms. Table 15.1 on the
following slide presents the credit terms offered by its suppliers and
the cost of giving up the cash discount in each transaction.
If the firm needs short-term funds, which it can borrow from its bank
at 13%, and if each of the suppliers is viewed separately, which (if
any) of the suppliers discounts should the firm give up?

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• Using the Cost of Giving Up the Cash Discount
Terms (cont.)
Table 15.1 Cash Discounts and Associated Costs
for Mason Products

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Lawrence Industries was extended credit terms of 2/10 net 30 EOM.
The cost of giving up the cash discount is 36.5%. If Lawrence were
able to stretch its accounts payable to 70 days without damaging its
credit rating, the cost of giving up the cash discount would fall from
36.5% to only 12.2% [2% x (365/60)].
Spontaneous Liabilities: Effects of
Stretching Accounts Payable
• Stretching accounts payable simply involves paying bills as
late as possible without damaging credit rating.
• This can reduce the cost of giving up the discount.

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Spontaneous Liabilities: Accruals
• Accruals are liabilities for services received for which
payment has yet to be made.
• The most common items accrued by a firm are wages
and taxes.
• While payments to the government cannot be
manipulated, payments to employees can.
• This is accomplished by delaying payment of wages, or
stretching the payment of wages for as long as possible.

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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 which are intended to carry firms
through seasonal peaks in financing needs.
• These loans are generally obtained as companies build up
inventory and experience growth in accounts receivable.
• As receivables and inventories are converted into cash, the loans
are then retired.
• These loans come in three basic forms: single-payment notes,
lines of credit, and revolving credit agreements.

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Loans: Bank Loans (cont.)
• Loan Interest Rates
– Most banks loans are based on the prime rate of
interest which is the lowest rate of interest charged
by the nation’s leading banks on loans to their most
reliable business borrowers.
– Banks generally determine the rate to be charged to
various borrowers by adding a premium to the prime
rate to adjust it for the borrowers “riskiness.”

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• Fixed & Floating-Rate Loans
– On a fixed-rate loan, the rate of interest is determined at a
set increment above the prime rate and remains at that rate
until maturity.
– On a floating-rate loan, the increment above the prime rate
is initially established and is then allowed to float with prime
until maturity.
– Like ARMs, the increment above prime is generally lower on
floating rate loans than on fixed-rate loans.

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• Method of Computing Interest
– Once the nominal (stated) rate of interest is established,
the method of computing interest is determined.
– Interest can be paid either when a loan matures or
in advance.
– If interest is paid at maturity, the effective (true) rate of
interest—assuming the loan is outstanding for exactly one
year—may be computed as follows:

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– If the interest is paid in advance, it is deducted from the loan
so that the borrower actually receives less money than
requested.
– Loans of this type are called discount loans. The effective
rate of interest on a discount loan assuming it is outstanding
for exactly one year may be computed as follows:

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(10% X $10,000) = 10.0%
$10,000
Booster Company, a manufacturer of athletic apparel, wants to
borrow $10,000 at a stated rate of 10% for 1 year. If interest is
paid at maturity, the effective interest rate may be computed as
follows:

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(10% X $10,000) = 11.1%
$10,000 - $1,000
Booster Company, a manufacturer of athletic apparel, wants to
borrow $10,000 at a stated rate of 10% for 1 year. If interest is
paid at maturity, the effective interest rate may be computed as
follows:
If this loan were a discount loan, the effective rate of interest
would be:

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• Single Payment Notes
– A single-payment note is a short-term, one-time loan
payable as a single amount at its maturity.
– The “note” states the terms of the loan, which include the
length of the loan as well as the interest rate.
– Most have maturities of 30 days to 9 or more months.
– The interest is usually tied to prime and may be either fixed
or floating.

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Gordon Manufacturing recently borrowed $100,000 from each of 2 banks
—A and B. Loan A is a fixed rate note, and loan B is a floating rate note.
Both loans were 90-day notes with interest due at the end of 90 days.
The rates were set at 1.5% above prime for A and 1.0% above prime for
B when prime was 6%.
Based on this information, the total interest cost on loan A is $1,849
[$100,000 x 7.5% x (90/365)]. The effective cost is 1.85% for 90 days.
The effective annual rate may be calculated as follows:
EAR = (1 + periodic rate)m
- 1 = (1+. 0185)4.06
- 1 = 7.73%

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Thus, the effective cost is 1.787% for 90 days. The effective annual rate
may be calculated as follows:
EAR = (1 + periodic rate)m
- 1 = (1+.01787)4.06
- 1 = 7.46%
During the 90 days that loan B was outstanding, the prime rate was 6%
for the first 30 days, 6.5% for the next 30 days, and 6.25% for the final 30
days. As a result, the periodic rate was .575% [7% x (30/365)] for the first
30 days, .616% for the second 30 days, and .596% for the final 30 days.
Therefore, its total interest cost was $1,787 [$100,000 x (.575% + .616%
+ .596%)].

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• Line of Credit (LOC)
– A line of credit is an agreement between a commercial bank
and a business specifying the amount of unsecured short-term
borrowing the bank will make available to the firm over a
given period of time.
– It is usually made for a period of 1 year and often places
various constraints on borrowers.
– Although not guaranteed, the amount of a LOC is the
maximum amount the firm can owe the bank at any point in
time.

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– In order to obtain the LOC, the borrower may be required to
submit a number of documents including a cash budget, and
recent (and pro forma) financial statements.
– The interest rate on a LOC is normally floating and pegged to
prime.
– In addition, banks may impose operating restrictions giving
it the right to revoke the LOC if the firm’s financial condition
changes.

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– Both LOCs and revolving credit agreements often require
the borrower to maintain compensating balances.
– A compensating balance is simply a certain checking
account balance equal to a certain percentage of the amount
borrowed (typically 10 to 20 percent).
– This requirement effectively increases the cost of the loan to
the borrower.

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Estrada Graphics borrowed $1 million under a LOC at 10% with a
compensating balance requirement of 20% or $200,000. Therefore,
the firm has access to only $800,000 and must pay interest charges
of $100,000. The compensating balance therefore raises the
effective cost of the loan to 12.5% ($100,000/$800,000) which is
2.5% more than the stated rate of interest.
If the firm normally maintains a balance of $200,000 or more, then
the stated rate will equal the effective rate of interest.

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• Revolving Credit Agreement (RCA)
– A RCA is nothing more than a guaranteed line
of credit.
– Because the bank guarantees the funds will be available, they
typically charge a commitment fee which applies to the
unused portion of of the borrowers credit line.
– A typical fee is around 0.5% of the average unused portion of
the funds.
– Although more expensive than the LOC, the RCA is less
risky from the borrowers perspective.

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• Revolving Credit Agreement (RCA)
REH Company has a $2 million RCA. Its average borrowing under the
agreement for the past year was $1.5 million. The bank charges a
commitment fee of 0.5% As a result, they had to pay 0.5% on the
unused balance of $500,000 or $2,500. In addition, REH paid $112,500
in interest on the $1.5 million it actually used. As a result, the effective
annual cost of the RCA was 7.67% [($112,500 + $2500)/$1,500,000].

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Table 15.2 Summary of Key Features of
Common Sources of Short-Term Financing
(cont.)

Managing Current Liabilities (Gitman)

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