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Flashcards in Working Capital Management Deck (40):

Working Capital Defined:

Working Capital: Current Assets - Current Liabiltiies


  • Maintain a level of working capital so as to:
    • Meet on-going operating and financial needs; for example:
      • Inventory to meet production requirements
      • Cash to meet obligations as they come due
    • But at the same time,
      • Not over invest or under invest in working capital. Over investing provides low returns or increases cost:
        • Excess idle cash (low rate of return)
        • Excess AR (don't earn interest)
        • Excess inventory (incurs storage cost and risks becoming obsolete)


If a firm's accounts payable, its only current liability, exceeds the sum of cash, accounts receivable and, inventory, the firm's only current assets, then net working capital will be:

A. Zero.

B. Positive.

C. Negative.

D. Adequate.

C. Negative.

Net working capital is computed as: Current Assets - Current Liabilities. If current liabilities exceed current assets, net working capital is negative.


When a financial manager takes action to minimize the firm's investment in current assets, which one of the following risks is likely to increase?

A. Accounts receivable defaults may increase.

B. Inventory spoilage may increase.

C. Inventory shortages may increase.

D. Inventory obsolescence may increase.

C. Inventory shortages may increase.

Reducing investment in current assets is likely to increase the risk that inventory shortages will increase. Excessive reductions in inventory may result in inventory shortages, which cause interruptions in operations and an inability to meet production requirements.


A production cycle of long duration would be expected to have which one of the following effects on working capital?

A. A higher working capital requirement than a shorter production cycle.

B. A lower working capital requirement than a shorter production cycle.

C. The same working capital requirement as a shorter production cycle.

D. No effect on the working capital requirement of the firm

A. A higher working capital requirement than a shorter production cycle.

As the term implies, the production cycle is the time needed to convert raw materials into finished goods. The longer the duration (time) of this cycle, the higher the level of working capital that would be expected to be devoted to the process. For example, more work-in-process inventory would be incurred in a long production cycle than would be involved in a short production cycle.


Cash Management Objective:

Cash Management Objective: Maintain a minimum balance consistent with operating needs:

  • Holding too much is an inneficient use of resources
  • Holding too little puts firm at risk of not meeting debt and operating needs. 

Within context of a targeted cash balance, firms will seek to:

  • Accelerate cash inflows, and
  • Defer cash outlows

The longer a firm holds cash, the more thar cash provides a source of financing.


Which one of the following cash management techniques focuses on cash disbursements?

A.  Lock-box system.
B.  Zero-balance account.
C.  Pre-authorized checks.
D.  Depository transfer checks

B.  Zero-balance account.

A zero-balance account is a cash management technique that permits control over cash outflows by using a checking account that has a zero ($0) real balance because payments made from the account exactly equal deposits to the account. From a financial management perspective, a zero-balance account arrangement enables decentralized units to write checks drawn on one of that unit's accounts that has no real balance.

As those checks clear the bank they create a temporary negative balance in the account. At the end of each day, the bank transfers an amount from another of the firm's accounts to exactly cover the negative balance in the account. Thus, it is a zero-balance account.

Zero-balance accounts also are used in another way to control cash disbursements, often as an element of internal control. In this context, a firm deposits to an account only an amount equal to known payments to be made from that account. For example, a firm might use a zero-balance account for its payroll. Once the dollar amount of the payroll checks is determined, only that amount is deposited to the account against which the checks are drawn. As a consequence, no more than the total amount of payroll checks can be paid out of the account. In addition, it is easier to reconcile the account and the real balance will be zero.


The time between paying cash for raw materials and collecting cash from the sale of products made with those raw materials is called which one of the following?

A. Inventory cycle.

B. Accounts receivable cycle.

C. Cash conversion cycle.

D. Business cycle.

C. Cash conversion cycle.

The cash conversion cycle is concerned with the period beginning with paying cash for inventory and ending with the collection of cash from the sale of products made with that inventory.


A lock-box system improves control over cash received because the lock-box is accessed directly by which one of the following?

A. Company's Treasurer.

B. Post office.

C. Company's bank.

D. Company's mail room staff.

C. Company's bank.

In a Lock-Box System: Customers remit payments to firm's post office box where they are collected and then processed and deposited by firm's bank; may reduce the float by several days.


