Corporate Finance

CHAPTER 1
INTRODUCTION

1.1 Background of the Case

Action Standard was established in 1920. It is a nationally known producer of top

lawnmowers, garden tractors, tillers and implements. It has been growing steadily since its
establishment. In 2005, it decided to embark on a rapid expansion program to take advantage
of the growing market for all purpose tractor/lawnmowers/snow blower machines. This
expansion called for increases in assets of approximately 50 percent in both 2006 and 2007.

Dianne Covington, financial vice president of Action Standard manufacturing Co. while
reviewing the financial projections for 2007 together with balance sheets for 2005 and 2006
and ratios (see table 1 and 2) saw significant trends developing. By the end of 2006, the
liquidity position was below the prescribed level and the projected level for 2007 was
unacceptable. The debt ratio is also not good but since the ratio was let to climb to the level
shown in 2007 at the last director's meeting, it was anticipated. However, the directors
tentatively agree to consider a cut in the dividend until the debt ratio can be reduced to
approximately the level of the industry average but final action has not been taken.

She had not expected the declining profit margin on sales and falling rate of return on assets.
She had expected both of these ratios to increase because of the increased level of efficiency,
resulting from the plant modernization and expansion program. While studying the figures,
she realized that the abandonment of its policy of taking discounts on all purchases had
contributed to the increase in costs and resulted in decline in the profit margin on sales and
rate of return. The firm purchases material on terms of 3/10, net 30.

Covington is convinced that important changes must be done and this is reinforced by a letter
that she receives from the insurance company that holds Action Standard's long term debt.
The insurance company voices concern in the declining liquidity position and points out the
agreement under which the loan was made requires the company to maintain a current ratio
of at least 2 to 1. The letter also states that Action Standard is expected to correct its liquidity
position in the near future. Covington is sure that if she devises a plan whereby the liquidity
ratios will be corrected within a reasonable period of time, the insurance company will give
time to correct the deficiency.

Covington thinks of various alternatives. Her first alternative is whether the company should
slow down its expansion program. However, this seems to be difficult to implement. The
company has already contracted for the fixed assets expansion which makes it impossible to
reduce the $ 23 million figure anticipated for 2007. The company could slow down its rate of
growth in sales by turning down orders thereby reducing the estimated figures for 2007 for
working capital. The turning down of offers will lead the company in not being able to make
profitable sales and could harm future operations if crucial retail outlets were lost. Hence,
Covington feels that this alternative is highly undesirable.

The anticipated level of accounts payable presents two problems. Firstly, the $ 17.7 million
accounts payable projected for 2007 is based on the assumption that accounts payable will
not be paid until 30 days past their due date. Even though such delay in payments is common
in the industry, Covington feels that this trend could hurt the company's reputation. Due to

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Action Standard's reputation of being a responsible company, its suppliers make every effort
to give quick delivery and call on available supplies during shortage periods and Action
Standard has been able to negotiate favorable prices in its supply contracts. With delay in
payments, it can easily lose these benefits. Secondly, the firm will continue to lose trade
discount as it did in 2006.

Another alternative could be reducing accounts payable by increasing the notes payables to
banks. Action Standard attempted to borrow additional funds from MidCon National Bank,
with whom it has been dealing since it was founded, in 2006. The bank was not able to
provide loan as it could not lend more than 10 percent of its capital and surplus amount of $
82 million to any one customer. Hence, Covington was focusing on establishing relations
with a larger bank. Rudolph Brenner, president of MidCon National Bank, suggested that
additional bank loans at a 10 percent rate, discount interest, with a 10 percent compensating
balance, could be gotten from the Security Bank & Trust Company. Under the terms of the
proposed bank loan, Action Standard would be required to give a blanket pledge on all assets
that are not now used as collateral for existing loans. Further, the bank loan could not be
granted if either accounts receivable pledging or factoring is employed.

Covington could obtain a loan secured by accounts receivable from a major finance company.
The interest rate on this loan would be 13 percent if accounts receivable are pledged for the
loan or 12 percent plus a 5 percent discount from the face value of each account receivable
invoice if the credit is obtained by factoring the receivables on nonrecourse basis. Covington
questions the wisdom of factoring accounts receivables, since her company has its own well
developed credit department.

