Working Capital Management Flashcards
(97 cards)
1
Q
What is working capital (also called Net Working Capital)? Express it in a formula.
A
The difference between a firm’s current assets and its current liabilities.
Formula: Currents assets - current liabilities
2
Q
Working capital management is only concerned about what types of assets and liabilities? It does not include what?
A
WCM only includes current assets and current liabilities. Not include long-term (fixed) assets or liabilities.
3
Q
If a firm over invests in net working capital, what are the consequences and outcomes of this?
A
- Earn LOWER RETURNS than would be possible if assets were invested in capital projects
- Excess idle cash - low rate of return
- Excess accounts receivable - does not earn interest
- Excess inventory - Incurs storage costs and risks becoming obsolete
- Excessive current assets that exceed immediate needs
- Net assets not being used effectively
4
Q
If a firm under invests in net working capital, what are the consequences and outcomes of this?
A
- Unable to meet current operating and financial needs
2. Inadequate cash and inventory shortages
5
Q
What is the objective of working capital?
A
Maintain adequate working capital in order to meet ongoing and financial needs of the firm.
Inventory - Meet production requirements
Cash - Meet obligations as they’re due
6
Q
What is a risk when management decides to minimize a firm’s investment in current assets?
A
Inventory Shortage may increase. Excessive reductions in inventory may result in inventory shortages.
7
Q
When investments in current fixed assets are reduced, how would this effect inventory spoilage, accounts receivable defaults, and inventory obsolescence?
A
These would all likely decrease.
8
Q
What is the current ratio expressed in a formula?
A
Current Assets/Current Liabilities
9
Q
If a firm increases cash balance by issuing additional shares, how does this effect working capital and current ratio? This scenario would increase common stock as well as cash.
A
Increases both ratios. This is because cash (ASSET) is increasing.
10
Q
If a company A uses debt financing and company B uses more equity financing. How will debt financing impact net earnings variability, financial leverage, and operating earnings compared to equity financing?
A
Debt financing provides
- Higher net earnings variability - Greater fixed charges in the form of interest (more volatile net earnings)
- Greater financial leverage
- No effect on operating earnings variability because operating income is computed prior to interest expense.
11
Q
The main reason to retain working capital is to meet the firm’s ___________?
A
Financial obligations.
12
Q
Determining the appropriate level of working capital requires?
A
Offsetting the benefit of current assets and current liabilities against the probability of technical insolvency.
13
Q
Explain the hedging principle of finance.
A
Asets 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.
14
Q
Provide an example of financing that would be considered too aggressive. This is in regards to the hedging principle of finance.
A
Financing long-term needs with short-term funds.
15
Q
In regards to hedging principle of financing, short-term liabilities should be used to finance short-term assets. Which of the following should short-term liabilities finance? A. Plant machinery B. Payment of bond at maturity C. Inventory D. Patent
A
C. Inventory. This is because it’s a short term asset. Plant machinery and patent are long-term assets which require long-term liabilities. Short-term liabilities should not repay bond principal at maturity.
16
Q
What are three examples of long-term financing?
A
- Issuing bonds
- Issuing preferred stock
- Issuing common stock
17
Q
An increase in merchandise inventory (short-term asset) would be best financed by?
A
Increase in current liabilities (short-term liability)
18
Q
What is the formula to calculate annual rate on the discount lost? Also known as the annual cost of not taking the discount offered.
A
Discount percentage/(100% - Discount %) x 360 days/(Total pay period - Discount Period)
19
Q
When you are offered credit terms from three different banks, what factors should you look for when deciding on choosing the credit terms that are best for the company?
A
- Choose the terms where you purchase in the # of days that give the discount. Don’t pick the ones where you can’t get a discount.
- Once you’ve selected the options that offer a discount, use the annual cost of not taking discount formula to see what options gives you the highest value
- Choose the option that gives you the highest value
- If you take the discount, more than likely you borrow from a bank and you will need to subtract that percentage from your amount.
