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Chapter 15: Problem 5

A chain of appliance stores, APP Corporation, purchases inventory with a net price of \(\$ 500,000\) each day. The company purchases the inventory under the credit terms of \(2 / 15,\) net \(40 .\) APP always takes the discount, but takes the full 15 days to pay its bills. What is the average accounts payable for APP?

Short Answer

Expert verified
The average accounts payable for APP is $7,350,000.

Step by step solution

01

Understanding the Credit Terms

The credit terms \(2/15, \text{ net } 40\) indicate that APP Corp can take a 2% discount if they pay within 15 days, otherwise, the full invoice amount is due within 40 days.
02

Calculating the Discounted Price

Since APP Corp always takes the discount, they only pay 98% of the net price. Calculate the discounted price: \[ \text{Discounted Price} = 500,000 \times (1 - 0.02) = 500,000 \times 0.98 = 490,000. \]
03

Daily Payment Calculation

APP Corp pays the discounted price every day, so each day they pay \( \$ 490,000. \)
04

Calculating Average Accounts Payable

Accounts payable refers to the amount the company owes suppliers over a certain period. Given that payments are made every 15 days, the average accounts payable is the amount due at any given time during the payment cycle. This is calculated as: \[ \text{Average Accounts Payable} = \text{Daily Payment} \times \text{Payment Cycle} = 490,000 \times 15. \]
05

Final Calculation

Multiply the daily payment by the length of the payment cycle to find the average accounts payable: \[ 490,000 \times 15 = 7,350,000. \]

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Accounts Payable
Accounts payable is essentially money owed by a business to its suppliers for goods or services purchased on credit. When APP Corporation purchases inventory and decides to take the full 15 days allowed by their credit terms to pay, this amount becomes part of their accounts payable. The accounts payable reflects the short-term liabilities in the company's balance sheet.
  • It represents the obligation of the company to pay its suppliers.
  • Timely management of accounts payable is crucial to maintaining good supplier relationships and optimizing cash flows.
  • Calculating the average accounts payable helps in understanding how much of the company's money is tied in payable obligations over a period, such as the 15-day cycle in APP's case.
Understanding accounts payable is critical as it affects liquidity, the ability to meet short-term obligations, and influences financial management decisions.
Inventory Management
Inventory management is the supervision of non-capitalized assets, or inventory, and stock items. APP Corporation purchases $500,000 worth of inventory daily, meaning they constantly manage a high volume of stock movement.
  • This process ensures that the right amount of stock is maintained to meet customer demand without delay.
  • Effective inventory management balances ordering costs against holding costs, ensuring financial efficiency.
  • Automating inventory management with technology can help track stock levels, orders, sales, and deliveries, minimizing errors.
Proper inventory management is essential for a company like APP as it directly impacts both revenue generation and cost control. Ensuring optimal stock levels translates to better customer service and profitability.
Credit Terms in Finance
Credit terms outline the guidelines regarding payment timelines and any discounts available for early payment. In the example of APP Corporation, the credit terms of "2/15, net 40" describe the specifics.
  • The numbers "2/15" imply a 2% discount is available if payment is made within 15 days.
  • The term "net 40" specifies that if the discount is not taken, the total invoice is due within 40 days.
  • Companies like APP Corporation benefit from taking advantage of such discounts, as they reduce cost per purchase.
Understanding and leveraging credit terms allow businesses to manage their expenses better, capitalize on savings opportunities, and maintain positive relationships with suppliers. The practice also supports better financial planning and liquidity management.

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Most popular questions from this chapter

