Deck 21: Working Capital Management

Question 1

The principal goal of most inventory management systems is to balance the costs of ordering, shipping, and receiving goods with the cost of carrying those goods, while simultaneously meeting the firm's policy with respect to avoiding running short of stock and disrupting production schedules.

Answer 1

True

Question 2

Determination of a firm's investment in net operating working capital and how that investment is financed are elements of working capital policy.

Answer 2

True

Question 3

The aging schedule is a commonly used method of monitoring receivables.

Answer 3

True

Question 4

The central goal of inventory management is to provide sufficient incentives to ensure that the firm never suffers a stock-out (i.e., runs out of an inventory item).

Question 5

Since receivables and payables both result from sales transactions, a firm with a high receivables-to-sales ratio will also have a high payables-to-sales ratio.

Question 6

The average accounts receivables balance is determined jointly by the volume of credit sales and the days sales outstanding.

Question 7

Cash is often referred to as a "non-earning" asset. Thus, one goal of cash management is to minimize the amount of cash necessary to conduct business.

Question 8

Offering trade credit discounts is costly to a firm and as a result, firms that offer trade discounts are usually those that are performing poorly and need cash quickly.

Question 9

If a firm has a large percentage of accounts over 30 days old, it is a sign that the firm's receivables management needs to be reviewed and improved.

Question 10

For a firm that makes heavy use of float, being able to forecast its collections and disbursement check clearings is essential.

Question 11

Firms hold cash balances in order to complete transactions that are necessary in business operations and as compensation to banks for providing loans and services.

Question 12

A firm's peak borrowing needs will probably be overstated if it bases its monthly cash budget on uniform cash receipts and disbursements, but actual receipts are concentrated at the beginning of each month.

Question 13

The four major elements in a firm's credit policy are (1) credit standards, (2) discounts offered, (3) credit period, and (4) collection policy.

Question 14

Net working capital may be defined as current assets minus current liabilities. This also defines the current ratio.

Question 15

If you receive some goods on April 1 with the follow¬ing terms; 3/20, net 30, June 1 dating, it means that you will receive a 3 percent discount if the bill is paid on or before June 20 and that the full amount must be paid 30 days after receipt of the goods.

Question 16

Shorter-term cash budgets, in general, are used for actual cash control while longer-term budgets are used primarily for planning purposes.

Question 17

Net working capital is defined as current assets divided by current liabilities.

Question 18

Inventory management is largely self-contained, that is, only minimum coordination among other departments such as sales, purchasing, and production is required for successful inventory management.

Question 19

An increase in a current asset account must be accompanied by a corresponding increase in a liability account.

Question 20

Lockbox arrangements are one way for a firm to speed up its collection of payments from customers.

Question 21

Short-term financing may be riskier than long-term financing since, during periods of tight credit, the firm may not be able to rollover (renew) its debt.

Question 22

The calculated cost of trade credit is reduced by paying late.

Question 23

The calculated cost of trade credit for a firm that buys on terms of 2/10, net 30, is lower (other things held constant) if the firm pays in 40 days than if it pays in 30 days.

Question 24

Although short-term interest rates have historically averaged less than long-term rates, the heavy use of short-term debt is considered to be an aggressive working capital financing strategy because of the inherent risks of using short-term financing.

Question 25

"Stretching" accounts payable is a widely accepted and costless financing technique.

Question 26

A firm changes its credit policy from 2/10, net 30, to 3/10, net 30. The change is meant to meet competition, so no increase in sales is expected. Average accounts receivable will probably decline as a result of this change.

Question 27

A firm is said to be extending net trade credit when its accounts receivable are less than its accounts payable.

Question 28

Accruals are "free" financing in the sense that no explicit interest is paid on accruals.

Question 29

Trade credit can be separated into two components: free trade credit, which involves credit received after the discount period ends, and costly trade credit, which is the cost of discounts not taken.

Question 30

The fact that no explicit interest cost is paid on accruals, and that the firm can exercise considerable control over their level, makes accruals an attractive source of additional funding.

Question 31

When deciding whether or not to take a trade discount, the cost of borrowing funds should be compared to the cost of trade credit to determine if the cash discount should be taken.

Question 32

A line of credit and a revolving credit agreement are similar except that a line of credit creates a legal obligation for the bank.

Question 33

If a firm is offered credit terms of 2/10, net 30, it is in the firm's financial interest to pay as early as possible during the discount period.

Question 34

As a rule, managers should try to always use the free component of trade credit but should use the costly component only after comparing its costs to the costs of similar credit from other sources.

