Deck 17: Working Capital Management and Short-Term Financing

Question 1

One of the advantages of short-term debt financing is that firms can obtain short-term credit more quickly than long-term credit.

Answer 1

True

Question 2

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

Answer 2

True

Question 3

If a firm takes actions that reduce its DSO, then, other things held constant, this will lengthen its CCC.

Answer 3

False

Question 4

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

Question 5

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

Question 6

A conservative financing approach to working capital will result in most of the permanent net operating working capital being financed by long-term securities.

Question 7

Short-term financing is riskier than long-term financing since, during periods of tight credit, the firm may not be able to rollover (renew) its debt. This is especially true if the funds are used to finance long-term rather than short-term assets.

Question 8

An increase in the holding of marketable securities must be accompanied by a corresponding increase in the net operating working capital.

Question 9

Net working capital is defined as current assets minus current liabilities.

Question 10

The cash conversion cycle (CCC) combines three factors-the inventory conversion period, the receivables collection period, and the payables deferral period-and its purpose is to show how long a firm must finance its operating working capital. Other things held constant, the shorter the CCC, the more effective the firm's working capital management.

Question 11

Gross working capital simply refers to current assets used in operations.

Question 12

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

Question 13

Minimizing cash holdings, inventories, or receivables, and maximizing payables or accruals are the aims of relaxed working capital policies.

Question 14

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

Question 15

Funds from short-term loans can generally be obtained faster than from long-term loans for two reasons: (1) when lenders consider long-term loans they must make a more thorough evaluation of the borrower's financial health, and (2) long-term loan agreements are more complex.

Question 16

You receive some goods on April 1 with the following terms: 3/20, net 30, June 1 dating. This means that you will receive a 3% discount if the bill is paid on or before June 20 and also that the full amount must be paid 30 days after receipt of the goods.

Question 17

Other things held constant, if a firm stretches its accounts payable, this will lengthen its CCC.

Question 18

Permanent net operating working capital reflects the fact that net operating working capital does not shrink to zero even when a business is at its seasonal or cyclical low. Thus, permanent net operating working capital represents a minimum level of net operating working capital that must be financed.

Question 19

The firm's total capital requirement grows over time with amounts including the base level of fixed assets and current assets. There exists seasonal variation around the trend showing the required temporary working capital.

Question 20

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 21

The inventory conversion period of the operating cycle terminates when the inventory is paid for with cash.

Question 22

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

Question 23

A line of credit can be either a formal or an informal agreement between a borrower and a bank regarding the maximum amount of credit the bank will extend to the borrower subject to certain conditions, including the borrower's maintaining its financial strength.

Question 24

The effect of compensating balances is to decrease the effective interest rate of a loan.

Question 25

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

Question 26

Interest rates charged on loans vary depending on the risk of borrower, and the size of the loan, but not the economic conditions.

Question 27

Under a public warehouse agreement, the inventory used as collateral for the loan is stored on the premises of a third party.

Question 28

When a firm's accounts payable are greater than its accounts receivable, the firm is receiving net trade credit.

Question 29

Due to the complexity of factoring procedures, factoring is rarely used as a source of short-term financing in Canada today.

Question 30

Generally, the longer the normal inventory holding period of customers, the longer the credit period.

Question 31

Accruals are "free" capital in the sense that no explicit interest must be paid on accruals.

Question 32

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 match maturities on an expected basis.

Question 33

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

Question 34

As a rule, managers should try to always use the free component of trade credit but should use the costly component only if the cost of this credit is lower than the costs of credit from other sources.

Question 35

Pledging of receivables involves the sale of accounts receivable.

Question 36

While the maturity of most bank loans is short term, they are frequently repaid on demand rather than on a specific maturity date.

Question 37

When the accounts receivable turnover and payables deferral period are decreased, a firm's cash conversion cycle will be lengthened.

Question 38

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 that vary depending on the level of interest rates. When short-term rates are relatively high, short-term assets will be financed with long-term debt to reduce costs and risk.

Question 39

One of the effects of not taking trade credit discounts when offered is that the firm's use of accounts payable rises.

Question 40

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

Question 41

The calculated cost of trade credit can be reduced by paying late.

Question 42

The cash budget and the capital budget are handled separately and, although they are both important, they are developed independently of one another.

Question 43

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

Question 44

The fact that no explicit interest is paid on accruals, and that the firm can vary the level of these accounts, makes accruals an attractive and flexible source of funding to meet increased working capital needs.

Question 45

Because money has time value, cash sales are always more profitable than credit sales.

Question 46

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

Question 47

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

Question 48

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 in 30 days.

Question 49

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

Question 50

Since depreciation is a noncash charge, it neither appears on nor has any effect on the cash budget.

Question 51

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

Question 52

The prime rate charged 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 making loans to specialty retailers.

Question 53

The relative profitability of a firm that employs an aggressive working capital financing policy will improve when the yield curve changes from upward sloping to downward sloping.

Question 54

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

Question 55

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

Question 56

If a firm is involuntarily stretching its accounts payable, then this is probably a sign that it is undercapitalized, that is, that it needs more working capital to support its operations.

Question 57

If a firm's suppliers stop offering discounts, then its use of trade credit is more likely to increase than to decrease.

Question 58

The risk to the firm of borrowing using short-term credit is usually greater than if it used 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 temporarily unable to repay it.

Question 59

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 its other current liabilities associated with working capital management.

Question 60

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

Question 61

Which of the following actions would likely shorten the length of the cash conversion cycle?

A) adopting a new inventory system that reduces the inventory conversion period
B) reducing the average DSO on its accounts receivable
C) reducing the amount of time the company takes to pay its suppliers
D) both a and b

Question 62

Which of the following statements best describes short-term financing?

