BEC 3 Leverage and Working Capital Management

Question 1

Define Operating Leverage?

Answer 1

Operating Leverage is defined as the degree to which a firm uses fixed operating costs, as opposed to variable operating costs.

Question 2

Define Financial leverage?

Answer 2

Financial leverage is defined as the degree to which a firm’s use of debt to finance the firm magnifies the effects of a given percentage change in EBIT on the percentage change in EPS.

Question 3

What is the formula for working capital?

Answer 3

Current Assets - Current Liabilities = Working Capital

Question 4

What are the three common motivations for holding cash?

Answer 4

1. Transaction Motive = A transaction motive for holding cash concerns having enough cash to meet payments arising from the ordinary course of business.
2. Speculative Motive = A speculative motive for holding cash concerns having enough cash to take advantage of temporary opportunities.
3. Precautionary Motive = A precautionary motive for holding cash concerns having enough cash to maintain a safety cushion so that unexpected needs may be met.

Question 5

What methods can be used to speed collection?

Answer 5

1. Customer screening
2. Prompt billing
3. Payment discount
4. Expedite deposits
5. Concentration banking
6. Factoring accounts receivables

Question 6

What methods can be used to delay disbursements?

Answer 6

1. Defer payments
2. Drafts
3. Line of credit
4. Zero-balance accounts

Question 7

What is the formula for computing the annual percentage rate for quick payment discounts?

Answer 7

360 / (Pay Period - Discount Period)

x

Discount % / (100% - Discount %)

Question 8

What is the cash conversion cycle formula?

Answer 8

Cash conversion Cycle =

Inventory Conversion period + Receivable Collection Period - Payables Deferral Period

Question 9

How is the inventory conversion period calculated?

Answer 9

Inventory Turnover = COGS / Average Inventory

Inventory conversion period = 365 / Inventory Turnover

Question 10

How is the receivables collection period calculated?

Answer 10

AR Turnover = Sales / Average AR

Receivables collection period = 365 / AR Turnover

Question 11

How is the payables deferral period calculated?

Answer 11

AP Turnover = COGS / Average AP

Payables Deferral Period = 365 / AP Turnover

Question 12

Explain factoring as a mechanism for speeding cash collection.

Answer 12

Factoring involves the sale of AR to another party (a factor) in exchange for cash.

The selling company will receive an upfront cash advance X% of their receivables and will be charged both a fee on all receivables purchased and an interest rate on the upfront advance (while saving on collection related expenses)

The factor will collect the fee and interest, while assuming the responsibility of collecting on the receivable owed by the customer of the selling company.

Question 13

What is the equation to calculate the reorder points for inventory?

Answer 13

Reorder point = Safety Sock + (Lead time x Sales during lead time)