Deck 16: Working Capital Management

Question 1

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

Answer 1

True

Question 2

The twin goals of inventory management are (1) to ensure that the inventories needed to sustain operations are available, but (2) to hold the costs of ordering and carrying inventories to the lowest possible level.

Answer 2

True

Question 3

Setting up a lockbox arrangement is one way for a firm to speed up the collection of payments from its customers.

Answer 3

True

Question 4

Shorter-term cash budgets--say a daily cash budget for the next month-- are generally used for actual cash control while longer-term cash budgets--say monthly cash budgets for the next year--are generally used for planning purposes.

Question 5

Determining a firm's optimal investment in working capital and deciding how that investment should be financed are critical to working capital management.

Question 6

If a firm has a large percentage of accounts over 30 days old, this is proof positive that its receivables manager is not doing a good job.

Question 7

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 current operating asset financing strategy because of the inherent risks of using short-term financing.

Question 8

A conservative current operating asset financing approach will result in permanent current assets and some seasonal current assets being financed using long-term securities.

Question 9

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

Question 10

If a firm takes actions that reduce its days sales outstanding (DSO), then, other things held constant, this will lengthen its cash conversion cycle (CCC).

Question 11

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

Question 12

The concept of permanent current operating assets reflects the fact that some components of current assets do not shrink to zero even when a business is at its seasonal or cyclical low. Thus, permanent current operating assets represent a minimum level of current assets that must be financed.

Question 13

Cash is often referred to as a "non-earning" asset. Thus, one goal of cash management is to minimize the amount of cash necessary for conducting a firm's normal business activities.

Question 14

The average accounts receivable balance is a function of both the volume of credit sales and the days sales outstanding.

Question 15

An increase in any current asset must be accompanied by an equal increase in some current liability.

Question 16

The overriding goal of inventory management is to ensure that the firm never suffers a stock-out, i.e., never runs out of an inventory item.

Question 17

Not taking cash discounts is costly, and as a result, firms that do not take them are usually those that are performing poorly and have inadequate cash balances.

Question 18

Other things held constant, if a firm "stretches" (i.e., delays paying) its accounts payable, this will lengthen its cash conversion cycle (CCC).

Question 19

Changes in a firm's collection policy can affect sales, working capital, and profits.

Question 20

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

Question 21

One of the effects of ceasing to take trade credit discounts is that the firm's accounts payable will rise, other things held constant.

Question 22

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

Question 23

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 assets rather than short-term assets.

Question 24

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

Question 25

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 cost of credit from other sources.

Question 26

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 plans to pay in 40 days than in 30 days.

Question 27

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

Question 28

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 29

Suppose 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. The average accounts receivable balance will probably decline as a result of this change.

Question 30

The maturity of most bank loans is short term. Bank loans to businesses are frequently made as 90-day notes which are often rolled over, or renewed, rather than repaid when they mature. However, if the borrower's financial situation deteriorates, then the bank may refuse to roll over the loan.
a. True
b. False

Question 31

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 32

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

Question 33

Loans from commercial banks generally appear on balance sheets as notes payable. A bank's importance is actually greater than it appears from the dollar amounts shown on balance sheets because banks provide nonspontaneous funds to firms.

Question 34

The facts (1) that no explicit interest is paid on accruals and (2) that the firm can control the level of these accounts at will makes them an attractive source of funding to meet working capital needs.

Question 35

If a firm busy on terms of 2/10 net 30, it should pay as early as possible during the discount period.

Question 36

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

Question 37

An informal line of credit and a revolving credit agreement are similar except that the line of credit creates a legal obligation for the bank and thus is a more reliable source of funds for the borrower.

Question 38

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

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

Short-term marketable securities are held for two separate and distinct purposes: (1) to provide liquidity as a substitute for cash and (2) as a non-operating investment. Marketable securities held while awaiting reinvestment are not available for liquidity purposes.

Question 41

Synchronization of cash flows is an important cash management technique, as proper synchronization can reduce the required cash balance and increase a firm's profitability.

Question 42

Dimon Products' sales are expected to be $5 million this year, with 90% on credit and 10% for cash. Sales are expected to grow at a stable, steady rate of 10% annually in the future. Dimon's accounts receivable balance will remain constant at the current level, because the 10% cash sales can be used to support the 10% growth rate, other things held constant.

Question 43

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

Question 44

Because money has time value, a cash sale is always more profitable than a credit sale.

Question 45

The maturity matching, or "self-liquidating," approach to financing involves obtaining the funds for permanent current assets with a combination of long-term capital and short-term capital that varies 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.

Question 46

The longer its customers normally hold inventory, the longer the credit period supplier firms normally offer. Still, suppliers have some flexibility in the credit terms they offer. If a supplier lengthens the credit period offered, this will shorten the customer's cash conversion cycle but lengthen the supplier firm's own CCC.

Question 47

On average, a firm collects checks totaling $250,000 per day. It takes the firm approximately 4 days from the day the checks were mailed until they result in usable cash for the firm. Assume that (1) a lockbox system could be employed which would reduce the cash conversion procedure to 2 1/2 days and (2) the firm could invest any additional cash generated at 6% after taxes. The lockbox system would be a good buy if it costs $25,000 annually.

Question 48

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

Question 49

For a zero-growth firm, it is possible to increase the percentage of sales that are made on credit and still keep accounts receivable at their current level, provided the firm can shorten the length of its collection period sufficiently.

Question 50

A firm's peak borrowing needs will probably be overstated if it bases its monthly cash budget on the assumption that both cash receipts and cash payments occur uniformly over the month but in reality payments are concentrated at the beginning of each month.