20
Q
If a firm purchases raw materials from its supplier on a 2/10, net 40, cash discount basis, the equivalent annual interest rate (using a 360-day year) of forgoing the cash discount and making payment on the 40th day is?
How do you solve this problem?
A
Use annual rate on discount lost formula
Discount %/(100% - Discount %) x 360 days/(total pay period-discount period)
Discount % = 2%
Total pay period = 40
Discount period = 10 days
Equation = 2%/(100%-2%) x 360/(40-10) = 24.49%
21
Q
When a firm has excess cash it can make short-term investments. What are the three major considerations when selecting these short-term investments?
A
- Safety of principal - little risk of default by issuer
- Price Stability - market price declines resulting in significant losses
- Ready Marketability/Liquidity - ability to readily convert the investment to cash without undue cost.
22
Q
What short-term investment provides the greatest safety of principal?
A
U.S. Treasury bills
23
Q
This short-term investment is a debt obligation of the U.S. government, has a maturity of one year or less, and is backed by the full faith and credit of U.S. government. What is this investment?
A
U.S. Treasury bills
24
Q
What are three important characteristics of U.S. treasury bills? (Hint: major considerations of short-term investments)
A
- Safety of principal
- Price stability
- Marketability/liquidity
25
This short-term investment is security which is an obligation of a federal government agency (ex. Fannie Mae). Not backed by good faith and credit of U.S. government.
1. More risk than treasury
2. Less marketable than treasury
3. Higher yields
Federal agency securities
26
This short-term investment is a security issued by banks in return for a fixed time deposit with the bank. Pay a fixed rate of interest and are available in different denominations.
1. High safety of pricinpal
2. Less marketability than treasury
Negotiable certificates of deposit.
27
These short-investments are orders to pay (a draft) drawn on a bank by an entity that has an account with the bank. If the bank accepts the draft, it accepts responsibility for payment to the holder of the acceptance.
1. Safety of principal
2. Higher risk
3. Less marketability
Bankers' acceptances
28
This short-term investment is a short-term unsecured promissory notes issued by established firms with outstanding credit ratings. However, since these promissory notes are not backed by collateral (security), they carry a risk of default.
1. Lack of marketability
2. Higher yield
3. More risk
Commercial paper
29
In this short-term investment, firm makes an investment (loan) and enters into a commitment to resell the security at the original contract price plus an agreed interest income.
Repurchase agreements (Repos)
30
Out of the four options below, which investment option would be expected to have the highest yield? And why?
Corporate bonds, US treasury bills, municipal bonds, and federal agency securities.
Corporate bonds because they are the riskiest investment. Municipal bonds are tax free so they yield less than corporate bonds.
31
What risk is 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.
Liquidity risk
32
What risk derives from the possibility that the issuer of the investment security will not be able to make future interest and/or principal payments?
Default risk
33
What risk derives from the possibility that the market rate of interest will increase, resulting in a decrease in the market value of already existing debt?
Interest rate risk
34
What risk derives from the possibility that a rise in the general price level will result in a reduction in the purchasing power of cash received in the future?
Purchasing power risk
35
What is the primary concern regarding cash and short-term investments? Two key things.
Liquidity and safety.
36
The coefficient of variation provides a measure of the relative variability of investments. The lower the CV, the better its total risk-return trade off. Lower CV means less risk. What is the formula for to calculate CV?
CV = Standard Deviation (SD)/Average rate of return on investment (AR)
**Lower CV is better. Means less risk**
37
When you are given the standard deviation and expected rate of return for two companies, how do you know what company's stock is riskier?
Company with higher coefficient of variation. CV = SD/AR.
38
```
Investment 1
Expected Return: 16%
Standard Deviation: 10%
Investment 2
Expected Return: 14%
Standard Deviation: 10%
How do you know which investment has least amount of risk?
