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3 FLG Co has annual credit sales of $4·2 million and cost of sales of $1·89 million. Current assets consist of inventory
and accounts receivable. Current liabilities consist of accounts payable and an overdraft with an average interest rate
of 7% per year. The company gives two months’ credit to its customers and is allowed, on average, one month’s credit
by trade suppliers. It has an operating cycle of three months.
Other relevant information:
Current ratio of FLG Co 1·4
Cost of long-term finance of FLG Co 11%
Required:
(a) Discuss the key factors which determine the level of investment in current assets. (6 marks)
(b) Discuss the ways in which factoring and invoice discounting can assist in the management of accounts
receivable. (6 marks)
(c) Calculate the size of the overdraft of FLG Co, the net working capital of the company and the total cost of
financing its current assets. (6 marks)
(d) FLG Co wishes to minimise its inventory costs. Annual demand for a raw material costing $12 per unit is 60,000
units per year. Inventory management costs for this raw material are as follows:
Ordering cost: $6 per order
Holding cost: $0·5 per unit per year
The supplier of this raw material has offered a bulk purchase discount of 1% for orders of 10,000 units or more.
If bulk purchase orders are made regularly, it is expected that annual holding cost for this raw material will
increase to $2 per unit per year.
Required:
(i) Calculate the total cost of inventory for the raw material when using the economic order quantity.
(4 marks)
(ii) Determine whether accepting the discount offered by the supplier will minimise the total cost of
inventory for the raw material. (3 marks)
(25 marks)

3 (a) There are a number of factors that determine the level of investment in current assets and their relative importance varies
from company to company.
Length of working capital cycle
The working capital cycle or operating cycle is the period of time between when a company settles its accounts payable and
when it receives cash from its accounts receivable. Operating activities during this period need to be financed and as the
operating period lengthens, the amount of finance needed increases. Companies with comparatively longer operating cycles
than others in the same industry sector, will therefore require comparatively higher levels of investment in current assets.
Terms of trade
These determine the period of credit extended to customers, any discounts offered for early settlement or bulk purchases, and
any penalties for late payment. A company whose terms of trade are more generous than another company in the same
industry sector will therefore need a comparatively higher investment in current assets.
Policy on level of investment in current assets
Even within the same industry sector, companies will have different policies regarding the level of investment in current assets,
depending on their attitude to risk. A company with a comparatively conservative approach to the level of investment in
current assets would maintain higher levels of inventory, offer more generous credit terms and have higher levels of cash in
reserve than a company with a comparatively aggressive approach. While the more aggressive approach would be more
profitable because of the lower level of investment in current assets, it would also be more risky, for example in terms of
running out of inventory in periods of fluctuating demand, of failing to have the particular goods required by a customer, of
failing to retain customers who migrate to more generous credit terms elsewhere, and of being less able to meet unexpected
demands for payment.
Industry in which organisation operates
Another factor that influences the level of investment in current assets is the industry within which an organisation operates.
Some industries, such as aircraft construction, will have long operating cycles due to the length of time needed to manufacture
finished goods and so will have comparatively higher levels of investment in current assets than industries such as
supermarket chains, where goods are bought in for resale with minimal additional processing and where many goods have
short shelf-lives.
(b) Factoring involves a company turning over administration of its sales ledger to a factor, which is a financial institution with
expertise in this area. The factor will assess the creditworthiness of new customers, record sales, send out statements and
reminders, collect payment, identify late payers and chase them for settlement, and take appropriate legal action to recover
debts where necessary.
The factor will also offer finance to a company based on invoices raised for goods sold or services provided. This is usually
up to 80% of the face value of invoices raised. The finance is repaid from the settled invoices, with the balance being passed
to the issuing company after deduction of a fee equivalent to an interest charge on cash advanced.

If factoring is without recourse, the factor rather than the company will carry the cost of any bad debts that arise on overdue
accounts. Factoring without recourse therefore offers credit protection to the selling company, although the factor’s fee (a
percentage of credit sales) will be comparatively higher than with non-recourse factoring to reflect the cost of the insurance
offered.
Invoice discounting is a way of raising finance against the security of invoices raised, rather than employing the credit
management and administration services of a factor. A number of good quality invoices may be discounted, rather than all
invoices, and the service is usually only offered to companies meeting a minimum turnover criterion.
(c) Calculation of size of overdraft
Inventory period = operating cycle + payables period – receivables period = 3 + 1 – 2 = 2 months
Inventory = 1·89m x 2/12 = $315,000
Accounts receivable = 4·2m x 2/12 = $700,000
Current assets = 315,000 + 700,000 = $1,015,000
Current liabilities = current assets/current ratio = 1,015,000/1·4 = $725,000
Accounts payable = 1·89m x 1/12 = $157,500
Overdraft = 725,000 – 157,500 = $567,500
Net working capital = current assets – current liabilities = 1,015,000 – 725,000 = $290,000
Short-term financing cost = 567,500 x 0·07 = $39,725
Long-term financing cost = 290,000 x 0·11 = $31,900
Total cost of financing current assets = 39,725 + 31,900 = $71,625
(d) (i) Economic order quantity = (2 x 6 x 60,000/0·5)0·5 = 1,200 units
Number of orders = 60,000/1,200 = 50 order per year
Annual ordering cost = 50 x 6 = $300 per year
Average inventory = 1,200/2 = 600 units
Annual holding cost = 600 x 0·5 = $300 per year
Inventory cost = 60,000 x 12 = $720,000
Total cost of inventory with EOQ policy = 720,000 + 300 + 300 = $720,600 per year
(ii) Order size for bulk discounts = 10,000 units
Number of orders = 60,000/10,000 = 6 orders per year
Annual ordering cost = 6 x 6 = $36 per year
Average inventory = 10,000/2 =5,000 units
Annual holding cost = 5,000 x 2 = $10,000 per year
Discounted material cost =12 x 0·99 = $11·88 per unit
Inventory cost = 60,000 x 11·88 = $712,800
Total cost of inventory with discount = 712,800 + 36 + 10,000 = $722,836 per year
The EOQ approach results in a slightly lower total inventory cost