23.1: The Importance of Working Capital Management Flashcards
What is the importance of working capital management?
Effective working capital management is critical for both the short-term and long-term viability of a firm.
It prevents liquidity problems that can force a firm into bankruptcy.
Define working capital management.
Working capital management is the way in which a firm manages both its current assets (e.g., cash, marketable securities, accounts receivable, and inventories) and its current liabilities (e.g., accounts payable, notes payable, and short-term borrowing arrangements).
What is illiquidity?
Illiquidity is the inability of an entity to raise funds on reasonable terms, unrelated to its creditworthiness.
What is insolvency?
Insolvency is the inability of an entity to meet its financial obligations as they come due, leading to a default.
Explain the relationship between illiquidity and insolvency.
While both can lead to a firm’s inability to meet financial obligations, illiquidity refers to the inability to raise funds despite creditworthiness, whereas insolvency refers to the inability to meet obligations due to financial difficulties
Why did American Airlines face bankruptcy despite having adequate liquidity?
American Airlines faced bankruptcy due to mismanagement of working capital, highlighting that liquidity alone does not prevent financial distress if other aspects of working capital are poorly managed.
List the key components of good working capital management.
- Maintenance of optimal cash balances.
- Investment of excess liquid funds in marketable securities with the best possible return, considering any constraints.
- Proper management of accounts receivable.
- Efficient inventory management.
- Maintenance of appropriate levels of short-term financing in a cost-effective manner.
What was the key issue highlighted by the example of Mr. Jones of ABC Co.?
The example illustrates how poor working capital management, despite profitable operations, can lead to cash shortages and financial distress.
Why are liquidity and solvency issues important to every company?
Liquidity and solvency issues are crucial because they determine a company’s ability to meet short-term and long-term obligations, ensuring ongoing operations and financial stability.
What are the risks of having too much cash on hand?
Holding excessive cash can lead to missed investment opportunities and lower returns, as cash typically earns less than other investments.
How can poor inventory management affect a company’s liquidity?
Poor inventory management can tie up cash in unsold goods, reducing liquidity and the firm’s ability to meet short-term obligations.
Why is it important to manage accounts receivable effectively?
Effective management of accounts receivable ensures timely collection of funds, maintaining liquidity and reducing the risk of bad debts.
