Flashcards in Topic 4 - Chapter 18: Working Capital Management Deck (23)
How do you calculate working capital?
Net working capital = Current assets – Current liabilities
What are examples of current assets?
Cash, marketable securities, accounts receivable and inventory)
What are examples of current liabilities?
Accounts payable, bank overdraft and accruals
When managing liquidity, what are some considerations?
A risk-return trade-off arises when managing the firm’s liquidity. Investing in current assets
improves liquidity and reduces the firm’s rate of return on investment. Using current
liabilities to finance assets reduces liquidity. This is known as risk-return trade-off
What is the principle of self liquidating debt?
According to this principle maturity the source of financing should be matched with the length of time that the financing is needed. Short-term assets should be financed with short-term borrowings and long-term requirements or investments should be financed with long-term sources of financing.
What is the working capital cycle concerned with?
The operating cycle and cash cycle
What is the operating cycle?
The operating cycle is the time it takes from acquiring inventory to the time we collect cash
from sales, and it has two distinct periods: the inventory period and the accounts receivable
or average collection period.
What are the two distinct periods associated with the operating cycle?
The inventory period and the accounts receivable
or average collection period.
What is the accounts payable period?
The period between the purchase of inventory and the cash payment of the inventory. This is involved in the cash cycle.
What is the cash conversion cycle?
This the period between when cash has been paid for the inventory until the cash from the sale is collected. It is the operating cycle, less the accounts payable deferral period.
What are liquid assets?
Those assets that can be readily converted to cash.
What are marketable securities?
Investments in securities that the firm can quickly convert into cash balances (high liquidity)
How can liquidity be measured?
Current ratio or Net working capital
Current ratio = current assets/liabilities
Net working capital = current assets-liabilities
What are permanent asset investments?
Permanent assets are those that the firms expects to hold for a period longer than one year. This can include a minimum level of current assets (e.g minimum accounts payable). Otherwise, plant, property assets would be an example of a permanent asset.
What are temporary assets?
Temporary assets are those current assets that a firm expects to convert to cash in less than one year (and not replaced).
What are temporary sources of financing?
These typically consist of current liabilities:
Promissory notes (IOU's)
Short term finance (unsecured bank loans)
What are permanent sources of financing?
Intermediate and long term secured bank loans
Issue of ordinary or preference shares
What are spontaneous sources of financing?
These arise naturyaly out of day to day operations. They include:
Accounts payable/trade credit
Interest and Tax accruals
How does the cash cycle differ from the operating cycle?
The cash cycle is different from the operating cycle in that it is only concerned with the period from which cash has been paid and must be recouped. the Operating cycle however, is concerned with the overall cycle from placing an inventory order to receipt of cash from sales of the product.
How does investing more heavily in current assets other things remaining the same increase firm liquidity?
Liquidity is the ability of a firm to convert it's current assets to cash in order to pay it's bills as they fall due. Investing more heavily in current assets provides access to additional cash in order to service payments as they are due, thus increasing liquidity.
How does the use of short term as opposed to long term liabilities affect a firm's liquidity?
Liquidity is the ability of a firm to convert it's current assets to cash in order to pay it's bills as they fall due. The use of short term liabilities increase liquidity as this increases the amount of outgoing cash in relation to the cash available to service the bills as they fall due. Long term liabilities have a longer repayment period and therefore much less impact on cash flow, however they are more expensive. The principle of self liquidating debt suggests that sources of finance should be matched to the period for which the asset is required.
What is the inventory conversion period
The number of days a firm uses to convert its inventory into cash or accounts receivable following a sale.