Question 35

One of the advantages of short-term debt financing is that firms can expand or contract their short-term credit more easily than their long-term credit.

Question 36

Trade credit is an inexpensive source of short-term financing if no discounts are offered.

Question 37

One of the disadvantages of not taking trade credit discounts when offered is that the firm's investment in accounts payable rises.

Question 38

Short-term loans generally are obtained faster than long-term loans because when lenders consider long-term loans they insist on a more thorough evaluation of the borrower's financial health and because the loan agreement is more complex.

Question 39

Accruals are "spontaneous," but, unfortunately, due to law and economic forces, firms have little control over the level of these accounts.

Question 40

When a firm has accounts payable that are greater than the level of its receivables, the firm is actually receiving net trade credit.

Question 41

The cash budget and the capital budget are planned separately, and although they are both important to the firm, they are independent of each other.

Question 42

A line of credit can be either a formal or informal agreement between borrower and bank regarding the maximum amount of credit the bank will extend to the borrower subject to certain conditions.

Question 43

Synchronization of cash flows is an important cash management technique and effective synchronization can actually increase a firm's profitability.

Question 44

The maturity of most bank loans is short-term. Bank to business loans are frequently 90-day notes which are often rolled over, or renewed, at the end of their maturity.

Question 45

A lockbox plan is one method of speeding up the check-clearing process for customer payments and decreasing the firm's net float position.

Question 46

Under a revolving credit agreement the risk to the firm of being unable to obtain funds when needed is lower than with a line of credit.

Question 47

Generally, the longer the normal inventory holding period of a customer the longer the credit period. One effect of extending the credit period to match the customer's merchandise holding period is to increase the deferrables period which actually serves to shorten the customer's cash conversion cycle.

Question 48

Changes in a firm's collection policy can affect sales, working capital and even additional funds needed.

Question 49

A firm has a daily average collection of checks equal to $250,000. It takes the firm approximately 4 days to convert the funds into usable cash. Assume (1) a lockbox system could be employed which would reduce the cash conversion procedure to 2 ½ days and (2) the firm could invest any additional cash received at 6 percent after taxes. The lockbox system would be a good buy if it costs only $23,000 annually.

Question 50

In managing a firm's accounts receivable it is possible to increase credit sales per day yet still keep accounts receivable fairly steady if the firm can shorten the length of its collection period.

Question 51

Since depreciation is a non-cash charge it does not appear nor have an effect on the cash budget.

Question 52

If your firm's DSO or aging schedule deteriorates from the first quarter of the year to the second quarter, this is a clear indication that your firm's credit policy has weakened.

Question 53

A firm which makes 90 percent of its sales on credit and 10 percent for cash is currently growing at a rate of 10 percent annually. If the firm maintains stable growth it will also be able to maintain its accounts receivable at its current level, since the 10 percent cash sales can be used to manage the 10 percent growth rate.

Question 54

If a firm's terms are 2/10, net 30 days, and its DSO is 28 days, we can be certain that the credit department is functioning efficiently and the percentage of past due accounts is minimal.

Question 55

A promissory note is the document signed when a bank loan is executed and it specifies financial aspects of the loan. The separate indenture note will specify items such as collateral and other terms and conditions.

Question 56

Collections float offsets disbursement float. If a firm's collections float is greater than its disbursement float then a firm is said to operate with positive net float.

Question 57

The target cash balance is set optimally such that it need not be adjusted for seasonal patterns and unanticipated fluctuations although it is changed to reflect long-term changes in the firm's operations.

Question 58

If a firm's sales and those of its customers are closely correlated with economic conditions, it is certainly possible for a firm's total investment in accounts receivable to decrease while its days sales outstanding increases.

Question 59

In part because money has time value, cash sales are always more profitable and more valuable than credit sales.

Question 60

A firm's collection policy and the procedures it follows to collect accounts receivable play an important role in keeping its deferrables period short, although too strict a collection policy can result in outright losses due to non-payment.

Question 61

If a firm is involuntarily "stretching" its accounts payable then this is one sign that it is undercapitalized, that is, that it needs more working capital for operations.

Question 62

The prime rate charged by big money center banks can vary greatly (for example, as much as 2 to 4 percentage points) across banks due to banks' ability to differentiate themselves and because particular banks develop particular clienteles, such as mainly making loans to small firms.

Question 63

If one of your firm's customers is "stretching" its accounts payable, this may be a nuisance but does not represent a real financial cost to your firm as long as the firm periodically pays off its entire balance.

Question 64

Which of the following items should a company explicitly include in its monthly cash budget?