Describe the use of preauthorized checks.

Payment/collection of an amount due through the use of checks that are authorized in advance. 


Describe the uses of zero-balance accounts.

Zero Balance Accounts:

A bank account with no real balance. Two variations exist:

1. Checks written on account overdraw the account, but by agreement with the bank the overdrawn amount is paid automatically from another account.

2. Only the known amount of payments from an account is deposited into the account (e.g., payroll account).


Define "float".

Float: The time between when a payment is initiated and when the related cash is available for use by the recipient. 


Describe a payment through draft.

Payment through Draft:

Payment is made with a legal instrument, called a "draft," that is drawn on an account of a bank and is guaranteed payment by the bank.

Examples include bank drafts, cashier's checks, certified checks and money orders. 


Describe concentration banking.

Concentration Banking: Funds collected in multiple local banks are transferred regularly and (usually) automatically to firm's primary bank; used to accelerate the flow of cash to a firm's principal bank.


A cash management system should be concerned with the float associated with both cash receipts and cash disbursement.

Will efficient practices seek to increase or decrease receipt float and disbursement float?

Receipt Float     Disbursement Float  
 Increase   Increase 
 Increase   Decrease 
 Decrease   Increase 
 Decrease   Decrease 

Receipt Float - Decrease 

Disbursement Float- Increase

Float is the length of time between the writing of a check (or other draft instrument) and the actual transfer of the funds.

  • Receipt float is the time between the writing of a check (or other instrument) by a customer and when those funds become available to the party to which the check was made.
  • Disbursement float is the time between the writing of a check by a firm writes and removal of the funds from the firm's account. Efficient cash management will seek to decrease receipt float and increase disbursement float.

By reducing receipt float, a firm has cash it is receiving available sooner than it would be available otherwise.

By increasing disbursement float, a firm has cash it is paying available longer than it otherwise would be available.

Thus, decreasing receipt float and increasing disbursement float make more cash available to a firm.



Which one of the following would most likely be used to manage a bank account used exclusively for payment of monthly salary checks?

A.  Electronic funds transfer.
B.  Zero-balance account.
C.  Concentration banking.
D.  Remote disbursing.

B.  Zero-balance account.

Under one application of the zero-balance account, only an amount equal to the amount of salary checks would be deposited into the account from which salary payments are made. As a consequence, the account would always have a zero real balance (i.e., after outstanding checks are deducted). This facilitates the management of the account, including its reconciliation


Short-term Securities Management:

Short-term investments are investments to be held one year or less.

  • Commonly short-term investments are used for temporary excess cash.
  • Investments must be made prudent because the funds may be needed in near term. 

Criteria for Short-term Investment include:

  • Safety of principal - little risk of default by issuer
  • Price stability - not subject to market declines that would result in siginificant loss
  • Marketability/Liquidity - have a ready market for converting cash
  • Other possible criteria - Taxability, diversification, and cost of administration. 


Major Short-term Investment Opportunities:

Major Short-term Investment Opportunities:

  • US Treasury Bills
  • Federal Agency Securities
  • Negotiable Certificates of Deposit
  • Bankers' Acceptances
  • Commercial Paper
  • Repurchase Agreements

Market for these securities is called the "Money Market"


All other things being equal, which one of the following types of investment securities would be expected to have the highest yield (return)?

A.  U.S. Treasury bills
B.  Municipal bonds
C.  Federal agency securities
D.  Corporate bonds

D.  Corporate bonds

Since corporate bonds are more risky than U.S. Treasury bills and Federal agency securities, and since the interest they pay is taxable, they would be expected to have the highest yield.


When making short-term investments, which one of the following is the risk associated with the ability to sell an investment in a short period of time without having to make significant price concessions?

A. Purchasing power risk.

B. Interest rate risk.

C. Default risk.

D. Liquidity risk.

D. Liquidity risk.

  • The risk associated with the ability to sell an investment in a short period of time without having to make significant price concessions is liquidity risk. Two possible elements are implied in the risk:
    • (1) the inability to sell for cash in the short term, and
    • (2) the inability to receive fair value in cash in the short term.


Which one of the following short-term investments is likely to provide the greatest safety of principal?

