4.4 working capital and liquidity

Question 1

Companies that produce physical goods go through a typical operating cycle:

Answer 1

1. Raw materials are purchased from suppliers.
2. The company converts raw materials into finished goods, which are held as inventory while waiting to be sold.
3. Finished goods are sold to customers.
4. The funds earned from selling inventory are used to purchase more raw materials.

Question 2

The three main working capital accounts are:

Answer 2

accounts receivable

inventory

Accounts payable

Question 3

activity ratios

Answer 3

Days of sales outstanding (DSO)

Days of inventory on hand (DOH)

Days of payables outstanding (DPO)

Question 4

Days of sales outstanding (DSO)

Answer 4

The average number of days taken by customers to settle credit sales in cash.

Question 5

Days of inventory on hand (DOH)

Answer 5

The average number of days inventory is held before being sold.

Question 6

Days of payables outstanding (DPO)

Answer 6

The average number of days taken by the company to pay suppliers for credit sales.

Question 7

cash conversion cycle

Answer 7

the average number of net days between when a company’s cash outflows and inflows.

DOH + DSO - DPO

Question 8

All else equal, a company reduces its cash conversion cycle in the following ways:

Answer 8

Increase DPO

Reduce DOH

Reduce DSO

Question 9

how to Increase DPO

Answer 9

A company can seek to obtain longer payment terms from its suppliers, but whether this can be achieved depends on the power dynamics of the relationship.

A supplier of critical inputs that sells to many other companies is unlikely to offer more generous payment terms.

A company is more likely to be successful if it commits to purchasing higher volumes from a particular supplier.

Question 10

how to Reduce DOH

Answer 10

Discontinue products with niche demand.

Use data analytics to improve demand forecasts and adjust stock levels accordingly.

Switch to “just in time” inventory management with smaller, more frequent deliveries from suppliers.

Question 11

how to Reduce DSO

Answer 11

Charge fees for late payments.

Tighten credit standards.

Require up-front deposits.

Accelerate installment payments. Contract with third-party collection agencies.

Offer a price reduction for cash settlement within a discount period.

Question 12

total working capital

Answer 12

current assets minus current liabilities

Question 13

adjusted net working capital

Answer 13

excludes cash and marketable securities from current assets and any interest-bearing debt from current liabilities.

Question 14

Liquidity

Answer 14

refers to the ability to generate the cash required to meet short-term obligations

Question 15

liquidity cost

Answer 15

the discount to market value that must be accepted to quickly convert it into cash

Question 16

Primary sources of liquidity

Answer 16

Cash and marketable securities

Borrowings

Cash flow from the business

Question 17

cash flow from operations (CFO) formula

Answer 17

CFO =

Cash received form customers
- Cash paid to employees
- Cash paid to suppliers
- Cash paid to government for tax obligations
- Cash paid to lenders for interest obligations

Question 18

The amount of free cash flow available to a company’s shareholders is:

Answer 18

Free cash flow to equity

= CFO - Investments in long-term assets

Question 19

Secondary Sources of Liquidity

Answer 19

Suspending or reducing dividend payments to shareholders.

Delaying or reducing capital expenditures, which helps meet short-term obligations but can lead to underperformance over the long-term.

Issuing new equity, which raises cash but dilutes the positions of existing shareholders.

Renegotiating the terms of contracts such as short-term and long-term debt, rental and lease agreements, and contracts with customers and suppliers.

Selling assets that can be liquidated relatively quickly without damaging the company’s long-term value.

Filing for bankruptcy protection and continuing to operate while the company is reorganized and debt obligations are renegotiated.

Question 20

what do people interpret when using Secondary Sources of Liquidity?

Answer 20

often interpreted as a signal a company’s worsening financial health.

Companies prefer to avoid relying on these relatively costly sources because their existing current capital providers are disadvantaged and will expect higher rates of return

Question 21

A drag on liquidity

Answer 21

a lag on cash inflows resulting in a shortage of available funds.

It occurs when funds are unavailable because assets are not being efficiently converted into cash.

Drags can be limited with stricter enforcement of credit and collection practices

Question 22

Major drags on liquidity include:

Answer 22

Uncollectable receivables

Obsolete inventory

Tight credit (i.e., lenders are less willing to lend or charging higher interest rates).

