(35) Working Capital Management

Question 1

LOS 39. a: Describe primary and secondary sources of liquidity and factors that influence a company’s liquidity position.

Answer 1

Primary sources of liquidity are sources of cash a company uses in its normal operations. If its primary sources are inadequate, a company can use secondary sources of liquidity such as:

• asset sales
• debt renegotiation
• bankruptcy reorganization

Question 2

LOS 39. a: Describe primary and secondary sources of liquidity and factors that influence a company’s liquidity position.

Answer 2

A company’s liquidity position depends on the effectiveness of its cash flow management and is influenced by drags on its cash inflows (e.g., uncollected receivables, obsolete inventory) and pulls on its cash outflows (e.g., early payments to vendors, reductions in credit limits).

Question 3

LOS 39. Describe key aspects of managing a firm’s net daily cash position.

Answer 3

The goal of managing the net daily cash position is to ensure that adequate cash is available to prevent the firm from having to arrange financing on short notice (and thus at high cost), which earning a return on cash balances when they are temporarily high by investing in short-term securities. A firm can meet this goal by forecasting its cash inflows and outflows to identify periods when its cash balance is expected to be lower or higher than needed.

“Minimizing uninvested cash balances” is inaccurate because a firm should maintain some target amount of available cash.

Question 4

LOS 39. b: Compare a company’s liquidity measures with those of peer companies. What are measures of a company’s short-term liquidity?

Answer 4

Measures of a company’s short-term liquidity include:

Current ratio

Quick ratio

Question 5

LOS 39. b: Compare a company’s liquidity measures with those of peer companies. Current ratio equation.

Answer 5

Current ratio = current assets / current liabilities

Question 6

LOS 39. b: Compare a company’s liquidity measures with those of peer companies. Quick ratio equation.

Answer 6

Quick ratio = (cash + marketable securities + receivables) / current liabilities.

Question 7

LOS 39. b: Compare a company’s liquidity measures with those of peer companies. What are the measures of how well a company is managing its working capital?

Answer 7

Measures of how well a company is managing its working capital include:

Receivables turnover

Number of days of receivables

Inventory turnover

Number of days of inventory

Payables turnover

Number of days of payables

Question 8

LOS 39. b: Compare a company’s liquidity measures with those of peer companies. Receivables turnover equation & Number of days receivable equation.

Answer 8

Receivables turnover = credit sales / average receivables

Number of days of receivables = 365 / receivables turnover

Question 9

LOS 39. b: Compare a company’s liquidity measures with those of peer companies. Inventory turnover equation & Number of days of inventory equation.

Answer 9

Inventory turnover = cost of goods sold / average inventory

Number of days of inventory = 365 / inventory turnover

Question 10

LOS 39. b: Compare a company’s liquidity measures with those of peer companies. Payables turnover equation & Number of days of payables equation.

Answer 10

Payables turnover = purchases / average trade payables

Number of days of payables = 365 / payables turnover

Question 11

LOS 39. c: Evaluate working capital effectiveness of a company based on its operating and cash conversion cycles and compare the company’s effectiveness with that of peer companies.

Answer 11

The operating cycle and the cash conversion cycle are summary measures of the effectiveness of a company’s working capital management.

Operating cycle = days of inventory + days of receivables

Cash conversion cycle = days of inventory + days of receivables – days of payables

Operating and cash conversion cycles are high relative to a company’s peers suggest the company has too much cash tied up in working capital.

Question 12

LOS 39. d: Describe how different types of cash flows affect a company’s net daily cash position. How does a firm manage its daily cash position?

Answer 12

To manage its net daily cash position, a firm needs to forecast its cash inflows and outflows and identify periods when its cash balance may be lower than needed or higher than desired.

Question 13

LOS 39. d: Describe how different types of cash flows affect a company’s net daily cash position. What are some cash inflow examples?

Answer 13

Cash inflows include:

• operating receipts
• cash from subsidiaries
• cash received from securities investments
• tax refunds
• borrowing.

Question 14

LOS 39. d: Describe how different types of cash flows affect a company’s net daily cash position. What are some cash outflow examples?

Answer 14

Cash outflows include:

• purchases
• payroll
• cash transfers to subsidiaries
• interest and principal paid on debt
• investments in securities
• taxes paid
• dividends paid.

Question 15

LOS 39. e: Calculate and interpret comparable yields on various securities, compare portfolio returns against a standard benchmark, and evaluate a company’s short-term investment policy guidelines. What are commonly used annualized yields for short-term pure discount securities that are based on the days to maturity (days) of the securities?

Answer 15

Commonly used annualized yields for short-term pure discount securities are based on the days to maturity (days) of the securities and include:

Discount-basis yields

Money market yields

Bond-equivalent yields

Question 16

LOS 39. e: Calculate and interpret comparable yields on various securities, compare portfolio returns against a standard benchmark, and evaluate a company’s short-term investment policy guidelines. Discount-basis yields equation.

Answer 16

Discount-basis yields = % discount from face value x (360/days)

Question 17

LOS 39. e: Calculate and interpret comparable yields on various securities, compare portfolio returns against a standard benchmark, and evaluate a company’s short-term investment policy guidelines. Money market yields equation.

Answer 17

Money market yields = HPY x (360/days)

Question 18

LOS 39. e: Calculate and interpret comparable yields on various securities, compare portfolio returns against a standard benchmark, and evaluate a company’s short-term investment policy guidelines. Bond-equivalent yields equation.

Answer 18

Bond-equivalent yields = HPY x (365/days)

Question 19

LOS 39. e: Calculate and interpret comparable yields on various securities, compare portfolio returns against a standard benchmark, and evaluate a company’s short-term investment policy guidelines. What is the overall objective of short-term cash management? How should the returns on short-term securities and the portfolio be stated?

Answer 19

The overall objective of short-term cash management is to earn a reasonable return while taking on only very limited credit and liquidity risk. Returns on the firm’s short-term securities investments should be stated as bond equivalent yields. The return on the portfolio should be expressed as a weighted average of these yields.

Question 20

LOS 39. e: Calculate and interpret comparable yields on various securities, compare portfolio returns against a standard benchmark, and evaluate a company’s short-term investment policy guidelines. What should an investment policy include?

Answer 20

An investment policy statement should include:

• the objectives of the cash management program
• details of who is authorized to purchase securities
• authorization for the purchase of specific types of securities
• limitations on portfolio proportions of each type
• procedures in the event that guidelines are violated.

Question 21

LOS 39. f: Evaluate a company’s management of accounts receivable, inventory, and accounts payable over time and compared to peer companies.

Answer 21

A firm’s inventory, receivables, and payables management can be evaluated by comparing days of inventory, days of receivables, and days of payables for the firm over time and by comparing them to industry averages or averages for a group of peer companies.

A receivables aging schedule and a schedule of weighted average days of receivables can each provide addition detail for evaluating receivables management.

Question 22

LOS 39. g: Evaluate the choices of short-term funding available to a company and recommend a financing method.

Answer 22

There are many choices for short-term borrowing. The firm should keep costs down while also allowing for future flexibility and alternative sources.

The choice of short-term funding sources depends on a firm’s size and creditworthiness. Sources available, in order of decreasing firm creditworthiness and increasing cost, include:

• Commercial Paper
• Bank lines of credit
• Collateral borrowing
• Nonbank financing
• Factoring