Week 2 Everything

Question 1

Gross working capital

Answer 1

The firm’s total investment in current assets.

Question 2

Net working capital

Answer 2

The difference between the firm’s current assets and its current liabilities.

Question 3

Current liabilities

Answer 3

Current liabilities are a company’s debts or obligations that are due within one year or within a normal operating cycle. They are short-term debts, accounts payables, accrued liabilities, and other similar debts.

Question 4

Working capital 2 issues to consider

Answer 4

How much short-term financing should the firm use?

What specific sources of short-term financing should the firm select?

Question 5

Net working capital represents

Answer 5

the amount of current assets that is financed with long-term funds

Question 6

An increase (change) in working capital

Answer 6

means the company has increased its receivables or other current assets or reduced its current liabilities (e.g. paid off short-term creditors)

Question 7

Working capital management

Answer 7

Working capital management is the management of short-term assets (investments) and liabilities (financing sources) to ensure that the firm has ability to have sufficient cash (from current assets) to pay for the current liabilities when they fall due. Poor working capital management generally results in financial distress and bankruptcy

Question 8

Operating cycle

Answer 8

the time period between the acquisition of inventory and the collection of cash from receivables.

Operating cycle = Inventory period + A/cs receivable period

Question 9

Cash cycle

Answer 9

the time period between the outlay of cash for purchases and the collection of cash from receivables.

Cash cycle = Operating cycle – A/cs payable period

Question 10

Cash conversion cycle

Answer 10

15/3/19

Question 11

What Specific Sources of Short-Term Financing Should the Firm Select?

Answer 11

Three basic factors influence the decision:

The effective cost of credit

The availability of credit in the amount needed and for the period that financing is required

The influence of a particular credit source on the cost and availability of other sources of financing

Question 12

Current assets

Answer 12

A firm’s current assets are assets, such as cash and marketable securities, accounts receivable, inventories, that are expected to be converted to cash within 1 year, or within a normal operating cycle.

Question 13

The Risk-Return Trade-Off

Answer 13

Holding more current assets will reduce the risk of illiquidity. However, liquid assets like cash and marketable securities earn relatively less compared to other assets. Thus, larger amounts of liquid investments will reduce overall rate of return. Increased liquidity must be traded off against the firm’s reduction in return on investment.

Question 14

Use of Current versus Long-Term Debt

Answer 14

Other things remaining the same, the greater the firm’s reliance on short-term debt or current liabilities in financing its assets, the greater the risk of illiquidity. Other things remaining the same, the greater the firm’s reliance on short-term debt or current liabilities in financing its assets, the greater the risk of illiquidity

Question 15

The Advantages of Current Liabilities: Return

Answer 15

Flexibility:
Current liabilities can be used to match the timing of a firm’s needs for short-term financing. Example: Obtaining seasonal financing versus long-term financing for short-term needs.

Interest Cost:
Interest rates on short-term debt are lower than on long-term debt.

Question 16

The Disadvantages of Current Liabilities: Risk

Risk of illiquidity increases due to:

Answer 16

Short-term debt must be repaid or rolled over more often

Uncertainty of interest costs from year to year

Question 17

What would be the an Appropriate level of working capital?

Answer 17

Managing working capital involves interrelated decisions regarding investments in current assets and use of current liabilities. Hedging principle or principle of self-liquidating debt provides a guide to the maintenance of appropriate level of liquidity.

Question 18

The Hedging Principle

Answer 18

The hedging principle involves matching the cash-flow-generating characteristics of an asset with the maturity of the source of financing used to finance its acquisition. Thus, a seasonal need for inventories should be financed with a short-term loan or current liability. On the other hand, investment in equipment that is expected to last for a long time should be financed with long-term debt.

Question 19

Permanent investments

Answer 19

Investments that the firm expects to hold for a period longer than one year

Question 20

Temporary investments

Answer 20

Current assets that will be liquidated and not replaced within the current year

Question 21

Sources of Financing

Answer 21

Total assets will be equal to sum of temporary, permanent, and spontaneous sources of financing.

Question 22

Temporary sources of financing

Answer 22

Temporary sources of financing consist of current liabilities such as short-term secured and unsecured notes payable

Question 23

Permanent sources of financing

Answer 23

Permanent sources of financing include intermediate-term loans, long-term debt, preferred stock, and common equity.

Question 24

Spontaneous Sources of Financing

Answer 24

Spontaneous sources of financing arise spontaneously in the firm’s day-to-day operations. Trade credit is often made available spontaneously or on demand from the firm’s suppliers when the firm orders its supplies or more inventory of products to sell. Trade credit appears on balance sheet as accounts payable. Wages and salaries payable, accrued interest, and accrued taxes also provide valuable sources of spontaneous financing

Question 25

Hedging principle explained further

Answer 25

The hedging principle, or principle of self-liquidating debt, involves matching the cash-flow-generating characteristics of an asset with the maturity of the source of financing used to fund its acquisition. Working capital management policy which states that the cash-flow-generating characteristics of a firm’s investments should be matched with the cash flow requirements of the firm’s sources of financing. Very simple terms, short-lived assets should be financed with short-term sources of financing, whereas long-lived assets should be financed with long-term sources of financing.