BEC 3 - Financial Modeling and Analysis, Capital Mgmt (including Working Capital)

Question 1

WC Management: what is the goal of Working Capital Management and what is the optimal mix?

Answer 1

Goal: maximize shareholder wealth

Optimal Mix: depends on nature of business/industry and requires offsetting the benefit of CA and CL against the probability of technical insolvency

Question 2

WC Management: What does working capital management seek to balance and what are the 2 styles of management?

Answer 2

Balance profitability and risk

2 styles:

(1) Aggressive:
- increase the ratio of CL to NCL
- more assets financed with CL
- high amount of current liabilities
- low Current Ratio
- low level of working capital
(2) Conservative:
- increase ratio of CA to NCA
- more CA financed by NCL
- high amount of current assets
- high Current Ratio
- high level of working capital

Question 3

WC Management: What ratio is considered to be the best single indicator of a company’s ability to meet short-term obligations?

Answer 3

Current Ratio

• measures liquidity at a point in time (not future cash flows)
• higher = less risk but lower return

Question 4

WC Management: What does an improving Current Ratio indicate?

Answer 4

company can generate cash from core business

Question 5

WC Management: How does the Quick (Acid Test) Ratio differ from the Current Ratio?

Answer 5

Excludes: inventory and prepaids from numerator

Variation:
- include prepaid assets (more conservative)

Question 6

WC Management: What are the limitations of the Current Ratio?

Answer 6

Not necessarily the best measure of the health of the business.

Industry impacts current ratio (bookstore vs. restaurant)

Question 7

WC Management: What is the relationship b/t Working Capital and Risk?

Answer 7

Less WC increases risk (lower Current Ratio):

• exposes company to likelihood of possible failure to meed current obligations
• may reduce firm’s ability to obtain additional short-term financing

Question 8

Cash Management: List the factors influencing the level of cash.

Answer 8

1. volume of collections and their timing
2. volume of disbursements and their timing
3. degree to which idle cash is invested in marketable securities

Question 9

What techniques are used to maximize cash balances?

Answer 9

1. Managing float
2. synchronizing cash inflows and outflows
3. speed collections and deposits
4. mitigating risks with overdraft systems or compensating balanes

Question 10

What are the 3 motives for holding cash?

Answer 10

1. transaction motive (pay bills)
2. speculative motive (opportunity arises)
3. precautionary motive (unexpected needs)
   - concern of treasurer
   - liquidity/safety

Question 11

What are the 3 disadvantages of high cash levels?

Answer 11

1. negative arbitrage (reduced ROA)
2. increased attractiveness as takeover target
3. increased shareholder dissatisfaction with allocation of assets

Question 12

What are the primary methods of increasing cash levels (reducing the operating cycle)?

Answer 12

1. Customer Screening and Credit Policy

2. Prompt Billing