READING 23 WORKING CAPITAL AND LIQUIDITY

Question 1

Which of the following best describes the Cash Conversion Cycle (CCC)?
A. The number of days it takes a company to repay its suppliers after receiving goods.
B. The number of days it takes to convert investments in inventory and receivables into cash.
C. The time between a company’s purchase of inventory and its recognition of revenue.

Answer 1

Correct Answer: B

Explanation:

CCC measures how quickly a company converts investments in inventory and receivables into cash.

Option A refers to just the Days Payable Outstanding (DPO).

Option C confuses cash collection with revenue recognition.

Question 2

A lower Cash Conversion Cycle typically indicates:
A. Inefficient use of capital and increased reliance on external financing.
B. Quick cash recovery from operations and efficient working capital management.
C. Reduced profitability due to lower inventory levels.

Answer 2

Correct Answer: B

Explanation:

A lower CCC means the company quickly converts inputs into cash, freeing up capital.

A is incorrect—shorter CCC reduces reliance on external financing.

C is incorrect—lower CCC can increase efficiency without necessarily harming profitability.

Question 3

Which of the following changes would decrease a company’s Cash Conversion Cycle (CCC), assuming all other factors remain constant?
A. Increase in Days Sales Outstanding (DSO)
B. Decrease in Days Inventory Held (DIH)
C. Decrease in Days Payables Outstanding (DPO)

Answer 3

Correct Answer: B

Explanation:

A decrease in Days Inventory Held (DIH) means the company holds inventory for fewer days, reducing the overall CCC.

A is incorrect because an increase in DSO means the company is taking longer to collect receivables, which increases CCC.

C is incorrect because a decrease in DPO means the company is paying suppliers more quickly, reducing the amount subtracted in the CCC formula, and thus increasing CCC.

Question 4

Company X has a CCC of 80 days. Which strategy would most effectively reduce this value?
A. Decreasing the days payable outstanding
B. Increasing inventory to prevent stockouts
C. Speeding up collections from customers

Answer 4

Correct Answer: C

Explanation:

Faster collections reduce DSO, thus reducing CCC.

A would increase CCC.

B would increase DIH, lengthening CCC.

Question 4

Which company is most likely to have the shortest CCC?
A. A manufacturing company holding large inventories
B. A retail chain with just-in-time inventory
C. A pharmaceutical company with patented drugs in stock

Answer 4

Correct Answer: B

Explanation:

Just-in-time inventory reduces DIH, lowering CCC.

A and C both maintain large inventories, increasing CCC.

Question 5

Which of the following best represents the formula for Cash Conversion Cycle (CCC)?
A. DSO + DPO – DIH
B. DIH + DSO – DPO
C. DIH + DPO + DSO

Answer 5

Correct Answer: B

Explanation:

Correct CCC formula: Days Inventory Held + Days Sales Outstanding – Days Payables Outstanding.

A has incorrect order and operation.

C wrongly adds all three.

Question 6

Which of the following is excluded from Net Working Capital (NWC) but included in Total Working Capital?
A. Cash
B. Accounts Receivable
C. Inventory

Answer 6

Correct Answer: A

Explanation:

Cash is part of total working capital (since it’s a current asset), but it’s excluded from NWC because it’s not an operating current asset.

B is incorrect because Accounts Receivable is an operating asset, so it’s included in both NWC and total working capital.

C is incorrect because Inventory is also an operating asset, included in both.

Question 7

Which of the following best explains why analysts prefer Net Working Capital over Working Capital in CCC analysis?
A. It includes financing items such as taxes and interest payable
B. It focuses on operational liquidity rather than overall short-term assets
C. It excludes inventory and accounts payable, which can distort ratios

Answer 7

Correct Answer: B

Explanation:

NWC isolates operational efficiency, aligning more closely with CCC.

A is incorrect—NWC excludes non-operational items.

C is incorrect—inventory and A/P are key operational components and included in NWC.

Question 8

Under which condition should a company pay early rather than take supplier credit?
A. If the EAR of supplier financing is lower than its bank’s borrowing rate
B. If the EAR of supplier financing is higher than its bank’s borrowing rate
C. If the company wants to conserve cash regardless of cost

Answer 8

Correct Answer: B

Explanation:

If supplier financing is more expensive, the company should borrow from the bank (cheaper source).