A. Commercial paper.

B. Bankers' acceptance.

C. Fannie Mae securities.

D. U.S. Treasury bills.

D. U.S. Treasury bills.

Treasury Bills are debt obligation of the U.S. government, have a maturity of one year or less, and are backed by the full faith and credit of the U.S. government. Treasury Bills are considered the safest securities available to the U.S. investor.   


Which of the following considerations typically would be important in selecting investments for the temporary use of "excess" cash?

  Safety of Principal     Ready Marketability 

Safety of Principal = YES   

Ready Marketability = YES

In selecting short-term investments for "excess" cash, a firm would be concerned with

  • (1) safety of principal,
  • (2) price stability of the investment instrument, and
  • (3) ability to readily convert the investment to cash without undue cost. 


Which one of the following is most likely not a major concern when selecting short-term investment opportunities?

A.  Safety of principal.
B.  Rate of return.
C.  Price stability.
D.  Marketability.

B.  Rate of return.

Because funds invested in short-term investments will earn a return for only a short period of time, the rate of return earned is normally not a major concern. More important concerns are safety of principal, price stability, and marketability of the investment. 


Accounts Receivable Management

AR Management: is concerned with conditions leading to both the:

  1. Recognition of Accounts Receivable; and
  2. Collection of Accounts Receivable

It's overall goal is to maximize profits, not minimize losses. 

AR Management Process involves:

  1. Establishing general terms of credit
  2. Determining customer creditworthiness and setting credit limits
  3. Collecting AR
  • A policy that is too loose with grant credit will result in bad debt, but a policy that is too tight, risks losing credit sales from customers who would pay. 



Moe's Boat Service currently does not offer a discount to encourage its customers to pay early for services provided to them. Moe has discussed with his accountant the possibility of offering a 2% discount to improve its cash conversion cycle. Moe's accountant determined the following:

  • Credit sales expected to remain unchanged at $1,000,000
  • The 2% discount is expected to be taken on 40% of accounts receivable balance amounts.
  • The average accounts receivable would likely decrease by $ 30,000
  • Moe has an opportunity cost of 15% associated with its use of cash.

Which one of the following is the dollar amount of net benefit or cost that Moe would obtain if the proposed 2% discount plan is implemented?

A.  $ 3,500
B.  $ 4,500
C.  $ 8,000
D.  $20,000

A.  $ 3,500

  • Benefits Obtained:
    • $30,000 avg AR x .15 opportunity cost = $4,500
  • Cost of Plan:
    • .02 discount x .40 AR = .008 x $1,000,000 credit sales = $8,000
  • Net Results: Cost $8,000-$4,500Benefit= $3,500


Which one of the following is least likely to enter into a firm's decision in setting the rate and period of its discount terms for early payment?

A.  A firm's margin of profit.
B.  The rate and period offered by competitors.
C.  Minimizing the firm's losses on account receivable.
D.  A firm's cost of financing its accounts receivable.

C.  Minimizing the firm's losses on account receivable.

A firm will be least likely concerned with minimizing the firm's losses on accounts receivable in setting the rate and period of its discount terms for early payment. First, the objective in setting account receivable policies is not to minimize losses, but to maximize net income. A firm could minimize its losses on accounts receivable by being a cash only business, but it would lose sales and net income. Secondly, setting the rate and period of discount terms is concerned with accelerating the collection of cash, not with minimizing losses. 


Asher Company eased its credit policy by lengthening its discount period from 10 days to 15 days. Which of the following is/are likely reasons for Asher lengthening its discount period?

I. To show a higher average age of accounts on its accounts receivable aging schedule.

II. To meet terms offered by competitors.

III. To seek to stimulate sales. 

II. To meet terms offered by competitors.

III. To seek to stimulate sales. 

Asher likely lengthened its discount period to meet terms offered by competitors (Statement II), and to seek to stimulate sales (Statement III). It would not have lengthened its discount period to increase the average age of its account receivable (no sense) (Statement I), but that was an undesirable, but necessary, outcome. 


Inventory Management:

Inventory Mgt: Risk Reward Trade Off:

There is a risk-reward trade off in managing inventory:

  1. Underinvesting in inventory to save costs, risks incuring in shortages
  2. Overinvesting in inventory to provide a "cushion", risks incurring excessive costs.

The inventory mgt objective is to neither under invest nor overinvest in inventory. 