```
The investment with lowest coefficient of variation. CV = SD/AR.
39
What is the preferred method for calculating an expected return of a long-term investment?
Geometric average. The geometric average depicts the compound annual return earned by the investor.
40
Provide three examples of measures of variability.
1. Variance
2. Standard deviation
3. Beta
41
The expected return of a portfolio is equal to _________?
Weighted-average of expected returns of the assets
42
According to the portfolio theory, an investment that correlates ______ to the current portfolio holdings is the best way to obtain optimal risk reduction.
Correlatives negatively. In that way, when one investment decreases in value others will increase. Therefore, the company should select an investment that correlates negatively to current portfolio holdings. Essentially, diversify and pick a different investment.
43
What is the formula to calculate expected return of the portfolio (also known as weighted-average of individual investments)?
Expected Return of Portfolio = Sum of Expected Return % x (Investment Amount/Total Investment Amount)
44
The overall objective of accounts receivable management is to?
Maximize profits
45
What are the downsides of an accounts receivable policy that is too loose or too strict?
Too loose - Grant credit to those who are not creditworthy and result in unnecessary uncollectible accounts and lower profit.
Too strict - will result in not making credit sales that would be paid and, thereby, increase profit.
46
Accounts receivable management is related to the _____ and ______ of accounts receivable?
Recognition and collection.
47
Review policies concerning recognition and collection of accounts receivable.
Recognition policies - include general terms under which credit will be granted and criteria for determining customer eligibility and limits.
Collection policies - cover monitoring accounts receivable and plans for collection action.
48
One objective of accounts receivable management is to _______ average age of accounts on its accounts receivable schedule.
Lower. This would reflect more timely collection of accounts receivable.
49
Given the following information, what amount is the balance in accounts receivable at closing on March 31st?
January Credit Sales: $20,000
February Credit Sales: $30,000
March Credit Sales: $50,000
Company collects 75% in the month of the sale and 25% in the following month.
AR Balance on January 1st is $25,000
The answer is $12,500 (.25 x $50,000). $50,000 is the credit sales in March. March 31st is at the end of the month. So the 25% applies to solve for AR balance. Since all sales are collected by the end of the month following the sales, only 25% of March sales would remain outstanding as of March 31.
Credit Sales x % company collected
50
Regarding accounts receivable management, a company is considering offering a 2% discount to improve cash conversion cycle. What is the formula to calculate net benefit/cost of implementing the discount plan? Given the following information below.
```
Credit Sales: $1,000,000
Proposed Discount: 2%
% expected to take discount: 40%
Probable increase/decrease AR: $30,000
Opportunity Cost: 15%
```
Net benefit/cost of proposed discount = Benefits obtained in reduction of working capital - cost of the plan
Or (True Formula answer)
(Increase/Decrease in AR x Opportunity Cost) - Credit Sales x (Proposed discount x % expected to take discount)
In formula,
(30,000 x .15) - $1,000,000 x (.02x.40) = -$3,500
51
Define discount, credit, and collection policy.
Discount policy - policy regarding the percentage discount given for early payment.
Credit policy - firm's requirements for customers in order to grant them credit.
Collection policy - procedures followed by the firm for ensuring payment of its accounts receivables. Diligence used to collect slow paying accounts.
52
Review the descriptions for collection policy, discount policy, and credit period.
Collection policy - Diligence to collect slow-paying accounts
Discount policy - % of discount allowed for early payment
Credit period - Length of time a buyer is given to pay for his/her purchases
53
Describe credit criteria.
Policies used to decide whether a customer should be extended credit. The required financial strength of acceptable customers.
54
Given the scenario below, what is the percentage of receivables in 31 to 60 day age group at the end of September?
