Flashcards in STUDY UNIT EIGHT WORKING CAPITAL Deck (21):

1

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Bankers’ acceptances are riskier than commercial paper.

True

False

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False

Your answer is correct.

Bankers’ acceptances are drafts drawn by a nonfinancial firm on deposits at a bank. The acceptance by the bank is a guarantee of payment at maturity. The payee can thus rely on the creditworthiness of the bank rather than on that of the (presumably riskier) drawer. Commercial paper, on the other hand, consists of unsecured, short-term notes issued by large companies. They are riskier than bankers’ acceptances.

2

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Mein Co.’s sales totaled $300,000 for the current year. Mein’s cost of goods sold was $150,000. Mein’s accounts receivable balance was $20,000 on January 1 and $30,000 on December 31. What was Mein’s accounts receivable turnover rate for the current year?

A 10 times.

B 15 times.

C 12 times.

D 6 times.

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C 12 times.

This answer is correct.

The accounts receivable turnover rate is the number of times in a year the total balance of receivables is converted to cash. It is calculated as net credit sales divided by the average balance in receivables. Therefore, Mein’s accounts receivable rate for the current year is 12 times {$300,000 ÷ [($30,000 + $20,000) ÷ 2]}.

3

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Fact Pattern: Depoole Company is a manufacturer of industrial products that uses a calendar year for financial reporting purposes. Assume that total quick assets exceeded total current liabilities both before and after the transaction described. Further assume that Depoole has positive profits during the year and a credit balance throughout the year in its retained earnings account.

Depoole’s payment of a trade account payable of $64,500 will

A Decrease both the current and quick ratios.

B Increase the quick ratio, but the current ratio would not be affected.

C Increase both the current and quick ratios.

D Increase the current ratio, but the quick ratio would not be affected.

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C Increase both the current and quick ratios.

This answer is correct.

Given that the quick assets exceed current liabilities, both the current and quick ratios exceed 1 because the numerator of the current ratio includes other current assets in addition to the quick assets of cash, net accounts receivable, and short-term marketable securities. An equal reduction in the numerator and the denominator, such as a payment of a trade payable, will cause each ratio to increase.

4

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Fact Pattern: Calculation of ratios and the determination of other factors are considered important in analysis of financial statements. Prior to the independent events described below, the corporation concerned had current and quick ratios in excess of one to one and reported a net income (as opposed to a loss) for the period just ended. Income tax effects are to be ignored. The corporation had only one class of shares outstanding.

The effect of recording a 2-for-1 stock split is to

A Leave working capital unaffected, decrease earnings per share, and decrease book value per share.

B Leave inventory turnover unaffected, decrease working capital, and decrease book value per share.

C Decrease the current ratio, decrease working capital, and decrease book value per share.

D Leave working capital unaffected, decrease earnings per share, and decrease the debt-to-equity ratio.

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A Leave working capital unaffected, decrease earnings per share, and decrease book value per share.

This answer is correct.

A 2-for-1 stock split involves an increase in shares outstanding with no increase in the capital stock account. Thus, the par or stated value of the shares is adjusted so that the total is unchanged. It has no effect on assets, liabilities, working capital, or total equity. Thus, the current ratio, the working capital, and the debt-to-equity ratio are unaffected. EPS and book value per share decline because more shares are outstanding.

5

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North Bank is analyzing Belle Corp.’s financial statements for a possible extension of credit. Belle’s quick ratio is significantly better than the industry average. Which of the following factors should North consider as a possible limitation of using this ratio when evaluating Belle’s creditworthiness?

A Belle may need to sell its available-for-sale investments to meet its current obligations.

B Fluctuating market prices of short-term investments may adversely affect the ratio.

C Belle may need to liquidate its inventory to meet its long-term obligations.

D Increasing market prices for Belle’s inventory may adversely affect the ratio.

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B Fluctuating market prices of short-term investments may adversely affect the ratio.