A is incorrect—EAR must be compared with alternatives.

C lacks consideration of cost-efficiency.

Question 9

A supplier offers terms of 2/10, net 30. What is the effective annual rate (EAR) of not taking the discount?
A. 18.25%
B. 36.5%
C. 44.6%

Answer 9

Correct Answer: C

Explanation:

EAR = (1 + 0.02/0.98)^(365/20) – 1 = 44.6%

A and B are distractors with incorrect exponent values or base calculations.

Question 10

Which of the following is most likely to increase a firm’s CCC?
A. Increasing the credit period for customers
B. Negotiating longer payment terms with suppliers
C. Reducing raw material inventory

Answer 10

Correct Answer: A

Explanation:

Longer customer credit increases DSO → CCC rises.

B increases DPO, which reduces CCC.

C reduces DIH → also reduces CCC.

Question 11

What is the main disadvantage of reducing inventory to shorten the CCC?
A. It can increase accounts receivable turnover
B. It can lead to stockouts and production delays
C. It can result in better supplier relationships

Answer 11

Correct Answer: B

Explanation:

Lower inventory may disrupt production or cause missed sales.

A and C are unrelated to inventory directly.

Question 12

Which of the following explains why pharmaceutical companies often have long CCCs?
A. They have low receivables and inventory turnover
B. They maintain high-margin drug inventories to meet uncertain demand
C. They have short payment terms from customers

Answer 12

Correct Answer: B

Explanation:

Pharma firms hold inventory for emergencies, lengthening DIH and CCC.

A is incomplete; C is incorrect—receivables may be long due to healthcare systems.

Question 13

Which company is most likely to have a negative CCC?
A. A fast food chain that receives payment before paying suppliers
B. A manufacturer with long production cycles
C. A hospital system that bills insurers after treatment

Answer 13

Correct Answer: A

Explanation:

Prepayment and delayed payables → negative CCC is possible.

B and C collect cash after paying for materials or services.

Question 14

Why should CCC comparisons be restricted within industries?
A. Inventory and credit policies vary significantly across industries
B. Working capital policies are identical across all sectors
C. CCC is not affected by industry-specific regulations

Answer 14

Correct Answer: A

Explanation:

Industries differ in business models and CCC structures.

B is false—working capital strategies vary.

C is misleading—industry norms and regulations do affect CCC.

Question 15

Which of the following best describes liquidity for a corporate issuer?
A. The firm’s ability to convert assets into long-term investments
B. The availability of cash and near-cash assets to meet short-term obligations
C. The firm’s use of short-term liabilities to fund long-term projects

Answer 15

Correct Answer: B

Explanation:

B is correct. Liquidity for a corporate issuer refers to the firm’s ability to meet short-term obligations using cash or liquid assets.

A is incorrect because converting assets into investments is related to capital budgeting, not liquidity.

C is incorrect because using short-term liabilities for long-term projects refers to maturity mismatch, not liquidity.

Question 16

Which asset is typically the least liquid among the following?
A. Marketable securities
B. Accounts receivable
C. Inventory

Answer 16

Correct Answer: C

Explanation:

C is correct. Inventory is the least liquid of the three, as it must be sold (possibly after processing), then converted to receivables, and then collected.

A is incorrect because marketable securities can be quickly converted to cash.

B is incorrect as receivables are more liquid than inventory.

Question 17

A conservative working capital management approach is most likely characterized by:
A. High levels of short-term liabilities and low levels of liquid assets
B. Low reliance on long-term capital and greater short-term funding
C. High levels of short-term assets financed by long-term sources

Answer 17

Correct Answer: C

Explanation:

C is correct. A conservative approach uses long-term financing for both fixed assets and permanent current assets, ensuring greater stability.

A is incorrect; this describes an aggressive approach.

B is incorrect; conservative approaches rely more on long-term funding, not less.

Question 18

Which of the following best describes a drag on liquidity?
A. Reduction in the firm’s credit line by suppliers
B. Increase in Days Payable Outstanding (DPO)
C. Slow collections on receivables

Answer 18

Correct Answer: C

Explanation:

C is correct. A drag on liquidity refers to slow cash inflows, such as delayed collections.

A is incorrect; that’s a pull on liquidity, where outflows increase.