Covington is also considering the use of commercial paper as another alternative. The
commercial paper rates at present as per the recent issues of The Wall Street journal are
approximately 10 percent. Covington was contacted by commercial dealers every two or
three months for the past few years to ask whether she was interested in obtaining funds
through the commercial paper market but she has not received any solicitation for the past six
months from those dealers.

Lastly, Covington thinks about obtaining credit secured by Action Standard's inventories
which are projected to rise to almost $ 21 million by the end of 2007. If a lower interest rate
could be obtained if the loan would be secured by inventories, Covington is willing to use
them as collateral.

There is no possibility of selling additional long term debt. The loan agreement with the
insurance company calls for Action Standard to receive an additional $ 4.695 million during
2007, but it specifies that the company can obtain no other new long term debt financing.
Because of the director's desire to maintain their control position, the board of directors has
decreed that there will be no new common stock issued during 2007.

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Table 1: Action Standard Manufacturing Co. (In '000 $)

2005 2006 Estimated
2007
Cash and Securities 1400 1800 4932
Accounts Receivable 6820 9030 14250
Inventories:
Raw Materials 698 1220 1538
Work in Process 5947 10131 18265
Finished Goods 375 649 1047
Total Inventories 7020 12000 20850
Total Current Assets 15240 22830 40032
Net Fixed Assets 12760 19170 22968
Total Assets 28000 42000 63000
Accounts Payable 2750 6800 17700
Notes Payable (Bank 10%) 3110 4071 4700
Total Current Liabilities 5860 10871 22400
Long Term Debt 5401 10305 15000
Common Equity 16739 20824 25600
Total Claims 28000 42000 63000
Sales 70000 90268 125350
Notes: Accounts payable are reported net of discounts even if not taken.

Table 2: Significant Industry Ratios

2005 2006 Estimated Average
2007 Industry
(2006)
Current Ratio, times 2.60 2.10 1.79 2.20
Quick Ratio, times 1.40 1.00 0.86 1.20
Debt Ratio (%) 40.2 50.4 59.4 43.0
Profit Margin on Sales (%) 6.0 5.3 5.3 6.0
Rate of return on assets (%) 15.0 11.4 10.6 11.0
Rate of return on net worth (%) 25.0 23.0 26.0 23.0

1.2 Statement of the Problem

This case analysis deals with following problems:

• Selection of the best alternative from the given forms of short term financing options.
• Convincing the Insurance Company to give time by providing a feasible plan to
improve the liquidity.

1.3 Objectives of the Case Study

The case analysis of Acton Standard Manufacturing Company will provide us understanding
of the meaning and nature of short term financing of a company. It will also explain the use
of secured and unsecured forms of short term financing. The pros and cons of unsecured short
term financing such as trade credit and commercial paper and secured short term financing
such as receivables financing and inventory loans will be analyzed. It also helps in
determining their costs. It also helps in analyzing the problem of selecting the best alternative

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with qualitative as well as quantitative analysis. The case also highlights the importance of
selection of effective short term financing to improve the liquidity status of a company and its
impact on company reputation and future business viability. It also shows how analysis of
interest rates, costs and savings play vital roles in determining the optimal form of short term
financing.

With consideration of all these aspects, the specific objectives of the study are as follows:

• Calculation of costs of each short term financing option and liquidity ratios.
• Analyzing the advantages and disadvantages of each alternative.
• Analyzing the financing proposals and selection of the best option.
• Provide evidence to support short term financing option.

1.4 Significance of the Case Study

Relevant financial concepts evident in the case

1. Short term financing
2. Secured and Unsecured forms of short term financing

1.5 Organization of the Case Study

The overall report is divided into five chapters. First chapter deals with background of the
study “Action Standard Manufacturing Company”, statement of problem, objectives of the
study, significance of the study, organization of the study. The second chapter literature
review deals with the review of the conceptual framework for the study. The third chapter
research methodology deals with how the case has been carried out and consists of the units
like research design, source of data, data selection procedure and the limitations of the study.
The fourth chapter deals case analysis and discussion of the questions. The fifth chapter
consists of the conclusion and recommendation of the case.