A) Its monthly depreciation expense.
B) Its cash proceeds from selling one of its divisions.
C) Interest paid on its bank loans.
D) Statements b and c are correct.
E) All of the statements above are correct.

Question 65

A firm constructing a new manufacturing plant and financing it with short-term loans that are scheduled to be converted to first mortgage bonds when the plant is completed, would want to separate the construction loan from other current liabilities associated with working capital management.

Question 66

A firm that employs an aggressive working capital financing policy stands to increase profitability when the yield curve changes from upward sloping to downward sloping.

Question 67

A revolving credit agreement is a formal line of credit usually used by large firms. The firm will pay a fee on the unused balance of the committed funds to compensate the bank for the commitment to extend those funds.

Question 68

Which of the following statements is most correct?

A) A good cash management system would minimize disbursement float and maximize collections float.
B) If a firm begins to use a well-designed lockbox system, this will reduce its customers' net float.
C) In the early 1980's, the prime interest rate hit a high of 21 percent. In 1995 the prime rate was considerably lower. That sharp interest rate decline has increased firms' concerns about the efficiency of their cash management programs.
D) If a firm can get its customers to permit it to pay by wire transfers rather than having to write checks, this will increase its net float and thus reduce its required cash balances.
E) A firm which has such an efficient cash management system that it has positive net float can have a negative checkbook balance at most times and still not have its checks bounce.

Question 69

Which of the following is typically part of the cash budget?

A) Payments lag.
B) Payment for plant construction.
C) Cumulative cash.
D) Statements a and c are correct.
E) All of the statements above are correct.

Question 70

A firm adopting an aggressive working capital financing approach is more sensitive to unexpected changes in the term structure of interest rates than is a firm with a conservative financing policy.

Question 71

If a firm fails to take trade credit discounts it may cost the firm money, but generally such a policy has a negligible effect on the firm's income statement and no effect on the firm's balance sheet.

Question 72

Uncertainty about the exact lives of assets prevents precise maturity matching in an ex post (i.e., after the fact) sense even though it is possible to maturity match on an expected basis.

Question 73

A firm that "stretches" its accounts payable rather than paying on net terms is actually increasing its calculated cost of credit given that it already does not take discounts when offered, other things held constant.

Question 74

The maturity matching or "self-liquidating" approach involves the financing of permanent net operating working capital with combinations of long-term capital and short-term capital depending on the level of interest rates. When short-term rates are high, short-term assets will be financed with long-term debt to reduce cost and risk.

Question 75

Long-term loan agreements always contain provisions, or covenants, which constrain the firm's future actions. Short-term credit agreements are just as restrictive in order to protect the interests of the lender.

Question 76

The risk to the firm of borrowing using short-term credit is usually greater than with long-term debt. Added risk stems from greater variability of interest costs on short-term debt. Even if its long-term prospects are good, the firm's lender may not renew a short-term loan if the firm is even only temporarily unable to repay it.

Question 77

Which of the following statements is most correct?

A) A cash management system which minimizes collections float and maximizes disbursement float is better than one with higher collections float and lower disbursement float.
B) A cash management system which maximizes collections float and minimizes disbursement float is better than one with lower collections float and higher disbursement float.
C) The use of a lockbox is designed to minimize cash theft losses. If the cost of the lockbox is less than theft losses saved, then the lockbox should be installed.
D) Other things held constant, a firm will need an identical line of credit if it can arrange to pay its bills by the 5th of each month than if its bills come due uniformly during the month.
E) The statements above are all false.

Question 78

Other things held constant, which of the following will cause an increase in working capital?

A) Cash is used to buy marketable securities.
B) A cash dividend is declared and paid.
C) Merchandise is sold at a profit, but the sale is on credit.
D) Long-term bonds are retired with the proceeds of a preferred stock issue.
E) Missing inventory is written off against retained earnings.

Question 79

Helena Furnishings wants to sharply reduce its cash conversion cycle. Which of the following steps would reduce its cash conversion cycle?

A) The company increases its average inventory without increasing its sales.
B) The company reduces its DSO.
C) The company starts paying its bills sooner, which reduces its average accounts payable without reducing its sales.
D) Statements a and b are correct.
E) All of the statements above are correct.

Question 80

Which of the following statements concerning the cash budget is correct?

A) Depreciation expense is not explicitly included, but depreciation effects are implicitly included in estimated tax payments.
B) Cash budgets do not include financial expenses such as interest and dividend payments.
C) Cash budgets do not include cash inflows from long-term sources such as bond issues.
D) Statements a and b are correct.
E) Statements a and c are correct.