Question 51

If a firm has set up a revolving credit agreement with a bank, the risk to the firm of being unable to obtain funds when needed is lower than if it had an informal line of credit.

Question 52

A firm's peak borrowing needs will probably be overstated if it bases its monthly cash budget on the assumption that both cash receipts and cash payments occur uniformly over the month but in reality receipts are concentrated at the beginning of each month.

Question 53

Since depreciation is a non-cash charge, it neither appears on nor has any effect on the cash budget. Thus, if the depreciation charge for the coming year doubled or halved, this would have no effect on the cash budget.

Question 54

A firm that follows an aggressive current asset financing approach uses primarily short-term credit and thus is more exposed to an unexpected increase in interest rates than is a firm that uses long-term capital and thus follows a conservative financing policy.

Question 55

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 during some future period, assuming the borrower maintains its financial strength.

Question 56

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 ex ante (expected) basis.

Question 57

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

Question 58

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

Question 59

A firm's collection policy, i.e., the procedures it follows to collect accounts receivable, plays an important role in keeping its average collection period short, although too strict a collection policy can reduce profits due to lost sales.

Question 60

A promissory note is the document signed when a bank loan is executed, and it specifies financial aspects of the loan.

Question 61

Which of the following statements is CORRECT?

Question 62

Which of the following is NOT directly reflected in the cash budget of a firm that is in the zero tax bracket?

A) Payments lags.
B) Depreciation.
C) Cumulative cash.
D) Repurchases of common stock.
E) Payment for plant construction.

Question 63

Which of the following statements is CORRECT?

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 developed separately, and although they are both important to the firm, one does not affect the other.
C) Since depreciation is a non-cash charge, it neither appears on nor has any effect on the cash budget.
D) The target cash balance should be set such that it need not be adjusted for seasonal patterns and unanticipated fluctuations in receipts, although it should be changed to reflect long-term changes in the firm's operations.
E) The typical cash budget reflects interest paid on loans as well as income from the investment of surplus cash. These numbers, as well as other items on the cash budget, are expected values; hence, actual results might vary from the budgeted amounts.

Question 64

If a firm sells on terms of 2/10 net 30 days, and its DSO is 28 days, then the fact that the 28-day DSO is less than the 30-day credit period tells us that the credit department is functioning efficiently and there are no past-due accounts.

Question 65

Firms generally choose to finance temporary current operating assets with short-term debt because

Question 66

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

A) matching the maturities of assets and liabilities reduces risk under some circumstances, and also because short-term debt is often less expensive than long-term capital.
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 is normally downward sloping.

Question 67

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

A) Adopt a new manufacturing process that speeds up the conversion of raw materials to finished goods from 20 days to 10 days.
B) Change the credit terms offered to customers from 3/10 net 30 to 1/10 net 50.
C) Begin to take discounts on inventory purchases; we buy on terms of 2/10 net 30.
D) Adopt a new manufacturing process that saves some labor costs but slows down the conversion of raw materials to finished goods from 10 days to 20 days.
E) Change the credit terms offered to customers from 2/10 net 30 to 1/10 net 60.

Question 68

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

A) Increase average inventory without increasing sales.
B) Take steps to reduce the DSO.
C) Start paying its bills sooner, which would reduce the average accounts payable but not affect sales.
D) Sell common stock to retire long-term bonds.
E) Sell an issue of long-term bonds and use the proceeds to buy back some of its common stock.

Question 69

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.
E) New shares issued in a stock dividend.

Question 70

Swim Suits Unlimited 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):

A) Swim Suits' current asset financing policy calls for exactly matching asset and liability maturities.
B) Swim Suits' current asset financing policy is relatively aggressive; that is, the company finances some of its permanent assets with short-term discretionary debt.
C) Swim Suits follows a relatively conservative approach to current asset 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 current asset financing policy.
E) Without cash flow data, we cannot determine the aggressiveness or conservatism of the company's current asset financing policy.

Question 71

If the yield curve is upward sloping, then short-term debt will be cheaper than long-term debt. Thus, if a firm's CFO expects the yield curve to continue to have an upward slope, this would tend to cause the current ratio to be relatively low, other things held constant.

Question 72

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 73

A lockbox plan is most beneficial to firms that

A) have suppliers who operate in many different parts of the country.
B) have widely dispersed manufacturing facilities.
C) have a large marketable securities portfolio and cash to protect.
D) receive payments in the form of currency, such as fast food restaurants, rather than in the form of checks.
E) have customers who operate in many different parts of the country.

Question 74

If a profitable firm finds that it simply must "stretch" its accounts payable, then this suggests that it is undercapitalized, i.e., that it needs more working capital to support its operations.

Question 75

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 (1) the greater variability of interest costs on short-term than long-term debt and (2) the fact that even if its long-term prospects are good, the firm's lenders may not be willing to renew short-term loans if the firm is temporarily unable to repay those loans.

Question 76

A lockbox plan is

A) used to protect cash, i.e., to keep it from being stolen.
B) used to identify inventory safety stocks.
C) used to slow down the collection of checks our firm writes.
D) used to speed up the collection of checks received.
E) used primarily by firms where currency is used frequently in transactions, such as fast food restaurants, and less frequently by firms that receive payments as checks.

Question 77

If a firm switched from taking trade credit discounts to paying on the net due date, this might cost the firm some money, but such a policy would probably have only a negligible effect on the income statement and no effect whatever on the balance sheet.

Question 78

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 interest of the lender.

Question 79

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

Question 80

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

A) Carry a constant amount 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) Continue to take all discounts that are offered and pay on the net date.
E) Offer longer payment terms to customers.