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CHAPTER 2
LITERATURE REVIEW

Short Term Financing

After planning investment in current assets and forecasting funds required by the firm over
the coming year, the financial manager must arrange for financing. After deciding on the
combination of debt and equity sources to be used, the financial manager must decide on the
particular type of debt financing. Short term borrowing is typically used to finance temporary
investments in current assets. Short term financing is less costly than long term debt but it is
more risky as compared to long term debt. It is more risky because it has to be paid within a
short period of time. There are various sources of short term financing available to a firm.
The short term borrowing is of two types i.e. unsecured and secured.

Trade credit, accrual financing, commercial paper, banker's acceptance, short term loans are
the unsecured form of financing. Trade credit is one of the most common sources to almost
all businesses and it represents the largest source of short term funds for business firms. It is
represented by accounts payable in the Balance Sheet. When a firm pays after a certain days
after purchase of goods and services, trade credit is created or accounts payable are
generated. This form of financing is important to firms because suppliers are generally more
liberal in the extension of credit than are financial institutions. Also small firms do not have
good access to capital markets and hence this form of financing is vital for them. It is a
spontaneous source of financing in that it arises from ordinary business transactions.

Accrual financing is a more spontaneous source of financing than trade credit financing.
Accruals are short term liabilities that arise when services are received but payment has not
yet been made. The two major accruals are wages payable and taxes payable. In accrual
accounts, usually a date is specified for making payments for accruals. Accruals are costless
form of financing but not discretionary form of financing.

Commercial paper represents unsecured, non bank, negotiable promissory notes sold in the
money market. The loan against the paper is not pledged by any collateral and its maturity is
within one year. It is suitable for credit worthy companies and is cheaper to bank loans.

Banker's acceptance is a major source of financing for companies engaged in foreign trade. It
is a written statement made by a bank that it will pay out money is specified conditions are
met.

The short term, unsecured loans are regarded as self liquidating type of loans. They are
known as short term because they have a maturity period of one year or less and they are
unsecured because they do not require any assets to be pledged as collateral. Unsecured short
term loan can be extended as a line of credit, a revolving credit agreement, a transaction loan.
Secured short term financing involves pledging of collateral to back a loan. This form of
financing is costlier than unsecured short term financing. The incremental cost that arises due
to security is passed on to the borrower in the form of fees and higher interest costs. The
major issue on secured loans is how much to lend against collateral and this depends on:
• Marketability
• Life of the collateral
• Risk

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For secured short term loans, the collateral may be accounts receivable or inventory,
equipment or other assets of the borrower. Receivable financing is a secured form of short
term financing and it is of two types i.e. assignment of receivables and factoring. By pledging
or assigning an account receivable, a firm gives up the rights to cash collected on that
account. Factoring is the term for a financial transaction in which a business sells its accounts
receivable to a specialized finance company. The receivables are sold at a discount and
finance company, known as the factor, has the responsibility of collecting the outstanding
amounts. This is sometimes referred to as accounts receivable financing or factoring.

Inventory loans are also regarded as a reasonably liquid asset. The loans to be provided
against the pledging of inventory depends on marketability, perishability, market price
stability and the difficulty and expense involved in selling the inventory. Even though these
factors are important, the actual decision depends on the cash flow ability of the borrower to
service debt. If the cash flow ability is good, more debt would be provided. There are various
methods of providing inventory loans such as trust receipt loans, floating lien, chattel
mortgage, terminal warehouse receipt loans, field warehouse receipt loans.

In giving a secured loan, the lender looks first to the cash flow ability of the company to
service debt and if this source of loan repayment should fail, to the collateral value of the
security. To provide a margin of safety, a lender usually will advance somewhat less than the
market value of the collateral.