Suncoast Boats Inc. estimates that because of the seasonal nature of its business, it will require an additional \(\$ 2\) million of cash for the month of July. Suncoast Boats has the following 4 options available for raising the needed funds (1) Establish a 1-year line of credit for \(\$ 2\) million with a commercial bank. The commitment fee will be 0.5 percent per year on the unused portion, and the interest charge on the used funds will be 11 percent per annum. Assume that the funds are needed only in July, and that there are 30 days in July and 365 days in the year. (2) Forgo the trade discount of \(2 / 10\), net \(40,\) on \(\$ 2\) million of purchases during July. (3) Issue \(\$ 2\) million of 30 -day commercial paper at a 9.5 percent per annum interest rate. The total transactions fee, including the cost of a backup credit line, on using commercial paper is 0.5 percent of the amount of the issue. (4) Issue \(\$ 2\) million of 60 -day commercial paper at a 9 percent per annum interest rate, plus a transactions fee of 0.5 percent. since the funds are required for only 30 days, the excess funds ( \(\$ 2\) million) can be invested in 9.4 percent per annum marketable securities for the month of August. The total transactions cost of purchasing and selling the marketable securities is 0.4 percent of the amount of the issue. a. What is the dollar cost of each financing arrangement? b. Is the source with the lowest expected cost necessarily the one to select? Why or why not?

The Christie Corporation is trying to determine the effect of its inventory turnover ratio and days sales outstanding (DSO) on its cash flow cycle. Christie's 2001 sales (all) on credit) were \(\$ 150,000,\) and it earned a net profit of 6 percent, or \(\$ 9,000 .\) It turned over its inventory 5 times during the year, and its DSO was 36.5 days. The firm had fixed assets totaling \(\$ 35,000\). Christie's payables deferral period is 40 days. a. Calculate Christie's cash conversion cycle. b. Assuming Christie holds negligible amounts of cash and marketable securities, calculate its total assets turnover and ROA. c. Suppose Christie's managers believe that the inventory turnover can be raised to 7.3 times. What would Christie's cash conversion cycle, total assets turnover, and ROA have been if the inventory turnover had been 7.3 for 2001 ?

Dorothy Koehl recently leased space in the Southside Mall and opened a new business, Koehl's Doll Shop. Business has been good, but Koehl has frequently run out of cash. This has necessitated late payment on certain orders, which, in turn, is beginning to cause a problem with suppliers. Koehl plans to borrow from the bank to have cash ready as needed, but first she needs a forecast of just how much she must borrow. Accordingly, she has asked you to prepare a cash budget for the critical period around Christmas, when needs will be especially high. Sales are made on a cash basis only. Koehl's purchases must be paid for during the following month. Koehl pays herself a salary of \(\$ 4,800\) per month, and the rent is \(\$ 2,000\) per month. In addition, she must make a tax payment of \(\$ 12,000\) in December. The current cash on hand (on December 1 ) is \(\$ 400\), but Koehl has agreed to maintain an average bank balance of \(\$ 6,000-\) this is her target cash balance. (Disregard till cash, which is insignificant because Koehl keeps only a small amount on hand in order to lessen the chances of robbery.) " The estimated sales and purchases for December, January, and February are shown below. Purchases during November amounted to \(\$ 140,000\). $$\begin{array}{lcr} & \text { SALES } & \text { PURCHASES } \\ \hline & & \\ \text { December } & \$ 160,000 & \$ 40,000 \\ \text { January } & 40,000 & 40,000 \\ \text { February } & 60,000 & 40,000 \end{array}$$ a. Prepare a cash budget for December, January, and February. b. Now, suppose Koehl were to start selling on a credit basis on December 1 , giving customers 30 days to pay. All customers accept these terms, and all other facts in the problem are unchanged. What would the company's loan requirements be at the end of December in this case? (Hint: The calculations required to answer this question are minimal.)

Suppose a firm makes purchases of \(\$ 3.65\) million per year under terms of \(2 / 10,\) net 30 and takes discounts. a. What is the average amount of accounts payable net of discounts? (Assume that the \(\$ 3.65\) million of purchases is net of discounts - that is, gross purchases are \(\$ 3,724,490,\) discounts are \(\$ 74,490,\) and net purchases are \(\$ 3.65\) million. b. Is there a cost of the trade credit the firm uses? c. If the firm did not take discounts but it did pay on the due date, what would be its average payables and the cost of this nonfree trade credit? d. What would its cost of not taking discounts be if it could stretch its payments to 40 days?

a. If a firm buys under terms of \(3 / 15,\) net \(45,\) but actually pays on the 20 th day and still takes the discount, what is the nominal cost of its nonfree trade credit? b. Does it receive more or less credit than it would if it paid within 15 days?
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