B is incorrect; an increase in DPO improves liquidity by delaying cash outflows.

Question 19

What does a quick ratio exclude from the calculation of current assets?
A. Cash and cash equivalents
B. Marketable securities
C. Inventory

Answer 19

Correct Answer: C

Explanation:

C is correct. The quick ratio excludes inventory, focusing on the more liquid assets like cash, receivables, and marketable securities.

A and B are incorrect because both are included in the quick ratio.

Question 20

Which of the following is most likely a primary source of liquidity?
A. Selling fixed assets
B. Suspending dividend payments
C. Cash generated from operations

Answer 20

Correct Answer: C

Explanation:

C is correct. Primary liquidity sources include cash from operations, cash on hand, and short-term borrowings.

A and B are secondary sources, used during financial stress.

Question 21

A firm increases the cash conversion cycle (CCC). All else equal, this will most likely:
A. Improve liquidity
B. Deteriorate liquidity
C. Reduce financial leverage

Answer 21

Correct Answer: B

Explanation:

B is correct. A longer CCC means more time to convert inventory into cash, reducing liquidity.

A is incorrect; longer CCC worsens liquidity.

C is unrelated to CCC; it affects liquidity, not leverage.

Question 22

A company needs immediate liquidity and sells assets worth $600,000 for $480,000. What is the cost of liquidity in %?
A. 10%
B. 20%
C. 25%

Answer 22

Correct Answer: B

Explanation:

B is correct. Cost of liquidity = (600,000 - 480,000) / 600,000 = 20%.

A and C are simple miscalculations.

Question 23

Which of the following is a pull on liquidity?
A. Obsolete inventory remains unsold
B. Customers delaying payment
C. Suppliers demanding faster payment terms

Answer 23

Correct Answer: C

Explanation:

C is correct. A pull on liquidity refers to faster cash outflows.

A and B are drags on liquidity, which delay cash inflows.

Question 24

What does the cash ratio include in its numerator? A. Cash and accounts receivable B. Cash and inventory C. Only cash and marketable securities

Answer 24

Correct Answer: C Explanation: C is correct. The cash ratio is the strictest liquidity metric and includes only cash and near-cash assets like marketable securities. A and B include less liquid assets and are incorrect.

Question 25

Which short-term liquidity source is generally the most expensive and signals distress? A. Bank borrowings B. Sale of long-term assets C. Bankruptcy filing

Answer 25

Correct Answer: C Explanation: C is correct. Filing for bankruptcy suspends obligations but severely damages reputation and access to capital, making it the most costly and extreme source. A is a common, lower-cost method. B is less severe than C.

Question 26

Which approach to working capital management provides the highest probability of meeting short-term obligations? A. Aggressive approach B. Moderate approach C. Conservative approach

Answer 26

Correct Answer: C Explanation: C is correct. The conservative approach prioritizes liquidity, ensuring enough capital is available at all times. A is risky and cost-effective, while B balances both.

Question 27

A firm funds permanent current assets with long-term capital and seasonal current assets with short-term loans. This describes: A. Aggressive approach B. Moderate approach C. Conservative approach

Answer 27

Correct Answer: B Explanation: B is correct. The moderate approach matches asset life with funding source—long-term capital for stable needs, short-term for temporary spikes. A is too risky, C is too safe (and costly).

Question 28

Which factor is least likely to affect a firm's short-term funding options? A. Legal system strength B. Seasonal sales variation C. Underlying collateral quality

Answer 28

Correct Answer: B Explanation: B is correct. While seasonality affects liquidity needs, it doesn't directly impact available funding sources. A and C influence lender confidence and terms.

Question 29

Which liquidity ratio is the most conservative and least forgiving in assessing short-term solvency? A. Current ratio B. Quick ratio C. Cash ratio

Answer 29

Correct Answer: C Explanation: C is correct. The cash ratio uses only the most liquid assets, offering the strictest test of liquidity. A and B include less-liquid assets.

Question 30

Which of the following best describes the objective of working capital management? A. Maximizing revenues while reducing operating costs B. Maximizing firm profits while ensuring sufficient liquidity to meet obligations C. Minimizing tax liability through short-term asset management

Answer 30

Correct Answer: B Explanation: Working capital management aims to maximize firm profits while ensuring the firm has enough liquidity to maintain operations and meet obligations. Option A is incorrect because it focuses only on revenues and costs, not liquidity. Option C is incorrect because tax liability minimization is not the main objective of working capital management.

