Felicia & Fred recently hired a new designer who has considerable experience in
ID: 2777789 • Letter: F
Question
Felicia & Fred recently hired a new designer who has considerable experience in product development of handbags and small leather goods. The intent was for the designer to initially work with the company’s innovation team to introduce a gift with purchase (GWP): a logo wristlet purse that can accommodate a smartphone. This GWP will be offered as a limited edition during the holiday season and customers or recipients will be encouraged through social media to participate in a survey regarding the product to determine future potential demand for handbags and other small leather goods bearing the Felicia & Fred logo.
The potential inclusion of handbags as part of the company’s product will require significant addition to the total value of Felicia & Fred’s working capital. The entire mix of assets and liabilities as part of the balance sheet might change.
Consider the following:
Name three working capital elements that may change as a result of expansion into a new product line. Indicate why this element of working capital will change. What types of transactions will be either increased or initiated as a result of taking on this endeavor?
In order to maintain the company’s debt covenants, it must maintain a current ratio of 1.5. Its current ratio is presently 1.75 and has been maintained at that level for some time. What happens to a company’s current ratio if it takes on additional short-term debt or accounts payable to fund current assets when the current ratio is greater than one? Less than one?
Given your consideration of the part 2 result, should the company fund a working capital increase with short-term debt or long-term debt?
Explanation / Answer
Solution:
Working capital or the net working capital is the difference between current assets and current liabilities of a company. It is the amount of money required to meet its short term day to day requirements. Current assets are the assets which are expected to generate revenue for the company within one year and current liabilities are the liabilities of the company which are to be paid by the company within one year.
Change in working capital is the difference in the net working capital of one period with the net working capital of other period.
Major components of current assets & current liabilties are:
Current assets - Accounts receivables, cash, inventories, short term investments
Current liabilities - Short term debt, accounts payable, accrued liabilities
Now when a company expand into a new product line, then three major components which might change are:
1. Inventories - With a new product line, inventories of the product will increase. The demand of the product at earlier stage is not expected to be high, hence there will be large amount of inventories of the product with the company.
2. Account receivables - Since the company has expanded to new product line, it will look to sell its products on credit basis initially to gain the market share of the product, so it will enable the accounts receivables of the company to rise.
3. Accounts Payables - The company will source the raw materials of the new product from suppliers on credit basis to control the cash outflow at an early stage, so the accounts payable will increase.
As a result of taking on this endeavor, the credit transactions are expected to increase or initiate.
Current ratio is the ratio of current assets with current liabilities. When the current ratio is greater than one, it means that the current assets are more than current liabilities and the if the company takes on additional short term debt or accounts payable, the current liabilties will increase and with the increase in denominator, the ratio will decrease and hence, current ratio will decrease.
But if the current ratio is less than one, current liabilities are more than current assets and if the company takes on additional short term debt or accounts payable, then current liabilites will increase further bringing down the current ratio further.
If the current ratio goes below 1.5 after taking short term debt, company should avoid it and start using long term debt to fund its working capital increase.
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