Inventory Management Systems:


  1. Traditional Materials Requirement Planning (MRP) System, characterized by:
    • Supply push - Goods are produced in anticipation of there being a demand for the goods;

    • Inventory buffers maintained; Long set-up times and long production runs;

    • Relationships with suppliers are impersonal; suppliers selected through bidding process;

    • Quality standards = Acceptable levels; allows for some defects;

    • Traditional cost accounting is used.

  2. Just-in-Time (JIT) Inventory System:
    • Demand pull - Goods are produced only when there is an end user demand;

    • Excess inventory is minimized;

    • Production in work centers that carry out a full set of production processes;

    • Relationships with suppliers are close and coordinated;

    • Quality standards = Total control of input quality and production process quality;

    • Simplified cost accounting is used.

Identify the benefits of a just-in-time inventory system (when compared with a traditional materials-requirement-planning inventory system).

  • Reduced investment in inventory;
  • Lower cost of inventory transportation, warehousing, insurance, taxes and related costs;
  • Reduced lead time in acquiring inputs;
  • Lower cost of defects;
  • Less complex and more relevant accounting and performance measurement.



Describe the Reorder Point.

Reorder Point:

The level of an inventory item on-hand at which that inventory item should be reordered; takes into account:

1. Inventory needed while ordered items are delivered.

2. Inventory need as "safety stock"-- to cover unexpected demand.


Identify some measures (averages and ratios) useful in assessing inventory management. 

  1. Inventory turnover;
  2. Number of days' sales in inventory.


Describe the Economic Order Quantity (EOQ).

Economic Order Quantity (EOQ).

A model (formula) for determining the size of an inventory order that will minimize total inventory cost, both cost of ordering and cost of carrying inventory; formula uses:

  • Total demand for the inventory item;
  • Cost of each order;
  • Cost of carrying each unit of inventory.

What assumptions are inherent in using the economic order quantity (EOQ) model? 

  • Demand is constant during the period;
  • Unit cost and carrying cost are constant during the period;
  • Delivery is instantaneous.


Which of the following assumptions is associated with the economic order quantity formula?

A. The carrying cost per unit will vary with quantity ordered.

B. The cost of placing an order will vary with quantity ordered.

C. Periodic demand is known.

D. The purchase cost per unit will vary based on quantity discounts.

C. Periodic demand is known.

The economic order quantity determines the order size that will minimize total inventory cost -- both order cost and carrying cost.

The economic order quantity model (formula) assumes that periodic demand is known and constant during the period. It also assumes that order cost and carrying cost per unit are known and constant during the period.


Which of the following inventory management approaches seeks to minimize total inventory costs by considering both the restocking (reordering) cost and the carrying costs?

A.  Economic order quantity.
B.  Just-in-time.
C.  Materials requirements planning.
D.  ABC.

A.  Economic order quantity.

The economic order quantity model seeks to determine the order size that will minimize total inventory cost, both order cost and carrying costs.

While the question can be answered quite easily, because the economic order quantity answer choice is the only one that is concerned with minimizing total inventory cost by considering carrying cost and restocking cost (reordering costs), the wording of the question is ambiguous at best. It would have been better worded as "Which of the following inventory management approaches seeks to minimize total inventory costs by considering both the restocking (reordering) cost and the carrying costs?" Because it is an actual AICPA exam question, the wording has been left unchanged.


An increase in which of the following should cause management to reduce the average inventory?

A.  The cost of placing an order.
B.  The cost of carrying inventory.
C.  The annual demand for the product.
D.  The lead time needed to acquire inventory.

B.  The cost of carrying inventory.

An increase in the cost of carrying inventory should cause management to reduce average inventory so as to avoid the increased cost of carrying the inventory (e.g., warehousing cost, insurance costs, etc.).


Which of the following inventory management techniques focuses on a set of procedures to determine inventory levels for demand-dependent inventory types such as work-in-process and raw materials?

A.  Materials requirements planning.
B.  Cycle counting.
C.  Safety stock reorder point.
D.  Economic order quantity.

A.  Materials requirements planning.

The materials requirement planning approach to manufacturing and inventory management focuses on a set of procedures to determine inventory levels for demand-dependent inventory types such as work-in-process and raw materials.