A) Under normal conditions, a firm's expected ROE would probably be higher if it financed with short-term rather than with long-term debt, but the use of short-term debt would probably increase the firm's risk.
B) Conservative firms generally use no short-term debt and thus have zero current liabilities.
C) A short-term loan can usually be obtained more quickly than a long-term loan, but the cost of short-term debt is normally higher than that of long-term debt.
D) If a firm that can borrow from its bank buys materials on terms of 2/10, net 30, and if it must pay by Day 30 or else be cut off, then we would expect to see zero accounts payable on its balance sheet.

Question 63

Other things held constant, which of the following would tend to reduce the cash conversion cycle?

A) Maintain the same level of receivables as sales decline.
B) Place larger orders for raw materials to take advantage of price breaks.
C) Take all discounts that are offered.
D) Do not take all discounts that are offered to get more trade credit.

Question 64

Which of the following statements is INCORRECT?

A) Commercial paper can be issued by virtually any firm so long as it is willing to pay the going interest rate.
B) Accruals are free in the sense that no explicit interest is paid on these funds.
C) A conservative approach to working capital will result in all permanent assets being financed with long-term capital.
D) The risk to the firm of borrowing with short-term credit is usually greater than with long- term debt. Added risk can stem from the greater variability of interest costs on short-term debt.

Question 65

Which of the following statements best describes cash budgets?

A) Shorter-term cash budgets, in general, are used primarily for planning purposes, while longer-term budgets are used for actual cash control.
B) 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.
C) Since depreciation is a noncash charge, it does not appear on nor have an effect on the cash budget.
D) The typical actual cash budget will reflect interest on loans and income from investment of surplus cash. These numbers are expected values and actual results might vary from budgeted results.

Question 66

The factoring of receivables involves the specific use of receivables as collateral for the loan.

Question 67

Which of the following statements best describes working capital financing policy?

A) Net working capital may be defined as current assets minus current liabilities, and an increase in the current ratio automatically indicates that net working capital has increased.
B) 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 strategy because of the inherent risks of using short-term financing.
C) If a company follows a policy of "matching maturities," this means that it matches its use of common shares with its use of long-term debt as opposed to short-term debt.

Question 68

Which of the following statements best describes compensating balances?

A) Compensating balance requirements apply only to businesses, not to individuals.
B) Compensating balances are essentially costless to most firms, because those firms would normally have such funds on hand to meet transactions needs anyway.
C) If the required compensating balance is larger than the transactions balance the firm would ordinarily hold, then the effective cost of any loan requiring such a balance is increased.
D) Banks are prohibited from earning interest on the compensating balances they hold.

Question 69

The blanket inventory lien gives the lender a lien against all inventories of the borrower. However, the borrower is free to sell them.

Question 70

The cost of an installment loan is always slightly less than twice the stated annual rate.

Question 71

Ski Lifts Inc. is in a highly seasonal business, and the following summary balance sheet data show its assets and liabilities at peak and off-peak seasons (in thousands of dollars): What can we conclude from this data?

A) Ski Lifts's working capital financing policy calls for exactly matching asset and liability maturities.
B) Ski Lifts's working capital financing policy is relatively aggressive; that is, the company finances some of its permanent assets with short-term discretionary debt.
C) Ski Lifts follows a relatively conservative approach to working capital financing; that is, some of its short-term needs are met by permanent capital.
D) Without income statement data, we cannot determine the aggressiveness or conservatism of the company's working capital financing policy.

Question 72

Helena Furnishings wants to reduce its cash conversion cycle sharply. Which of the following actions should it take?

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) The company increases its DSO.

Question 73

Which of the following borrowers benefit the most from a revolving line of credit?

A) a local grocery retailer located in downtown Toronto
B) an owner of a gift shop with majority of its annual sales during Christmas season
C) an ice cream seller whose business is located in a Niagara Falls resort
D) a manufacturer of hand tools whose sales are generally evenly distributed throughout the year

Question 74

Discount loans are usually provided for terms of only 1 year or less. Their interest is paid together with the principal at the end of the loan.

Question 75

Firms must have high credit quality in order to issue commercial paper; therefore, all commercial papers are equally risky.

Question 76

Which of the following statements is most correct?

A) Accruals are an expensive way to finance working capital.
B) A conservative financing policy is one in which the firm finances all of its fixed assets with long-term capital and part of its permanent net operating working capital with short- term, nonspontaneous credit.
C) If a company receives trade credit under terms 2/10, net 30, this implies the company has 10 days of free trade credit.
D) Statements a and b are correct.

Question 77

Which of the following statements best describes cash budgets?

A) Depreciation expense is not explicitly included, but depreciation effects are reflected in the 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) Changes that affect the DSO do not affect the cash budget.

Question 78

Which of the following items should a company report directly in its monthly cash budget?

A) its monthly depreciation expense
B) cash proceeds from selling one of its divisions
C) accrued interest on zero coupon bonds that it issued
D) new shares issued in a stock split

Question 79

Why do firms generally choose to finance temporary net operating working capital with short-term debt?

A) Matching the maturities of assets and liabilities reduces risk.
B) Short-term interest rates have traditionally been more stable than long-term interest rates.
C) A firm that borrows heavily on a long-term basis is more apt to be unable to repay the debt than a firm that borrows short term.
D) The yield curve has traditionally been downward sloping.

Question 80

Which of the following is typically NOT considered when constructing a cash budget?

A) payments lag
B) payment for plant construction
C) cumulative cash
D) writing off bad debts