This answer is correct.

The quick ratio equals current assets minus inventory and prepaid expenses, divided by current liabilities. Because short-term marketable securities are included in the numerator, fluctuating market prices of short-term investments may adversely affect the ratio if Belle holds a substantial amount of such current assets.

6

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Green, Inc., a financial investment-consulting firm, was engaged by Maple Corp. to provide technical support for making investment decisions. Maple, a manufacturer of ceramic tiles, was in the process of buying Bay, Inc., its prime competitor. Green’s financial analyst made an independent detailed analysis of Bay’s average collection period to determine which of the following?

A Financing.

B Operating profitability.

C Liquidity.

D Return on equity.

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C Liquidity.

This answer is correct.

Liquidity is a firm’s ability to pay its current obligations as they come due. The average collection period is the average number of days between the time of a sale and the receipt of the invoice amount. Thus, the average collection period is an asset management ratio measuring an entity’s use of assets to generate cash flows. It indicates when proceeds from sales are available to pay debts.

7

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As a company becomes more conservative with respect to working capital financing policy, it would tend to have a(n)

A Increase in the ratio of current liabilities to noncurrent liabilities.

B Decrease in the operating cycle.

C Decrease in the quick ratio.

D Increase in the ratio of current assets to noncurrent assets.

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D Increase in the ratio of current assets to noncurrent assets.

This answer is correct.

A conservative working capital policy finances working capital mostly with long-term debt. Thus, it results in an increase in working capital (current assets – current liabilities). It is typified by a reduction in liquidity risk. Increasing the current ratio, whether by decreasing current liabilities or increasing current assets, minimizes the risk that the company will not be able to meet its obligations as they fall due. Thus, an increasing ratio of current to noncurrent assets means that a company is forgoing the potentially higher returns on long-term assets in order to guard against short-term cash flow problems.

8

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A company has cash of $100 million, accounts receivable of $600 million, current assets of $1.2 billion, accounts payable of $400 million, and current liabilities of $900 million. What is its acid-test (quick) ratio?

A 0.78

B 0.11

C 2.11

D 1.75

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A 0.78

This answer is correct.

The acid-test (quick) ratio equals current assets other than inventory and prepaid assets, divided by current liabilities. Quick assets are cash, net receivables, and marketable securities. Thus, the quick ratio equals 0.78 [($100 million cash + $600 million accounts receivable) ÷ $900 million current liabilities]. NOTE: This calculation is based on the assumption that the entity’s current assets do not include marketable securities.

View Subunit 8.2 Outline

9

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The chief financial officer of Smith Glass, Inc., follows the policy of matching the maturity of assets with the maturity of financing. The implications of this policy include all of the following, except that

A Cash, receivables, and inventory should be financed with long-term debt or equity.

B The minimum level of cash, receivables, and inventory required to stay in business can be considered permanent and financed with long-term debt or equity.

C The seasonal expansion of cash, receivables, and inventory should be financed by short-term debt, such as vendor payables and bank debt.

D Long-term assets, like plant and equipment, should be financed with long-term debt or equity.

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A Cash, receivables, and inventory should be financed with long-term debt or equity.

This answer is correct.

Arranging a portfolio so that the maturity of funds will coincide with the need for funds (called maturity matching) will maximize the average return on the portfolio and provide increased flexibility. Supporting short-term assets, such as cash and receivables, with long-term financing is risky and counterproductive.

View Subunit 8.1 Outline

10

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A company has equity of $9,000. Long-term debt is $1,900. Net working capital, other than cash, is $2,500. Fixed assets are $2,200. What amount of cash does the company have?

A $2,400

B $6,200

C $7,400

D $6,800

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B $6,200

This answer is correct.

According to the accounting equation, a firm’s assets are equal to its liabilities plus equity. Net working capital equals current assets minus current liabilities. A firm’s assets and liabilities consist of current and noncurrent (long-term) assets and liabilities. The firm’s amount of cash can be derived from the following equation: $2,500 net working capital without cash + Cash + $2,200 fixed assets = $1,900 noncurrent liabilities + $9,000 equity. Therefore, the company’s cash equals $6,200.