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CHAPTER 3
RESEARCH METHODOLOGY
Research is defined as human activity based on intellectual application in the investigation of
matter. The primary purpose for applied research is discovering, interpreting, and
developing methods and systems for the advancement of human knowledge on a wide
variety of matters.

3.1 Research Design

The research was started with an objective to study and analyze different forms of short term
financing. To meet this objective, all the necessary information (descriptive data) was
collected and then presented. The information was then used to select the most effective
alternative to choose the best form of short term financing that would result in the
improvement of the liquidity ratios of the company.

3.1.1 Descriptive Research

To further support the study, descriptive research was conducted. The descriptive research
was carried out to study and analyze the reasons for selecting the best method for short term
financing and choosing the best option among the provided alternatives. In the course of
descriptive research, textbook was used as the major source.

3.2 Data Collection Procedures

3.2.1 Sources of Data

Secondary data have been used for the purpose of the study. The data includes:
• Internet searching
• Text books

3.3 Data Analysis Tools

Collected data have been categorized into homogeneous nature for clear understanding and
these data have been presented in graphs and figures.

3.4 Limitations of the Study

The research was carried competently by consultation of several textbooks and Internet
sources. However it has certain limitations that are as follows:
• The case analysis was completed in a short span of time. So due to the time constraint,
the analysis may not deal with the minute issues related with the topic under study.

• The analysis part of the study only deals with a certain time period and ignores other
times where significant events may have occurred and thus caused financial
fluctuations in the Egret Printing and Publishing Company.

• The reasons given for the selection of short term financing and the best alternative

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among the given options are based on our understanding of principles of finance.
However these reasons are judgmental and opinionated to a very large extent and
therefore may not be hundred percent accurate.

• The case analysis depends both on quantitative and qualitative analysis. However,
some qualitative factors might have gone unconsidered in the evaluation of the best
form of short term financing.

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CHAPTER 4
CASE ANALYSIS
4.1 Question 1

Does the commercial paper market now present a feasible alternative to Action
Standard? Explain your reasoning.

Action Standard is a nationally known producer of top quality lawnmowers, garden tractors,
tillers, and implements. As the company is going through rapid expansion program to take
advantage of the growing market the company is in desperate need of short term funds.
Although accounts payable was one of source of short term financing the firm is trying to use
as per the projection for 2007, it is based on the assumption that accounts payable will not be
paid until 30 days past their due day. However, this may hurt the company’s reputation for
being an excellent customer which may hamper its ability to negotiate favorable prices in its
supply contracts as well as this will also result in losing of trade discounts for the company.

So, in order to minimize the extra burden on accounts payable, commercial paper seems to be
quite a good source of short term financing for Action Standard Manufacturing Company.
The other factors that make commercial paper a feasible alternative to Action Standard are:
• As Action Standard Manufacturing Company is a nationally known company it will
be easier for it to get short term financing through commercial paper.
• Commercial paper avoids inconvenience and expense of financing arrangements with
a number of institutions.
• It is cheaper to bank loans.
• There is no need to pledge collateral.
However, use of Commercial Paper as the source of short term funds depends upon how
much certainty there is in the economy. Similarly, commercial paper will not be a viable
option if Action Manufacturing Company needs the fund immediately.

4.2 Question 2

Discuss the feasibility of Action Standard's using its inventory as collateral for a loan. If
this form of financing is undertaken, what type of security arrangements would
probably be used? Do you think that Action Standard's inventories would make very
good security for a loan?

Inventories are regarded as reasonably liquid assets. They are acceptable as security to the
lender for short term loan. However, the lender will decide how much to lend against the
inventories of Action Standard. This decision will depend upon the quality of the company's
inventories. The company sells lawn mowers, garden tractors which are specialized
equipments and hence their marketability is somewhat low. The marketability of the
inventories represents the quality of the inventories. Since the marketability of Action
Standard's inventories are not good, that is they are difficult to sell, the lender may be hesitant
to provide loan. Also, the equipments will involve cost at the time of sale, thereby reducing
the probability of Action Standard's probability of getting higher percentage of loans.
If inventories are pledged as collateral to obtain loan, Action Standard will be able to use the
following security arrangements:

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• Trust receipt loan

Trust Receipt (TR) is a type of short-term import loan to provide the buyer with financing to
settle goods imported under Letter of Credit where title of goods is held by the bank. Under a
TR arrangement, the Bank retains title to the goods but allows the buyer to take possession of
the goods on trust for resale before paying the Bank on TR due date. TR financing is
applicable to goods imported under documentary credit

Action Standard can enjoy the following benefits under TR:

 Do not need to effect payment immediately when documents are presented under
documentary credit, documentary collection or open account.
 Financing can be up to 100% of the documentary credit, documentary collection or
invoice value.
 Enjoy credit terms pre-approved by the Bank, with principal and interest only payable
on maturity.
 Its working capital or cash flow is not tied up and can be deployed for other business
purposes

Even though these securities do have several benefits, there are a few potential disadvantages.
One of the biggest disadvantages is that these securities cost a lot of money to issue. When
issued, the company that issues them has to pay a higher interest rate than they would for
other types of debt. The reason behind this is that this type of debt is subordinated behind
other types of debt. Since investors are taking a bigger risk of losing their capital because of
this, they are going to require a higher interest rate.

• Chattel mortgage
If inventories are identifiable by serial number or by some other means, then inventory loans
may be provided under chattel mortgages. Under this arrangement, Action Standard will hold
title to the goods, but the lender exercises a lien on inventory. It means inventory cannot be
sold without the consent of the lender. The chattel mortgages are suited for Action Standard's
inventories because it does not involve rapid turnover and hence its inventories are not
difficult to be identified.

• Terminal warehouse receipt loans

Action Standard can secure a terminal warehouse receipt loan by storing inventory with a
public, or terminal, warehousing company. The warehouse company will issue a warehouse
receipt, which evidences title to specified goods that are located in the warehouse. Under
such an arrangement, the warehouse can release the collateral to the borrower only when
authorized to do so by the lender. Consequently, the lender is able to maintain strict control
over the collateral and will release collateral only when the borrower pays a portion of the
loan. For protection, the lender usually requires the borrower to take out an insurance policy
with a loss payable clause in favor of the lender. Action Standard can secure a nonnegotiable
warehouse receipt which is issued in favor of the lender who is given title to the goods and
has sole authority to release them. The release of goods can be authorized only in writing.

• Field Warehouse Receipt Loans

Field warehousing, will permit loans to be made against inventory that is located on Action
Standard's premises. Under this arrangement, a field warehousing company sets off a
designated storage area on the borrower's premises for the inventory pledged as collateral.

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The field warehousing company has sole access to this area and is supposed to maintain strict
control over it.
The terminal and warehouse receipt loans are available options for Action Standard to secure
loans but these forms will be more expensive for the company as it will have to insure the
inventories and hence have to incur additional insurance costs. Action Standard can pledge its
inventory as truest receipt loan or chattel mortgage for less cost.
Action Standard's inventories consist of lawn mowers, garden tractors, tillers and implements
and these inventories do not have high marketability as compared to food grains. The
inventories are such that they are specialized equipments and will be difficult to sell. The
lender will have to incur additional expenses in its selling with the inventories being of
reasonably large size and face difficulty in selling due to their low marketability. The lender
may provide small percentage of loans against the inventories or may refuse to lend. So,
Action Standard's inventories will not make a good security for the loan.

4.3 Question 3

Determine the approximate rate of interest on foregone discounts. What are the
advantages and disadvantages of allowing accounts payable to build up, as the financial
staff has suggested? Discuss specifically the firm's declining liquidity position and its
use of "spontaneous" financing through trade credit. Would it be a wise policy to build
up accounts payable?

The approximate rate of return on foregone discounts is calculated below:

.

Therefore, the approximate rate of return on foregone discount is 56.44%.

