7. Ratio and Measures for Working Capital Management

Question 1

What does ratio analysis and related measurements involve?

Answer 1

The development of quantitative relationships between various elements of a firm’s financial and other information.

Question 2

What does ratios and measures do?

Answer 2

• Enable comparisons over time for a firm
• Enable comparisons across firms
• Facilitate identifying financial strengths and weaknesses of a firm

Question 3

What must you do when using balance sheet values with income stmt values? Why?

Answer 3

Use the average for the B/S values because IS is for period and BS is for point in time.
(Beg + End balance) / 2

Question 4

What are 4 major types of measures?

Answer 4

• Liquidity or solvency measures
• Operational activity measures
• Profitability measures
• Equity or investment leverage measures

Question 5

Liquidity Measures: what is it?

Answer 5

Also called solvency measures assess the ability of a firm to pay its obligations as they become due.

Question 6

Liquidity Measures: when are they particularly appropriate?

Answer 6

for management of working capital.

Question 7

Liquidity Measures: Formula for WC? WC ratio (also called?)?

Answer 7

WC = current assets - current liabilities
WC ratio (current ratio) = current assets / current liabilities = measures the number of times current assets cover current liabilities.

Question 8

Liquidity Measures: what is acid test ratio (also called?)? Formula?

Answer 8

Also called quick ratio measures the number of times HIGHLY LIQUID assets cover current liabilities.
ATR = (cash, receivables, marketable securities) / current liabilities.
*Inventory is excluded from the numerator - more conservative than WC ratio.

Question 9

Liquidity Measures: what is defensive interval ratio? Formula?

Answer 9

Measures the number of times highly liquid assets cover average daily use of cash.
(Cash + receivables + Marketable securities) / Average daily cash pmts

Question 10

Liquidity Measures: What is times interest earned (TIE)? Formula?

Answer 10

Measures the number of times current earnings cover interest pmts for the period.
TIE = (net income + interest expense + income tax expense) / interest expense
*Interest and income tax expense are added back to net income because they were subtracted in getting net income
*Since you are dividing by interest expense, you want income before that is deducted.

Question 11

Liquidity Measures: What is times preferred dividends earned? Formula?

Answer 11

Measures the number of times current earnings cover preferred dividends for the period.
= Net income / Annual preferred dividend obligation

Question 12

Operational Activity Measures: What does it measure?

Answer 12

Assess the efficiency of an entity’s operations in different areas.

Question 13

Operational Activity Measures: what is accounts receivable turnover? Formula?

Answer 13

Measures the number of times that accounts receivable are incurred and collected during a period (quality of credit policies and efficiency of accounts receivable collection).
= Net credit sales / Average accounts receivable

Question 14

Operational Activity Measures: Number of days’ sales in average receivables? Formula?

Answer 14

Measures the average number of days required to collect receivables ( = average age of receivables).
= 360 ( or other days) / accounts receivable turnover

Question 15

Operational Activity Measures: Inventory turnover? Formula?

Answer 15

Measures the number of times inventory is acquired and sold during a period (= helps identify overstocking or under-stocking of inventory and obsolete inventory).
= Cost of goods sold / Average inventory.

Question 16

Operational Activity Measures: Number of days’ supply in inventory? Formula?

Answer 16

Measures the number of days inventory is held before it is sold or used ( = can assess efficiency of general inventory management).
= 360 (or other days) / Inventory turnover

Question 17

Operational Activity Measures: Operating (working capital) cycle length?

Answer 17

Measures average length of time to acquire inventory, convert inventory to accounts receivable, and collect receivable.

Question 18

Operational Activity Measures: Cash conversion cycle length?

Answer 18

Measures average length of time from expenditure of cash for inventory to the collection of cash from accounts receivable; cash-to-cash.

Question 19

Operational Activity Measures: What is inventory conversion?

Answer 19

time of purchase inventory to sale.

Question 20

Operational Activity Measures: Accounts receivable conversion?

Answer 20

Time of inventory sale to collection.

Question 21

Operational Activity Measures: Accounts payable conversion?

Answer 21

Time of inventory purchase to Pay A/P.

Question 22

Operational Activity Measures: Cash conversion?

Answer 22

Time of payment A/P for inventory to collect receivable to inventory sale.

Question 23

Operational Activity Measures: Operating cycle length formula?

Answer 23

= Inventory conversion + Accounts receivable conversion OR

= Number of days’ supply in inventory + Number of days’ sales in average receivables.

Question 24

Operational Activity Measures: what does operating cycle length encompasses?

Answer 24

• Purchase lead time: time from order until goods received
• Production time: Time to convert inputs to final product
• Sales time: Time from goods being available until sale
• Delivery time: Time from sale to deliver to customer
• Collection time: Time from sale on account until collection
• *Reduction in any of these will reduce operating cycle
• *Reducing operating cycle reflects more efficient performance

Question 25

Operational Activity Measures: Examples of how to reduce inventory conversion cycle? A/R conversion cycle?

Answer 25

Inventory: Apply JIT concept or supply chain management.

A/R: Appropriate credit policies, timely collection actions

Question 26

Operational Activity Measures: Formula for cash conversion cycle?