Question 23

A pull on liquidity

Answer 23

occurs when disbursements are made before cash can be generated from sales

Question 24

Major pulls on payments (on liquidity) include:

Answer 24

Making payments early

Reduced credit limits from suppliers (i.e., suppliers tightening their credit terms)

Limits on short-term lines of credit from banks

Low liquidity positions

Question 25

creditworthiness

Answer 25

the perception of a borrower’s ability to meet debt obligations, even under adverse circumstances

Question 26

top 3 liquidity ratios

Answer 26

current ratio

quick ratio

cash ratio

Question 27

current ratio

Answer 27

current assets / current liabilities

Question 28

quick ratio

Answer 28

(cash + short term marketable securities + receivables) / current liabilities

Question 29

cash ratio

Answer 29

(cash + short term marketable securities) / current liabilities

Question 30

Permanent current assets

Answer 30

represent the base levels of cash, inventory, and receivables needed to maintain routine operations at any point throughout the year

Question 31

Variable current assets

Answer 31

the incremental increases above the base levels to meet additional needs during periods of peak production and sales

Question 32

Conservative Approach to Working Capital Management

Answer 32

A conservative approach is characterized by relatively large positions for current account items to minimize the risk of disruptions and increase the ability to respond to uncertainty

This approach relies on long-term debt and equity to fund all permanent (and some variable) current assets

Question 33

advantages to the Conservative Approach to Working Capital Management

Answer 33

Relying on long-term sources of capital reduces rollover risk

Greater certainty over financing costs and cash flows

Lower risk of inventory shortages

Greater flexibility to adapt to adverse market conditions

Question 34

Companies will tend to prefer the Conservative Approach to Working Capital Management if they:

Answer 34

Are in the early-stage of their development with limited access to access to short-term borrowing facilities;

Are more established with higher margins and greater ability to pass the higher borrowing costs onto their customers;

Expect interest rates to either remain stable or rise;

Have a preference for cash flow stability and want to avoid rollover risk, particularly during periods of market turmoil.

Question 35

disadvantages to the Conservative Approach to Working Capital Management

Answer 35

Higher borrowing costs (if the yield curve is upward-sloping)

Higher cost of equity and shareholder dilution

Less flexibility to borrow on an as-needed basis

Issuing long-term debt and equity requires longer lead times

Long-term debt typically imposes more covenants
Increased risk of inventory obsolescence

Question 36

Aggressive Approach to Working Capital Management

Answer 36

An aggressive approach to working capital management maintains relatively low levels of cash, inventory, etc., and relies on short-term funding sources to finance all variable (and some permanent) current assets

Taking an aggressive approach to working capital management increases the risk of running out of inventory or cash, so companies must be confident that their sales and production forecasts can be relied on to anticipate cash flow needs with a high degree of precision.

Question 37

advantages of the Aggressive Approach to Working Capital Management

Answer 37

Lower financing costs under a normal upward-sloping yield curve

Greater flexibility to borrow only as needed

Short-term borrowing imposes fewer covenants and involves less rigorous credit analysis

Ability to reduce borrowing costs by refinancing on short notice if interest rates fall

Question 38

Firms will tend to prefer the Aggressive Approach to Working Capital Management if they:

Answer 38

Are seeking a cost advantage relative to their competitors in a low-margin industry;

Are able to predict their future sales volumes and cash needs more accurately;

Expect interest rates to fall;

Want to shorten their cash conversion cycle;
Have inventories that can be liquidated quickly.

Question 39

disadvantages of the Aggressive Approach to Working Capital Management

Answer 39

Risk of having to refinance at higher short-term rates

Potential difficulty rolling over short-term debt during periods of market turmoil

Possible need to rely on relatively expensive trade credit or sell receivables to raise cash if short-term debt cannot be rolled over

Sales may suffer if customer credit terms are tightened to reduce the cash conversion cycle

Question 40

Moderate Approach to Working Capital Management

Answer 40

Companies may seek to strike a balance between these two extremes by taking a moderate approach characterized by funding permanent working capital requirements with long-term debt and equity and relying on short-term resources to fund variable working capital needs.

Because of this balance, it is known as a “matched” approach.

Question 41

Major objectives when formulating a short-term borrowing strategy include:

Answer 41

Maintaining diversified sources of credit that are sufficient to meet ongoing cash needs. A firm should not be dependent on a single lender.

Ensuring sufficient capacity to meet variable cash needs that change due to seasonal demand or planned expansion.

Borrowing at cost-effective rates with terms that do not unduly impair the company’s operations and anticipate changing market conditions.

Determining an overall borrowing rate that accounts for both explicit funding costs as well as implicit costs (e.g., trade credit).

Question 42

A company’s short-term borrowing strategy will be influenced by the following factors:

Answer 42

Size

Creditworthiness

Legal considerations

Regulatory considerations

Underlying assets

Question 43

Which of the following is most likely a secondary source of liquidity?

A) Bank line of credit

B) Inventory liquidation

C) Trade credit

Answer 43

B) Inventory liquidation