View Subunit 8.1 Outline

11

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Which one of the following statements about trade credit is correct? Trade credit is

A A source of long-term financing to the seller.

B Not an important source of financing for small firms.

C A key factor in a conservative financing policy.

D Subject to risk of buyer default.

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D Subject to risk of buyer default.

This answer is correct.

Trade credit is ordinarily a short-term source of financing while a conservative financing policy finances working capital mostly with long-term debt.

View Subunit 8.1 Outline

12

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Fact Pattern: Depoole Company is a manufacturer of industrial products that uses a calendar year for financial reporting purposes. Assume that total quick assets exceeded total current liabilities both before and after the transaction described. Further assume that Depoole has positive profits during the year and a credit balance throughout the year in its retained earnings account.

Depoole’s issuance of serial bonds in exchange for an office building, with the first installment of the bonds due late this year,

A. Decreases net working capital.

B. Affects all of the answers as indicated.

C. Decreases the quick ratio.

D. Decreases the current ratio

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B. Affects all of the answers as indicated.

Answer (B) is correct.

The first installment is a current liability; thus the amount of current liabilities increases with no corresponding increase in current assets. The effect is to decrease working capital, the current ratio, and the quick ratio.

(8.3.49)

13

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Fact Pattern: Depoole Company is a manufacturer of industrial products that uses a calendar year for financial reporting purposes. Assume that total quick assets exceeded total current liabilities both before and after the transaction described. Further assume that Depoole has positive profits during the year and a credit balance throughout the year in its retained earnings account.

Depoole’s purchase of raw materials for $85,000 on open account will

A. Decrease the current ratio.

B. Decrease net working capital.

C. Increase net working capital.

D. Increase the current ratio.

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A. Decrease the current ratio.

Answer (A) is correct.

The purchase increases both the numerator and denominator of the current ratio by adding inventory to the numerator and payables to the denominator. Because the ratio before the purchase was greater than 1, the ratio is decreased.

(8.3.46)

14

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In Year 1, a company’s cash is 15% of sales, accounts receivable is 10% of sales, inventory is 20% of sales, accounts payable is 30% of sales, and long-term debt is 5% of sales. The company is preparing its forecasts and anticipates that sales will increase from $50,000 in Year 1 to $55,000 in Year 2. The company uses the percentage-of-sales method. What amount would be the required net working capital in Year 2?

A. $7,500

B. $(2,750)

C. $8,250

D. $5,500

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Answer (C) is correct.

Net working capital reports the resources the company would have to continue operating in the short run if it had to liquidate all of its current liabilities at once. It is calculated as current assets minus current liabilities. The company’s net working capital equals 15% of sales (15% cash + 10% accounts receivable + 20% inventory – 30% accounts payable). The anticipated sales for Year 2 is $55,000 ($50,000 × 110%). Therefore, the required net working capital in Year 2 is $8,250 ($55,000 × 15%).

(8.1.15)

15

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In a comparison of Year 2 with Year 1, Baliol Co.’s inventory turnover ratio increased substantially although sales and inventory amounts were essentially unchanged. Which of the following statements explains the increased inventory turnover ratio?

A. Accounts receivable turnover increased.

B. Total asset turnover increased.

C. Gross profit percentage decreased.

D. Cost of goods sold decreased.

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Answer (C) is correct.

The inventory turnover ratio equals cost of goods sold divided by the average balance in inventory. If inventory is unchanged, an increase in cost of goods sold increases the inventory turnover ratio. A decrease in the gross profit percentage [(sales – cost of goods sold) ÷ sales] signifies an increase in cost of goods sold given that the amount of sales is constant.