Outstanding Accounts Receivables on 3rd quarter = $350
Month of July
Credit Sales = $600
Still outstanding end of Sept. = $100
Month of August
Credit Sales = $900
Still outstanding end of Sept. = $170
Month of September
Credit Sales = $500
Still outstanding end of Sept. = $80
To calculate % of receivables in 31-to-60 day age group at end of September, it's important to recognize that 31 to 60 days falls in the month of August.
In order to solve this problem. Use this formula.
AR still outstanding at the end of September for month of August/Outstanding accounts receivable on 3rd quarter. So....
$170/$350 = 48.57%
55
What is the formula to calculate balance of accounts receivable for reduction in average collection period? For example, there are payment terms of 2/10, net 60. Several customers are paying in 70 days (10 days over payment period).
```
Payment terms: 2/10, net 60
# of units sold per day: 1,000
Unit Price = $10
60% of customers take discount in 10 days
40% of customers pay in 70 days
```
Formula to calculate balance of accounts receivable for reduction in average collection period
AR Balance reduction in Avg. Coll. Period = Daily unit sales x Unit Price x % of customers paying late x # of days reduction outstanding
Formula = .4 x 1,000 x $10 x 10 = $40,000
56
What is the general objective of cash management?
Maintain a cash balance between holding too little cash and holding too much cash.
57
What is the downside of a firm holding too little cash?
A firm must maintain adequate cash on an on-going basis to meet its cash-requiring obligations that arise in the normal course of its business activities--accounts payable, salaries and wages, etc.
58
What is the downside of a firm holding too much cash?
Holding too much cash (excess cash over that needed for immediate obligations) is an inefficient use of resources, since the return on unneeded cash usually is less than could be earned if the cash were invested in assets with a higher return (e.g., securities, inventory, capital projects, etc.).
59
Define float, receipt float, and disbursement float.
Float - length of time between the writing of a check (or other draft instrument) and the actual transfer of the funds.
Receipt float - 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 - time between the writing of a check by a firm writes and removal of the funds from the firm's account.
60
Efficient cash management will seek to ______ receipt float and ______ disbursement float.
Decrease receipt float
| Increase disbursement float
61
Regarding effective cash management, what is the effect of reducing receipt float and increasing disbursement float?
Reducing receipt float - a firm has cash it is receiving available sooner than it would be available otherwise.
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.
62
With regards to cash management techniques, which techniques below focus on cash disbursement and cash receipts?
Techniques: lock-box system, zero-balance account, pre-authorized checks, and depository transfer checks
```
Cash Receipts
-Lock-box system
-Pre-authorized checks
-Depository transfer checks
Cash disbursements
-Zero-balance account
```
63
Explain the cash management technique of a lock-box system.
In a lock-box system, a firm's customers submit checks to a post office box (a locked box) that is convenient to and accessed by the firm's bank. The bank collects the payments, processes the checks, and deposits the proceeds directly into the firm's account with the bank. Such a system can reduce the float on receipts by several days.
64
Explain cash management technique of pre-authorized checks.
In a pre-authorized check arrangement, customers preauthorize a firm to draw checks on the customer's checking (or other demand deposit) account. On a prescribed date, preauthorized checks are prepared and processed by the firm, and the amounts deposited directly to the firm's bank account.
65
Explain cash management technique of depository transfer checks.
Depository transfer checks are typically used to move cash receipts deposited into dispersed local banks to a central bank, sometimes called a "concentration bank". The objective of such transfers is to better manage cash received from many sources.
66
Explain cash management technique of 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. Amount deposited = amount used for payment.
67
What is the formula to calculate net annual benefits/cost for lock-box agreement?
```
You are given the following variables in problem.
Daily cash receipts = $100,000
Collection time = 4 days
Lock-box collection time = 2 days
Lock-box monthly fee = $500 per month
# of months = 12 (annual)
Interest rate = 6% (.06)
```
Net annual benefit/cost of lock-box = Gross annual benefits - gross annual costs
Gross annual benefits = (Daily cash receipts x lock-box # of days) x interest rate
Gross annual cost = lock-box monthly fee x # of months in annual year (12)
(Daily cash receipts x lock-box # of days) x interest rate - (lock-box monthly fee x # of months)
($100,000 x 2) x .06 = $12,000 - $6,000 ($500 x 12) = $6,000
68
A minimum (checking account) balance required by the bank to compensate the bank for services is called?