Answer 26

= Inventory conversion + A/R conversion - A/P conversion
OR
= Number of days’ supply inventory + Number of days’ sales in average receivables - Number of days’ purchase in average payables.

Question 27

Operational Activity Measures: what is accounts payable turnover? formula?

Answer 27

Measures the number of times that accounts payable turnover during a period (= rate at which average A/P is paid = how well paying obligation is managed).
= Credit purchases(COGS) / Average A/P

Question 28

Operational Activity Measures: Number of days’ purchases in average A/P? Formula?

Answer 28

Measures the average number of days required to pay accounts payable.
= 360 (or other days) / A/P turnover

Question 29

Operational Activity Measures: what does cash conversion cycle measure?

Answer 29

Efficiency of use of working capital items (A/R, inventory, A/P).
Shorter the cycle, more efficient the use of working capital.

Question 30

Operational Activity Measures: How can cash conversion cycle be reduced?

Answer 30

By reducing inventory conversion and accounts receivable conversion cycles.
By increasing A/P conversion cycle.

Question 31

Operational Activity Measures: can cash conversion cycle be negative? Why?

Answer 31

Yes (rare).
Occurs when pmt of A/P for inventory acquired occurs after collection of A/R for sale of inventory.
= A/P conversion cycle > The operating cycle

Question 32

Financial Management Risk: what is risk?

Answer 32

the possibility of loss or other unfavorable outcome that results from the uncertainty in future events.

Question 33

Financial Management Risk: What is business risk?

Answer 33

the broad macro-risk a firm faces largely as a result of the relationship between the firm and the environment in which it operates.

Question 34

Financial Management Risk: Business risk: what are the factors related to nature of the firm?

Answer 34

Products/services, cost structure, financial structure, other firm specific factors.

Question 35

Financial Management Risk: Business risk: what are the factors related to environment of the firm?

Answer 35

General economic conditions, competition, customer demand, technology, other firm specific factors.

Question 36

Financial Management Risk: Business risk: what are the 2 classification?

Answer 36

1. Diversifiable risk (also Unsystematic or Firm-specific): elements of risk that can be eliminated through diversification of investments.
   * Diverse projects, investment portfolio, locations, etc.
2. Non-diversifiable risk (Systematic or Market-related risk): elements of risk that can’t be eliminated through diversification of investments.
   * Related to general economic and political factors.

Question 37

Financial Management Risk: Business risk: How is it measured?

Answer 37

By the expected variability in a firm’s earnings before interest and taxes (EBIT).
EBIT measures the results of a firm’s operating activities, except debt financing.
Greater the variability in EBIT, the greater the perceived business risk.

Question 38

Financial Management Risk: Business risk: what specific measure is used for EBIT?

Answer 38

beta = a specific measure of how variability in a firm’s results compare to variability in a benchmark.

Question 39

Financial Management Risk: what is financial risk?

Answer 39

Common shareholders’ risk that result from the use of debt financing and pref. stock which require pmt before com. shareholders receive a return on investment.

Question 40

Financial Management Risk: what is default risk?

Answer 40

Risk that the issuer of a security will not be able to make future interest and/or principal pmts; the risk that the issuer may default on its obligation.

Question 41

Financial Management Risk: Interest rate risk? What is the nature of relationship between changes in the general interest rate and changes in the market value of existing debt?

Answer 41

Risk that increases in market rate of interest will decrease the value of outstanding debt.
Inverse.

Question 42

Financial Management Risk: what is inflationary risk? What is it also called?

Answer 42

Also called purchasing power risk; Risk that a rise in general price level (inflation) will result in a reduction in the purchasing power of a fixed sum of money.
EX: future cash flows from a project would lose purchasing power.

Question 43

Financial Management Risk: what is liquidity risk? Also called?

Answer 43

Marketability risk; Risk that an asset can’t be readily sold at FV for cash.
EX: An investment with a “thin” market

Question 44

Financial Management Risk: what is political risk?

Answer 44

Risk associated with operations in a foreign country that has different political, governmental, cultural, ethical, market structure, or other socio-political elements than a firm’s domestic market.

Question 45

Financial Management Risk: what is currency exchange risk?

Answer 45

Risk that associated with changes in exchange rates between 2 currencies.

Question 46

Financial Management Risk: what are 3 subtypes of currency exchange risk?

Answer 46

• Foreign currency transactions: Risk that transactions to be settled in a foreign currency will lose dollar value as a result of unfavorable changes int he exchange rate between the dollar and the foreign currency.
• Foreign currency translations: Risk that the dollar value of translated FS of direct foreign investments will lose value from unfavorable changes in the exchange rate between the dollar and the foreign currency of the investment.
• Foreign currency economic risk: Risk that changes in exchange rates will make future international transactions less financially viable.

Question 47

Financial Management Risk: what are examples of foreign currency economic risk?

Answer 47

• Dollar value of foreign currency revenues may be reduced to unacceptable level.
• Dollar cost of foreign currency expense may be increased to unacceptable level.

Question 48

What is the risk/reward ratio? Also called? Formula?

Answer 48

Measures the risk associated with the investment instruments.
Also Sharpe ratio.
= mean return on the instrument / Std deviation.