(8.7.87)

16

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An auto parts store must maintain inventory of a wide variety of parts to satisfy its diverse customer base. As a result, the store’s inventory has a high risk of obsolescence. Which of the following features would be most desirable to the store’s creditors during a financial review of the auto parts store?

A. A high debt ratio.

B. A high number of days sales outstanding in ending trade receivables.

C. A high quick ratio.

D. A low inventory turnover ratio.

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C. A high quick ratio.

Answer (C) is correct.

The quick (acid-test) ratio is a measure of liquidity that divides the sum of cash and equivalents, marketable securities, and net receivables by current liabilities. The quick ratio excludes inventories and prepaids from the numerator, recognizing that those assets are difficult to liquidate at their stated values. The creditors’ biggest concern is whether the lender has enough assets to repay the debt. Since the store’s inventory has a high risk of obsolescence, the creditors would like to assess the store’s liquidity without considering the inventory. Therefore, the quick ratio would be the most desirable ratio. A high quick ratio indicates that there are more liquid assets to cover the company’s current liabilities.

(8.2.33)

17

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Fact Pattern: Depoole Company is a manufacturer of industrial products that uses a calendar year for financial reporting purposes. Assume that total quick assets exceeded total current liabilities both before and after the transaction described. Further assume that Depoole has positive profits during the year and a credit balance throughout the year in its retained earnings account.

Obsolete inventory of $125,000 was written off by Depoole during the year. This transaction

A. Increased net working capital.

B. Decreased the quick ratio.

C. Decreased the current ratio.

D. Increased the quick ratio.

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C. Decreased the current ratio.

Answer (C) is correct.

Writing off obsolete inventory reduced current assets, but not quick assets (cash, receivables, and marketable securities). Thus, the current ratio was reduced and the quick ratio was unaffected.

(8.3.48)

18

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Stewart Co. uses the economic order quantity (EOQ) model for inventory management. A decrease in which one of the following variables would increase the EOQ?

A. Annual sales.

B. Cost per order.

C. Safety stock level.

D. Carrying costs.

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D. Carrying costs.

Answer (D) is correct.

The EOQ model minimizes the total of ordering and carrying costs. The EOQ is calculated as follows:

Increases in the numerator (demand or ordering costs) will increase the EOQ, whereas decreases in demand or ordering costs will decrease the EOQ. Inversely, a decrease in the denominator (carrying costs) will increase the EOQ.

(8.8.97)

19

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Starrs Company has current assets of $400,000 and current liabilities of $300,000. Starrs could increase its net working capital by the

A. Prepayment of $50,000 of next year’s rent.

B. Refinancing of $50,000 of short-term debt with long-term debt.

C. Acquisition of land valued at $50,000 through the issuance of common stock.

D. Purchase of $50,000 of trading securities for cash.

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B. Refinancing of $50,000 of short-term debt with long-term debt.

Answer (B) is correct.

Net working capital is defined as the excess of current assets over current liabilities. Refinancing short-term debt with long-term debt decreases current liabilities with no effect on current assets, resulting in an increase in working capital.

(8.1.10)

20

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North Bank is analyzing Belle Corp.’s financial statements for a possible extension of credit. Belle’s quick ratio is significantly better than the industry average. Which of the following factors should North consider as a possible limitation of using this ratio when evaluating Belle’s creditworthiness?

A. Belle may need to sell its available-for-sale investments to meet its current obligations.

B. Fluctuating market prices of short-term investments may adversely affect the ratio.

C. Belle may need to liquidate its inventory to meet its long-term obligations.

D. Increasing market prices for Belle’s inventory may adversely affect the ratio.

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B. Fluctuating market prices of short-term investments may adversely affect the ratio.

Answer (B) is correct.

The quick ratio equals current assets minus inventory and prepaid expenses, divided by current liabilities. Because short-term marketable securities are included in the numerator, fluctuating market prices of short-term investments may adversely affect the ratio if Belle holds a substantial amount of such current assets.

(8.2.16)

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