23.4: Working Capital Management in Practice

Question 1

What are two common measures of firm liquidity mentioned in the content?

Answer 1

The current ratio and the quick (or acid test) ratio.

Question 2

How is the current ratio calculated?

Answer 2

Current ratio = Current assets (CA) / Current liabilities (CL)

Question 3

How is the quick ratio calculated?

Answer 3

Quick ratio = (Cash (C) + Marketable securities (MS) + Accounts receivable (AR)) / Current liabilities (CL)

Question 4

What does the receivables turnover (RT) ratio measure?

Answer 4

RT measures the revenues (Rev) that are generated for each dollar tied up in receivables.

Question 5

How is the average collection period (ACP) calculated?

Answer 5

ACP = (Accounts receivable (AR) / Average daily revenue (ADR)) = 365 / Receivables turnover (RT)

Question 6

What does the inventory turnover (IT) ratio measure?

Answer 6

IT measures how efficiently a firm manages its inventory, calculated as Cost of goods sold (CGS) / Inventory or Revenue (Rev) / Inventory.

Question 7

How is the average days revenues in inventory (ADRI) calculated?

Answer 7

ADRI = (Inventory / Average daily revenue (ADR)) = 365 / Inventory turnover (IT)

Question 8

What does a higher receivables turnover and inventory turnover indicate?

Answer 8

Higher turnover ratios generally indicate more efficient management of these current assets.

Question 9

What is the payables turnover (PT) ratio?

Answer 9

PT shows how many times a year a firm pays off its suppliers, calculated as Revenue (Rev) / Accounts payable.

Question 10

How is the average days of revenues in payables (ADRP) calculated?

Answer 10

ADRP = (Accounts payable / Average daily revenue (ADR)) = 365 / Payables turnover (PT)

Question 11

Why are current and quick ratios insufficient when viewed in isolation?

Answer 11

These ratios, while useful, do not provide the full picture of working capital management.

A firm might have high liquidity ratios due to inefficient management or excessive liquidity.

Question 12

Why is it important to consider both liquidity ratios and turnover ratios in working capital management?

Answer 12

Considering both types of ratios provides a more comprehensive understanding of a firm’s efficiency in managing its assets and liabilities.

Question 13

How can a firm use turnover ratios to improve working capital management?

Answer 13

By analyzing turnover ratios, a firm can identify areas to improve efficiency, such as speeding up receivables collection or optimizing inventory levels.

Question 14

What is the operating cycle (OC)?

Answer 14

The operating cycle represents the average time required for a firm to acquire inventory, sell it, and collect the sales proceeds.

It is calculated as the sum of average days of revenues in inventory (ADRI) and the average collection period (ACP).

Question 15

How is the operating cycle (OC) calculated?

Answer 15

OC = ADRI + ACP

Question 16

How is the cash conversion cycle (CCC) calculated?

Answer 16

CCC = OC - ADRP
or

CCC = (ADRI + ACP) - ADRP

Question 17

Why is the cash conversion cycle (CCC) important?

Answer 17

The CCC indicates the average number of days a firm must finance its operations outside the use of trade credit, helping firms manage their liquidity and financing needs.

Question 18

How can a firm reduce its cash conversion cycle (CCC)?

Answer 18

A firm can reduce its CCC by decreasing the average days in inventory (ADRI), speeding up the collection period (ACP), or extending the average days of revenues in payables (ADRP).

Question 19

What is the average days of revenues in payables (ADRP)?

Answer 19

ADRP represents how long a firm defers payments to its suppliers, calculated as 365 divided by the payables turnover (PT).

Question 20

How is the average days of revenues in payables (ADRP) calculated?

Answer 20

ADRP = 365 / Payables turnover (PT)

Question 21

What is the significance of the payables turnover (PT) ratio?

Answer 21

The PT ratio shows how many times a year a firm pays off its suppliers, indicating how quickly it settles its payables.

Question 22

How does a higher inventory turnover affect the operating cycle (OC)?

Answer 22

A higher inventory turnover reduces the average days revenues in inventory (ADRI), shortening the operating cycle (OC).

Question 23

What are some industry “norms” for working capital ratios?

Answer 23

Industry norms provide benchmarks for comparing a firm’s working capital efficiency against others in the same industry, such as average collection period, inventory turnover, and payables turnover.

Question 24

How did Bristol-Myers Squibb Company engage in channel-stuffing?

Answer 24

Bristol-Myers engaged in channel-stuffing by inflating sales and earnings through excessive inventory shipments to wholesalers, ahead of actual demand, and recognizing these sales prematurely.

Question 25

What are the implications of maintaining adequate liquidity for a firm?

Answer 25

Adequate liquidity ensures a firm can meet its short-term obligations, maintain operations, and avoid financial distress, particularly during economic downturns or financial crises.

Question 26

Why is it important to distinguish between illiquidity and insolvency?

Answer 26

Distinguishing between illiquidity and insolvency helps in understanding a firm’s financial health, as illiquidity refers to a temporary cash shortage, while insolvency indicates a more severe inability to meet long-term obligations.

Question 27

How does the cash conversion cycle (CCC) relate to a firm’s liquidity management?

Answer 27

The CCC helps firms understand the duration they need to finance their operations without incoming cash flows, crucial for effective liquidity management and planning.

Question 28

What are some practical steps a firm can take to improve its working capital management?

Answer 28

A firm can improve working capital management by optimizing inventory levels, speeding up receivables collection, extending payables terms, and maintaining accurate cash flow forecasts.