Question 31

A company uses long-term debt and equity to finance all its short-term and long-term assets. This is most consistent with which working capital approach? A. Aggressive B. Conservative C. Moderate

Answer 31

Correct Answer: B Explanation: A conservative approach uses long-term financing for both long-term and current assets, resulting in greater liquidity and lower risk. Option A is incorrect because an aggressive approach uses more short-term financing. Option C is incorrect because a moderate approach matches long-term capital with permanent current assets and short-term funding with variable current assets.

Question 32

Which of the following is most likely a disadvantage of a conservative working capital management approach? A. High rollover risk B. Lower profitability C. Limited liquidity

Answer 32

Correct Answer: B Explanation: A conservative approach uses long-term financing, which is more expensive and results in lower profitability. Option A is incorrect because conservative approaches reduce rollover risk. Option C is incorrect because conservative approaches increase liquidity.

Question 33

A firm funds its seasonal inventory buildup with short-term bank loans and its permanent current assets with long-term financing. This is best described as: A. Aggressive B. Moderate C. Conservative

Answer 33

Correct Answer: B Explanation: The moderate approach matches financing terms with the nature of the assets (short-term sources for temporary assets, long-term for permanent ones). Option A is incorrect because aggressive strategies use short-term funding for both types. Option C is incorrect because conservative strategies use long-term funding for all assets.

Question 34

Which of the following best explains the risk of using an aggressive approach to working capital financing? A. Increased cost of capital B. Operational constraints from long-term lenders C. Inability to meet obligations during market disruptions

Answer 34

Correct Answer: C Explanation: Aggressive strategies rely on short-term financing, which poses risks if credit markets tighten or if the firm is unable to roll over loans. Option A is incorrect because aggressive financing generally has lower capital costs. Option B is incorrect because operational constraints are more common with long-term financing.

Question 35

Which factor is least likely to influence a firm’s approach to short-term funding? A. Seasonality in business operations B. Creditworthiness C. Political ideology of shareholders

Answer 35

Correct Answer: C Explanation: Political ideology of shareholders is irrelevant to short-term funding decisions. Option A is incorrect because seasonal needs influence the timing and amount of short-term funding. Option B is incorrect because creditworthiness affects access to and cost of financing.

Question 36

Why might a firm choose to use long-term sources of financing for short-term assets? A. To take advantage of lower short-term interest rates B. To minimize the risk of refinancing under unfavorable conditions C. To increase the cash conversion cycle

Answer 36

Correct Answer: B Explanation: Using long-term financing for short-term assets reduces the risk of needing to refinance during tight credit conditions. Option A is incorrect because long-term financing is typically more expensive. Option C is incorrect because the cash conversion cycle is influenced by operational factors, not financing terms directly.

Question 37

Which of the following is most consistent with an aggressive approach to working capital management? A. Maintaining high levels of cash and marketable securities B. Financing temporary and permanent current assets with short-term debt C. Using long-term debt to fund inventory buildup

Answer 37

Correct Answer: B Explanation: Aggressive approaches seek cost efficiency by funding both types of current assets with cheaper short-term financing. Option A is incorrect because high cash holdings are characteristic of conservative approaches. Option C is incorrect because that resembles a more conservative or moderate strategy.

Question 38

One advantage of the conservative approach to working capital management is: A. Greater reliance on short-term funding B. Higher profitability C. Higher probability of meeting short-term obligations

Answer 38

Correct Answer: C Explanation: Conservative strategies reduce risk and ensure liquidity by using more stable long-term financing. Option A is incorrect because conservative approaches use less short-term funding. Option B is incorrect because they tend to reduce profitability due to higher financing costs.

Question 39

Which of the following is most likely a reason smaller firms have limited short-term funding options? A. They often operate in highly regulated industries B. They have more complex corporate structures C. They may have lower creditworthiness and fewer assets for collateral

Answer 39

Correct Answer: C Explanation: Smaller firms may struggle to secure financing due to lack of credit history or insufficient collateral. Option A is incorrect because firm size is not necessarily linked to regulation. Option B is incorrect because smaller firms typically have simpler structures, not more complex ones.