chapter 15 - key concepts (working capital management)

Question 1

What are the three goals of working capital management?

Answer 1

Find the optimal levels of:

1. Cash/marketable securities
2. Inventory & Accounts receivable (sales/credit policy)
3. Prepare Cash Budget

Question 2

Know the pro/cons of having too much or too little inventory

Answer 2

Too much inventory: wasting capital/resources

Too little: losing sales because customers can’t find product

Revolution in inventory management due to real-time tracking technology (sold items automatically scanned) & databases

Question 3

Know how to calculate net working capital and net operating working capital

Answer 3

Working capital simply means current assets! (Think products)

Net working capital = (CA – CL)
- Current assets minus current liabilities.

Net operating working capital
= (CA – CL - Excess Cash + Notes payable)
- Operating current assets – operating current liabilities
- Interest bearing notes are excluded from current liabilities b/c it’s a financing cost, not operating cost

Question 4

What is the difference between relaxed versus restricted investment policy?

Answer 4

Relaxed: company holds large amounts of cash, inventories, and high level of receivables. LOW ROE
- Give the consumer plenty of time to play, generous credit
- Pro: easier to make sales
- Con: collect money slowly, may not receive payments
- iPhone: finance over 2 years or pay at once?

Restricted: low levels of cash, inventories, receivables HIGH ROE
- Demand customers pay quickly
- More common in high-turnover industries such as groceries (!)

Question 5

What are the three components of working capital?

Answer 5

1. Fixed Assets: long-lasting assets
2. Permanent Level of Current Assets (CA): Inventory needed at the lowest
3. Temporary current assets: Most businesses have sales seasonality
   - Examples: Christmas for retailers, ice cream sales in summer

Question 6

Where are the three approaches to financing working capital?

Answer 6

Moderate: match the maturity of the assets with the maturting of the financing

Aggressive: use short-term financing to finance permanent assets

Conservative: use permanent capital for permanent asset and temporary assets

Question 7

Maturity matching (moderate risk) - one of the three approaches to financing working capital

Answer 7

Match the maturities of assets & liabilities
All fixed assets/ permanent current assets financed with long-term capital (bank loans or bonds)
Temporary current assets financed with short-term debt
Moderate level of risk b/c some short—term debt

Question 8

Conservative (low risk) - one of the three approaches to financing working capital

Answer 8

All long-term assets AND some short-term assets are financed using long-term capital
Safest approach

Question 9

Aggressive (high risk) - one of the three approaches to financing working capital

Answer 9

Finance permanent assets with short-term capital -Riskiest approach

1. Rising interest rate risk
2. Loan renewal risk (recession or liquidity crisis)

Benefit: often cheaper source of funding, save money

Question 10

What are the pros and cons of using short-term capital to finance current assets?

Answer 10

It is tempting to use short-term capital to finance current assets because:
1. Cheaper (interest rates typically upward sloping);
2. Easier to arrange/get loan from bank
3. Few covenants

BUT IT IS RISKY!
1. Interest rates could rise
2. Rollover Risk

depends though: stable business and/or good economy, can use more short-term debt

Question 11

What is the CCC (Cash Conversion Cycle?)

Answer 11

The cash conversion cycle (CCC) is a metric that expresses the time (measured in days) it takes for a company to convert its investments in inventory and other resources into cash flows from sales.

Question 12

how to calculate the CCC using the given formulas

Answer 12

CCC = Inventory conversion period + Average collection period - Payables deferral period

CCC = DIO - DPO + DSO

Question 13

Do we want CCC to be higher or lower?

Know how changes in the different subcomponents (inventory turnover, avg collection
period, payable deferral period) impact the CCC

Answer 13

we want CCC to be low; sale items quicker, collect more quicker, pay suppliers later (up)

CCC = Inventory conversion period + Average collection period - Payables deferral period

Question 14

What is a cash budget and its main functions?

Answer 14

• Forecasts cash inflows, outflows, and ending cash balances.
• Used to plan loans needed or funds available to invest.
• Can be daily, weekly, or monthly, forecasts.
  —> Monthly for annual planning and daily for actual cash management

Question 15

What are some strategies that firms use to minimize cash holdings?

Answer 15

Goal: Want to minimize cash holdings so we don’t have to borrow money

Strategies:
- Use wire transfers or credit cards (Get cash sooner)
- Synchronize cash inflows and outflows
- Reduce need for “safety stock” of cash –> Increase forecast accuracy and Negotiate a line of credit

Question 16

What are four elements of credit policy?

Answer 16

Credit policy:
How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales

Cash discounts:
Lowers price, attracts more sales and reduces DSO

Credit standards:
more sales, potential losses
Tough standards → fewer sales, but fewer customers that can’t pay. Fewer bad debts reduce DSO.

Collection policy:
How tough? Aggressive collection policy will reduce DSO but may damage customer relationships.

Question 17

if a company has a longer average collection period than the industry average,
what does this mean? Is this a good or bad thing?

Answer 17

Average collection period refers to the amount of time it takes for a business to receive payments owed by its clients in terms of accounts receivable (AR)

Companies prefer a longer average collection period over a shorter one as it indicates that a business can NOT efficiently collect its receivables.

Question 18

What are the pros and cons of tightening a company’s credit policy?

Answer 18

Pro: fewer defaults, quicker payment

Con: discourage sales, some customers may go elsewhere if they are pressured to pay their bills sooner.