7.1 Working Capital Flashcards
Of the following, the working capital financing policy that would subject a firm to the greatest level of risk is the one where the firm finances
A. Fluctuating current assets with short-term debt
B. Permanent current assets with long-term debt
C. Fluctuating current assets with long-term debt
D. Permanent current assets with short-term debt
D. Permanent current assets with short-term debt
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X Corporation follows an aggressive financing policy in its working capital management while Y corporation follows a conservative financing policy. Which one of the following statements is correct?
A. X has a low ratio of short-term debt to total debt while Y has a high ratio of short-term debt to total debt.
B. X has a low current ratio while Y has a high current ratio.
C. X has less liquidity risk while Y has more liquidity risk.
D. X’s interest charges are lower than Y’s interest charges.
B. X has a low current ratio while Y has a high current ratio.
Determining the appropriate level of working capital for a firm requires
A. Changing the capital structure and dividend policy of the firm.
B. Maintaining short-term debt at the lowest possible level because it is generally more expensive than long-term debt.
C. Offsetting the benefit of current assets and current liabilities against the probability of technical insolvency.
D. Maintaining a high proportion of liquid assets to total assets in order to maximize the return on total investments.
C. Offsetting the benefit of current assets and current liabilities against the probability of technical insolvency.
Working capital finance concerns the determination of the optimal level, mix, and use of current assets and current liabilities. The objective is to minimize the cost of maintaining liquidity while guarding against the possibility of technical insolvency. Technical insolvency is defined as the inability to pay debts as they come due.
Net working capital is the difference between
A. Current assets and current liabilities.
B. Fixed assets and fixed liabilities.
C. Total assets and total liabilities.
D. Shareholders’ investment and cash.
A. Current assets and current liabilities.
Net working capital is defined by accountants as the difference between current assets and current liabilities. Working capital is a measure of short-term solvency.
Which one of the following would increase the net working capital of a firm?
A. Cash payment of payroll taxes payable.
B. Purchase of a new plant financed by a 20-year mortgage.
C. Cash collection of accounts receivable.
D. Refinancing a short-term note payable with a 2-year note payable.
D. Refinancing a short-term note payable with a 2-year note payable.
Net working capital equals current assets minus current liabilities. Refinancing a short-term note with a 2-year note payable decreases current liabilities, thus increasing working capital.
A company is experiencing a sharp increase in sales activity and a steady increase in production, so management has adopted an aggressive working capital policy. Therefore, the company’s current level of net working capital
A. Would most likely be the same as in any other type of business condition as business cycles tend to balance out over time.
B. Would most likely be lower than under other business conditions in order that the company can maximize profits while minimizing working capital investment.
C. Would most likely be higher than under other business conditions so that there will be sufficient funds to replenish assets.
D. Would most likely be higher than under other business conditions as the company’s profits are increasing
B. Would most likely be lower than under other business conditions in order that the company can maximize profits while minimizing working capital investment.
When a firm has an aggressive working capital policy, management keeps the investment in working capital at a minimum. Thus, a growing company would want to invest its funds in capital goods and not in idle assets. This policy maximizes return on investment at the price of the risk of minimal liquidity.
If a firm increases its cash balance by issuing additional shares of common stock, net working capital
A. Increases and the current ratio decreases.
B. Increases and the current ratio remains unchanged.
C. Remains unchanged and the current ratio remains unchanged.
D. Increases and the current ratio increases.
D. Increases and the current ratio increases.
Net working capital is the excess of current assets over current liabilities. The current ratio equals current assets divided by current liabilities. Selling stock for cash increases current assets and stockholders’ equity, with no effect on current liabilities. The result is an increase in working capital and the current ratio.
A board of directors has determined 4 options to increase working capital next year. Option 1 is to increase current assets by $120 and decrease current liabilities by $50. Option 2 is to increase current assets by $180 and increase current liabilities by $30. Option 3 is to decrease current assets by $140 and increase current liabilities by $20. Option 4 is to decrease current assets by $100 and decrease current liabilities by $75. Which option should the board of directors choose to maximize net working capital?
A. Option 3
B. Option 4
C. Option 2
D. Option 1
D. Option 1
Net working capital is the excess of current assets over current liabilities. An increase in current assets or a decrease in current liabilities will increase net working capital. Option 1 maximizes net working capital, increasing it by $170 ($120 + $50).
All of the following statements in regard to working capital are true except
A. Current liabilities are an important source of financing for many small firms.
B. Profitability varies inversely with liquidity.
C. The hedging approach to financing involves matching maturities of debt with specific financing needs.
D. Financing permanent inventory buildup with long-term debt is an example of an aggressive working capital policy.
D. Financing permanent inventory buildup with long-term debt is an example of an aggressive working capital policy.
Financing permanent inventory buildup, which is essentially a long-term investment, with long-term debt is a moderate or conservative working capital policy. An aggressive policy involves using short-term, relatively low-cost debt to finance inventory buildup. It focuses on high profitability potential, despite high risk and low liquidity. An aggressive policy involves reducing liquidity and accepting a higher risk of short-term lack of liquidity. Financing inventory with long-term debt increases the current ratio and accepts higher borrowing costs in exchange for greater liquidity land lower risk.
C Corporation follows an aggressive financing policy in its working capital management while L Corporation follows a conservative financing policy. Which one of the following statements is correct?
A. C has less liquidity risk while L has more liquidity risk.
B. C has a low current ratio while L has a high current ratio.
C. C’s interest charges are lower than L’s interest charges.
D. C has a low ratio of short-term debt to total debt while L has a high ratio of short-term debt to total debt.
B. C has a low current ratio while L has a high current ratio.
A conservative working capital management financing policy uses permanent capital to finance permanent asset requirements and also some or all of the firm’s seasonal demands. Thus, L’s current ratio (current assets/current liabilities) will be high since its current liabilities will be relatively low. An aggressive policy entails financing some fixed assets and all the current assets with short-term capital. This policy results in a lower current ratio.
