chapter 10 Flashcards
what is net working capital?
current assets minus current liabilities
do different firms require different amounts of working capital?
yes
why would it be costly to keep lots of net working capital on hand?
because tying up funds by holding cash or large amounts of inventory can be costly and extending credit to customers or paying suppliers early leads to opportunity cost
what are the 4 main components of working capital?
cash
inventory
accounts receivables
accounts payables
what is the formula for net working capital?
NWC= cash+current assets-current liabilities
how will increasing LT debt and equity and decreasing NWC and fixed assets impact the firms cash?
it will increase cash to the firm
what is the cash cycle?
the length of time between when the firm pays cash for initial inventory and when it receives cash from the sale of output produced from inventory
what can the gap in the cash cycle be filled by?
by either borrowing or maintains sufficient liquidity
what is the formula for the cash conversion cycle?
accounts receivable days+inventory days-accounts payable days
what does it mean if the firms cash cycle is longer?
the more working capital it has and the more cash it needs to carry to conduct daily operations
when a firm reduced working capital, how does it impact the firm?
it frees up cash and increases firm value
when the inventory and receivables periods gets longer, how does that impact the cash cycle?
it increases the cash cycle
if the company can delay payment of payables, how will that impact the cash cycle?
it will decrease the cash cycle
is most firms cash cycle positive or negative?
most firms have a positive cash cycle, this requires financing for inventory and receivables
the longer the cash cycle, what does a firm need to operate?
they need more financing
what is a firms short-term financial policy determined by?
the size of its investment in current assets and the financing of those assets
what is a flexible financial policy?
it might consist of large cash balances, making large investments in inventory, or granting easy credit terms, leading to high receivables
why would a company want a flexible financial policy?
so they have enough cash on hand so they can adapt to any changes
what is a restrictive financial policy?
it consist of small cash balances, making small investments in inventory, or granting hard credit terms leading to low receivables
why would a company want a flexible financial policy?
to maximize return and use extra cash to invest and create returns
what is the optimal financial policy for a firm?
depends on the costs associated with larger cash balances, higher inventory, and easy credit terms, against the potential benefits of higher sales, stimulated by the credit terms, fast delivery of inventory, and low liklihood of product shortages
what if long-term financing costs are low, what is the optimal financial policy?
it would be optimal to obtain sufficient financing to cover any variations in current asset requirements (both day-to-day fluctuations and seasonal variations), any excess cash is can be invested in marketable securities
what is long-term financing costs are high, what is the optimal financial policy?
the firm can obtain some minimize, level of long-term financing to meet minimum, current asset requirements, and use short-term borrowing to cover short-term cash deficits caused by day-to-day or seasonal variations
what is trade credit?
credit the firm extends to its customers allowing them to pay at a later date (essentially a loan to the customer, with the price discount representing the interest rate)
what is the format trade credit is usually quoted in?
2/10 net 30
what does the trade credit format “2/10 net 30” mean?
the buying form receives a 2% discount if it pays within 10 days, otherwise full payment is due in 30 days
say a firm is offered trade credit terms of 2/10 net 30. what is the effective annual interest rate?
per 100 owed, the discount is 2% or 2 dollars, if paid in 10 days, the customer owes 98 dollars instead of 100 if paid in 10 days
2/98 =2.04%
EAR=(1.0204) ^365/20-1 = 44.6%
how can firms monitor accounts receivables?
they can use accounts receivable days compared to other firms or past performance, or an aging schedule, which categorizes accosts by the number of days they have been on the book
when should a firm choose to borrow using accounts payable?
only if trade credit is the cheapest source of funding
when using trade credit, when should the firm pay?
they should always pay on the latest day allowed
how can firms monitor its past payment performance?
by using accounts payable days outstanding
why does inventory need to managed correctly?
because holding excess inventory uses cash
how can holding inventory be helpful?
it can reduce the risk of running out of product
how can seasonal factors impact inventory?
seasonal factors may force firms to hold inventory at certain times of the year
what is the negative of a firm holding cash?
it causes opportunity cost cause they could be using that cash for investment opportunities
what is the positive of a firm holding cash?
it reduces risk
what firms tend to hold more cash?
risky firms and high-growth firms tend to hold more cash
what firms tend to hold less cash?
firm with easy access to capital markets tend to hold less cash