The advantages of allowing accounts payable to build up are:

• It will be readily available source of fund for Action Standard Manufacturing
Company.
• It acts as the continuous source of credit.
• There is no need to arrange financing formally and negotiate much.
• It has shorter lead time as being a source of short term fund.
• There is no need to pledge collateral.
Similarly, the major disadvantages of allowing accounts payable to build up are:
• The cost of cash discount foregone.
• The possible deterioration of credit rating. This may hurt the company’s reputation for
being an excellent customer which may hamper its ability to negotiate favorable
prices and terms and conditions in its supply contracts.

As seen in the table 2 of the case the liquidity position of the company is in decreasing trend
which is shown by Current and Quick ratios. The reason behind this is % increase in current
assets is less than % increase in current liability of the company which can be seen on table 1
of the case. As the company is expanding there is increase in production of the company

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which requires higher amount of purchase of raw material and this has resulted in building up
of accounts payable. Similarly, the stretching of accounts payable has more worsened the
liquidity position of the company.

The insurance company that holds Action Standard’s long-term debt has already voiced its
concern over the declining liquidity position and has pointed out the agreement under which
the loan was made requires the company to maintain a current ratio of at least 2:1. Building
up of accounts payable will further deteriorate the liquidity position to less than prescribed by
its lender. Similarly, the cost of foregone discount is quite high and stretching of accounts
payable also hampers its credit rating. So, it would not be the wise policy to build accounts
payable.

4.4 Question 4

Discuss the pros and cons of Action Standard's using account receivable financing at the
present time. What would be the impacts of accounts receivable financing on current
ratio and quick ratio? Determine the new level of these ratios. If the company elects to
use receivable financing, would it be better off factoring or pledging its accounts
receivable? (Assume 95% loan on receivables).

Action Standard Manufacturing Company can obtain accounts receivable financing in two
ways i.e. through assignment of accounts receivables or factoring.

The major advantages of using accounts receivable financing at the present time are:
• Quick access to financing: Accounts receivable are one of the most liquid forms of
assets. They act as attractive collateral to commercial banks and finance companies as
securing a loan against this form of financing involves less bureaucracy. In case of
factoring, the business can receive cash immediately from the factor instead of
waiting to receive from customer accounts receivables. This is important for Action
Standard as it needs cash to pursue finance growth.

• Ease of cash flow problem: The Company can receive instant cash which will help
ease the cash flow problem. The cash can be used to improve the financial
performance of the company. This type of arrangement will improve cash flow and
shorten the cash cycle. The business will be able to receive immediate cash from the
factor and without carrying out the collections process.

• Focus on income generating activities: Selling receivables can free the owners up to
work on income generating activities. Instead of tracking down missing payments,
owners can concentrate on other business operations.

• Protection from bad debts: Since the factoring alternative is on a non-recourse basis,
the factor will assume the risk of bad debts. Hence, if a customer account cannot be
collected, the factor must absorb the loss. This will protect the company against the
bad debt losses.

• High size of receivables: Action Standard sells top quality lawnmowers, garden
tractors, tillers and implements which cost high amount. The accounts receivable for
the year 2006 and 2007 are $ 9,030,000 and 14,250,000 which are huge amounts.

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Hence, the size of accounts receivable is big. This is a benefit for the company as it
can secure higher percentage of loan against the size of its receivables.

However, there are some disadvantages of accounts receivable financing as well:

• Sell at discount: Action Standard’s owners will have to sell their accounts receivables
at a discount under factoring which means that they get less money for them.

• Cost: Under a factoring agreement, the factor purchases accounts receivable at a

discount. Depending on the discount amount, a factoring agreement may imply a very
high cost of capital. This cost must be compared to the cost of other methods of
financing available to the business.

• Factor’s influence: When Action Standard will work with a factor, they will be
introducing an outside influence into their business. Since the factor will be
responsible for collecting accounts receivable and may be responsible for amounts
which cannot be collected, they may try to influence sales practices. This can include
attempts to influence sales policies and timing, as well as the customers that a
business with deal with.

• Customer relations: When a factor comes into play, he/she as a third party will now
deal directly with customers to collect amounts owed, this can have a negative impact
customer perception of the business. This is especially true if the factor engages in
aggressive or unprofessional practices when collecting receivables.

