Los 23.b Flashcards
(12 cards)
How does an increase in the Cash Conversion Cycle (CCC) affect liquidity?
An increase in the CCC reduces an issuer’s liquidity by slowing down the process of converting investments into cash. A higher CCC can be caused by:
Drag on liquidity: Occurs when cash inflows are delayed (e.g., excess inventory or slow collections).
Pull on liquidity: Occurs when cash outflows accelerate (e.g., suppliers reduce credit lines or demand faster payments).
hat is the current ratio and how is it calculated?
The current ratio measures a company’s ability to meet its current liabilities with its current assets. A current ratio greater than 1 indicates the company has sufficient assets to cover its short-term liabilities.
Calculation: Current Ratio = Current Assets / Current Liabilities
What is the quick ratio and why is it a more stringent measure of liquidity than the current ratio?
The quick ratio is a stricter measure of liquidity because it excludes inventory (which is the least liquid current asset) from current assets. It provides a clearer view of the company’s ability to meet short-term obligations with more liquid assets.
Calculation: Quick Ratio and Marketable Securities + Accounts Receivable / Current Liabilities
What is the cash ratio and why is it the most stringent measure of liquidity?
The cash ratio is the most stringent liquidity measure because it only considers cash and marketable securities, excluding both inventory and accounts receivable. It shows the company’s ability to cover its current liabilities with its most liquid assets.
Formula: Cash Ratio = Cash and Marketable Securities / Current Liabilities
What is the goal of working capital management?
The goal of working capital management is to maximize firm profits while ensuring sufficient liquidity to maintain operations and meet obligations. This involves balancing short-term assets and liabilities to optimize liquidity without compromising profitability.
What are the pros and cons of holding more short-term assets in working capital management?
Holding more short-term assets ensures liquidity to meet obligations, but they offer lower rates of return compared to long-term assets. While it provides cash for operations, it can reduce profitability due to lower returns. Firms must consider the risk of being able to refinance short-term debt at reasonable costs.
How does the firm size affect working capital management?
When analyzing working capital management, it’s crucial to control for size differences. This is done by comparing the amounts of long-term versus short-term assets relative to sales. Larger companies typically have more funding options than smaller companies due to scale and access to capital.
What is a conservative approach to working capital management, and what are its advantages and disadvantages?
A conservative approach involves holding higher amounts of short-term assets and financing working capital with long-term sources (e.g., long-term debt, equity).
Advantages: Greater flexibility during disruptions, high probability of meeting short-term obligations, and more permanent capital with fewer rollover needs.
Disadvantages: Higher costs, lower profitability, and potential operational constraints (e.g., minimum interest coverage ratio imposed by lenders).
What is an aggressive approach to working capital management, and what are its risks and benefits?
An aggressive approach involves holding lower levels of short-term assets and financing working capital with short-term debt.
Benefits: Lower costs.
Risks: Greater likelihood of failing to meet obligations, increased vulnerability to market disruptions, and higher risk due to dependence on short-term debt.
What is a moderate approach to working capital management?
A moderate approach seeks a balance by funding permanent current assets with long-term capital and using short-term sources for variable (seasonal) assets. This approach tries to mitigate the risks and costs of both the conservative and aggressive strategies.