The compensating balance.
69
Review the definitions for transaction balance, precautionary balance, and speculative balance.
Transaction balance - amount of funds the firm needs on deposit to conduct day-to-day transactions.
Precautionary balance - represents the balance available for emergencies.
Speculative balance - represents the balance available for bargain purchases.
70
Regarding receivables management, a lockbox would minimize or maximize float collection float? Does it effect disbursement float?
Lockbox minimizes collection float.
| Not affect disbursement float.
71
This credit instrument calls for immediate payment upon delivery of the shipping documents to the bank’s customer and acceptance of goods by the bank. What is it?
A. Sight Draft
B. Open Account for Buyer/Seller Relationship
C. Banker's acceptance
D. Conditional Sales Contract
A. Sight Draft
72
This credit instrument involves an invoice being signed by the banker upon receipt of goods, after which both the banker and the seller record the transaction on their respective books. What is it?
A. Sight Draft
B. Open Account for Buyer/Seller Relationship
C. Banker's acceptance
D. Conditional Sales Contract
B. Open Account for Buyer/Seller Relationship
73
This credit instrument is a time draft payable on a specified date and guaranteed by the bank. What is it?
A. Sight Draft
B. Open Account for Buyer/Seller Relationship
C. Banker's acceptance
D. Conditional Sales Contract
C. Banker's acceptance
74
This is credit instrument is a method of sales financing in which the seller retains title to the goods until the buyer has completed the payment.
A. Sight Draft
B. Open Account for Buyer/Seller Relationship
C. Banker's acceptance
D. Conditional Sales Contract
D. Conditional Sales Contract
75
The major advantage of a zero-balance account system is that it ________ the float involved in cash __________?
1. Maximizes
| 2. Disbursements
76
Review definition of compensating balance.
A compensating balance compensates a financial institution for services rendered by providing it with deposits of funds.
77
A firm is deciding on several different proposals to establish a lock-system. Given the information below, determine the most optimal (lowest cost) proposal for the firm in a 360-day year.
# of checks per day = 700
$ amount per check = $1,800 each
cost of short term funds = 7% (.07)
```
Proposals (Determine lowest cost)
A. A $0.50 fee per check
B. Flat fee of $125,000 per year
C. A fee of 0.03% of amount collected
D. Compensating balance of $1,750,000
```
How do you go about solving this problem?
Determine the cost per proposal.
A. $0.50 fee per check
700 (# of checks) x 360 (# days in yr) x 0.50 (fee per check) = $126,000 cost
B. Flat fee of $125,000 per year
Cost is equal to $125,000 cost
C. A fee of 0.03% of amount collected
700 (# of checks) x $1,800 ($ per check) x 360 days (# of days) x 0.03 (fee on proposal)
Cost = $136,080
D. Compensating Balance of $1,750,000
$1,750,000 (CB) x .07 (cost of ST funds)
Cost = $122,500 (LOWEST cost: ANSWER)
78
```
A firm has a choice between opening two accounts and they are trying to determine which one to choose. Which account would provide the best savings considering the information below?
Information
80 checks written per month
$500 minimum balance for firm
Standard account
-$10 per month charge by bank
-$0.10 per check charge
-No minimum balance
Premium account
-$2,500 required minimum balance
-No monthly fees or per check charges
-Cost of funds is 10%
```
Standard account
$10 per month charge + $8 check charge (0.10 x 80) = $18 per month or $216 per year (12 x $18)
Premium account
$2,000 required ($2500 min. fee - $500 min. firm balance) x .10 (cost of funds %) = $200
$216 (standard) - $200 (premium) = $16 savings on premium. Choose premium.