• Sign of weakness: Receivable financing is seen by many creditors and customers as a

sign of weakness. Creditors may view receivables financing as harmful to next
period’s cash and may feel that the firm must be facing financial difficulties.

4.5 Question 5
Assume that Action Standard does not go along with suggestions of building up
accounts payable to 60 days (reflected in the 2007 proforma balance sheet in Table 1)
but opts instead to start paying in 10 days and taking discounts.

a. What is revised amount of Action Standard's projected year end 2007 accounts
payable?

Given, Accounts Payable net of discounts for 60 days = $ 17,700

Since Action Standard Manufacturing Company starts to pay in 10 days and take discount,
Revised amount of accounts payable = $ 17,700 × 10
60
= $ 2,950

The revised amount of Action Standard’s projected year end 2007 accounts payable is
$2,950.

b. Determine the amount of funds Action Standard would have to borrow in order
to take discounts. What would be the effective cost? Assume at this point that
bank borrowing, at 10 percent discount interest and with a 10 percent
compensating balance requirement, is used. Also assume that all asset accounts,

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including cash and securities now on hand, cannot be reduced. Base your answer
on Action Standard's "steady state" borrowing requirements, which means
disregarding the one-time funds requirements to account for the fact that
accounts payable are currently carried at net, yet most of them will have to be
paid off at gross.

c. What are the net savings that Action Standard will realize from borrowing to
take the discounts? Note that accounts payable are recorded net of discounts.
(Hint: find the annual gross purchases as the initial step, followed by discount
revised, interest on borrowing and so on).

Accounts Payable in the year 2007 = $ 17700 (net of discounts)

Term of credit is 3/10, net 30
Calculating the net savings that Action Standard can realize from borrowing to take the
discounts
Annual Gross Purchase = 17700
0.97
= $ 18247

Bank borrowing at 10% discount interest and with a 10% compensating balance requirement
is used

Amount to be borrowed for taking discount = 18247

100% - 10% - 10%
= $ 22809
Discount Amount = 18247 × 3% = $ 547
Interest on borrowed amount = 10% on $ 22809
= $ 2281

Net Savings from borrowing = Discount amount – Interest on borrowed amount

= $ (547 - 2281)
= - $ 1734

From the above calculation, we can say that when borrowing is made from the bank in order
to get cash discount on the purchases, there will be loss for the company. The interest on the
borrowed amount is more than the discount that the company will receive. So, it is not
profitable for the company to borrow in order to take discount on its purchases.

4.6 Question 6

What effect would Covington's decision to take cash discounts have upon the current
ratio, quick ratio and profit margin? No further calculations are required for this
question.

4.7 Question 7

Should Action Standard establish relations with and arrange a line of credit from
Security Bank and trust Company?

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4.8 Question 8

What specific actions do you think Dianne Covington should recommend for Action
Standard during the coming year?

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CHAPTER 5
CONCLUSION AND LESSONS LEARNT
5.1 Synopsis

Dianne Covington, financial vice president of Action Standard Manufacturing Company saw
that the company's liquidity ratio and profit margin is declining and the debt ratio in
increasing while reviewing the financial projections for 2007 along with balance sheets for
2005 and 2006. The company is in the midst of an expansion program and she is faced with
the decision of selecting the best form of short term financing among the various alternatives
to improve the liquidity ratio of the company so that she can convince the Insurance
Company, that holds Action Standard' long term debt, to give them time to correct the
deficiency. She has the alternatives of:
• slowing down the expansion program which is highly undesirable as the profit margin
will go down,
• stretching accounts payable which will hurt the company's reputation of being an
excellent customer,
• increasing notes payable by obtaining bank loan,
• obtaining loan by either assigning accounts receivable from a major finance company
or factoring the receivables on a non recourse basis,
• using commercial paper,
• obtaining credit by pledging its inventories as collateral.
Covington has to choose from among these alternatives the best form of short term financing
that will help Action Standard to improve their financial performance and obtain loans at the
lowest cost.

5.2 Conclusion

5.3 Lessons Learnt

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