Under this approach, inventories are maintained at every level in the process (as raw materials, work-in-process and finished goods) as buffer against unexpected increases in demand.

The alternative approach, just-in-time inventory, seeks to eliminate excess raw material, work-in-process and finished goods inventories.


Which one of the following is not a characteristic of a just-in-time inventory system?

A.  Reducing distance and time between related production operations.
B.  Establishing close, long-term relationships with suppliers.
C.  Decreasing the number of deliveries from suppliers.
D.  Reducing raw material safety stock.

C.  Decreasing the number of deliveries from suppliers.

Under a just-in-time inventory system, a firm reduces its inventory on-hand and relies on suppliers to make more frequent deliveries -- deliveries that provide inventory just in time to be input into the production process.

Thus, decreasing the number of deliveries from suppliers is not a characteristic of a just-in-time inventory system; rather, such a system increases the number of deliveries.


In computing the reorder point for an item of inventory, which of the following factors are used?

I. Cost of inventory.

II. Inventory usage per day.

III. Acquisition lead-time.

A.  I and II are correct.
B.  II and III are correct.
C.  I and III are correct.
D.  I, II and III are correct.

B.  II and III are correct.

Determining the level of stock (inventory) at which the inventory should be reordered is a function of the minimum level of inventory to be maintained, referred to as the safety stock, and the length of time it takes to receive inventory after it is ordered, referred to as the lead-time or delivery-time stock.

Both the safety stock and the lead-time stock are based on the rate of inventory usage. The calculation of the reorder point would be:

  • Reorder point = safety stock + delivery-time stock The cost of inventory does not enter into the determination of the reorder point (but it does enter into the optimum quantity to reorder). 


Current Liabilities Summary:


  1. Short-term liabilities  --  most appropriately incurred in connection with assets which will generate cash in the short term to repay the liability. This is the essence of the principle of self-liquidating debt, also called the hedging principle of financing.
  2. Permanent amount of financing  --  Just as some amount of current assets is a permanent use of financing, some amount of current liabilities provides a permanent amount of financing. For example, to the extent a minimum balance always remains in trade accounts payable, that minimum amount is a form of permanent financing.
  3. Short-term borrowing  --  Generally, short-term borrowing does not require collateral and does not impose restrictive covenants.
  4. Early payment  --  Discounts offered for early payment of trade accounts payable are usually significant, many with an effective annual interest rate of over 30%, and should be taken if possible.
  5. Effective cost of borrowing  --  If current liabilities (e.g., short-term notes, line of credit, etc.) require maintaining a compensating balance (greater than any balance that would otherwise be maintained with the institution), the effective cost of borrowing is greater than the stated cost.
  6. Stand-by financing  --  A line of credit provides an effective means of arranging "stand-by" financing. The credit is prearranged and can be used when needed, thus reducing the cost associated with any idle borrowing. 


In managing its working capital, your firm tries to follow the hedging principle of finance. Which one of the following would be too aggressive to be consistent with that principle as applied to working capital?

A. Financing short-term needs with long-term funds.

B. Financing long-term needs with short-term funds.

C. Financing seasonal needs with short-term funds.

D. Financing a permanent build-up in inventory with long-term debt.

B. Financing long-term needs with short-term funds.

Under the hedging principle of finance, assets are acquired with financing that matches the life of the asset. Thus, short-term assets would be financed with short-term liabilities and long-term assets would be financed with long-term liabilities or equity.

The financing of long-term needs with short-term funds would be an aggressive approach to financing long-term needs that would not be consistent with the hedging principle. 


Alpha Company learns that it may have an opportunity to acquire a large quantity of its raw material in the near future at a significant discount. If the opportunity materializes, it would require that Alpha make an immediate decision and that it pay for the inventory at that time. Which one of the following would Alpha most likely employ in anticipation of such an opportunity so that funds would be available when needed?

A.  Execute a short-term note.
B.  Arrange to issue additional shares of authorized common stock.
C.  Arrange a line of credit.
D.  Execute documents to enable it to issue bonds.

C.  Arrange a line of credit.

Arranging a line of credit would provide "stand-by" financing that could be used if and when the opportunity to acquire the inventory materializes. Such an arrangement would avoid incurring interest cost and other costs unless and until the credit is actually used.