79
What are seven characteristics of a just-in-time inventory system?
1. Reducing distance and time between related production operations. This will reduce amount of inventory tied to production process.
2. Establishing close, long-term relationships with suppliers.
3. Increasing the number of deliveries from suppliers.
4. Reducing raw material safety stock. JIT increases speed at which inventory is replenished.
5. Reduction of inventories (ideally to zero)
6. Simplification of production activities by eliminating non-value-added activities.
7. Sharing of sales forecasts with vendors.
80
Review the definition of a just-in-time inventory system.
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.
81
What inventory management approach is a system for obtaining and delivering inventory just as and only when it is needed?
Just-in-time (JIT)
82
What inventory management approach is a system that envisions the production of goods in anticipation of sales.?
Material requirement planning
83
What inventory management approach is a system of costing that assigns cost to activities performed in the organization and then to products according to their use of the various activities?
ABC (Activity-based costing)
84
What inventory management approach seeks to minimize total inventory costs by considering both the restocking (reordering) cost and the carrying costs? Or which of the following inventory management approaches seeks to minimize total inventory costs by considering both the restocking (reordering) cost and the carrying costs?
Economic order quantity model
85
With regards to inventory management, what is the definition of safety stock?
Minimum level of inventory (stock) to be maintained.
86
With regards to inventory management, what is the definition of lead-time or delivery-time stock?
Length of time it takes to receive inventory after it is ordered
87
With regards to inventory management, explain what the reorder point is.
Basically, it's the level of stock (inventory) at which the inventory should be reordered.
88
What is the formula to calculate reorder point in inventory management?
Re-order point = Safety stock + Delivery-time stock
89
What are the two factors that help determine the computation or reorder point for an item of inventory?
1. Inventory Usage Per Day - Both the safety stock and the lead-time stock are based on the rate of inventory usage.
2. Acquisition lead time - length of time it takes to receive inventory after it is ordered
90
What is the formula to calculate economic order quantity? What variables are inside the formula?
Square root (2 x annual demand x cost per order/carrying cost per unit)
- Periodic demand is known
- Constant carrying cost per unit
- Constant cost per order
- Constant purchase cost per unit
91
Safety stock is a factor in determining reorder point or economic order quantity? Or both?
Only reorder point.
92
Is immediate incoming inspection of materials a feature of just-in-time (JIT) systems?
No, vendors inspect their own goods and guarantee that they are free of defects, thus eliminating the need for incoming inspection by the purchaser.
93
In the economic order quantity formula, which variables are in the numerator and which are in the denominator?
Numerator: 2, cost per order, and demand units
Denominator: carrying cost per unit
94
A reduction of ________ would increase the average quantity of inventory?
Cost of carrying inventory
95
When a JIT inventory system is successful, which cost category will increase and which one would decrease?
Cost Category Increase: Stockout costs. The company will be receiving fewer materials at any point in time, increasing the likelihood of stockout.
Cost Category Decrease: Carrying costs. the average inventory will be less, resulting in a reduction in the carrying costs.
96
What is the formula to calculate annual cost of carrying inventory?
Annual cost of carrying inventory = Avg. Inventory Level (Order size/2) x Unit Cost x Cost of Capital
97
```
What is the formula to calculate the number of units in safety stock that you should hold that would provide the lowest cost?
You are given the following variables
-Stockout cost
-Carrying cost per unit
-# of purchase orders
-# of units in safety stock
```
Formula for lowest cost for # of units of safety stock = Carrying Cost + Stockout costs/# of orders
Carrying cost = # of units x carrying cost per unit
Stockout costs/# of orders = Stockout cost x probability of running out of safety stock x # of purchase orders
Or (# of units x carrying cost per unit) + (stockout cost x probability of running out safety stock x # of purchase orders)
**Remember to calculate the cost for each answer choice to determine lowest cost**
