Chapter 2 - Analysis of the Working Capital Cycle

Question 1

cash conversion period

Answer 1

the time between when cash is received versus when it is paid

Question 2

The shorter the cash conversion period,

Answer 2

the more efficient the firm’s working capital

Question 3

A firm is solvent when

Answer 3

its assets exceed its liabilities

this accounting measure is based on book, not market values

Question 4

A firm is liquid when

Answer 4

it can pay its bills on time without undue cost

Question 5

Net working capital

Answer 5

current assets - current liabilities

• a dollar based solvency measure
• it is absolute, not relative, so it ignores scale and trends
• too much working capital is considered a drag on financial performance

Question 6

Net working capital

Answer 6

working capital requirement + net liquid balance

Question 7

Working capital requirement

Answer 7

Operating current assets - operating current liabilities

Question 8

Net liquid balance

Answer 8

Financial current assets - financial current liabilities

shows ability of stock resources to pay “arranged” maturing debt which is unaffected by the operating cycle

Question 9

If net working capital is positive

Answer 9

a portion of current assets is financed with permanent funds (LT liabilities and Equity)

Question 10

If net working capital is negative

Answer 10

a portion of current liabilities are funding long term

Question 11

During expansion, higher levels of WCR must be financed by

Answer 11

drawing down NLB

adding to permanent working capital by acquiring new LTD, equity or both

Question 12

Current ratio

Answer 12

current assets / current liabilities

Indicates the degree of coverage provided to short term creditors if short terms assets were to be liquidated

Question 13

Limitations of current ratio

Answer 13

It does not consider the ‘going-concern’ aspect of the firm, which assumes the firm would have to liquidate these assets to pay off the liabilities. Plus, it is only a point in time, and not always representative.
Its use is limiting based on the components (firm might have a high ratio due to large balance of uncollectible receivables and/or obsolete inventory).

Question 14

Quick ratio

Answer 14

CA - Inventory/CL

*excludes inv from CA b/c it is the least liquid CA

Question 15

Cash conversion period

Answer 15

the elapsed time between payments to suppliers and receipt of customers payments
Production Cycle + Collection Cycle - Payment Cycle
or (DIH + DSO) - DPO

Question 16

Days inventory held

Answer 16

Inventory/(Cost of sales/365)

Measures inventory turnover

Question 17

Days sales outstanding

Answer 17

Receivables/(sales/365)

Measures receivables turnover

Question 18

Days payable outstanding

Answer 18

Payables/(cost of sales/365)

Measure payable turnover

Question 19

Operating cycle

Answer 19

Production cycle - collection cycle

DIH + /50DSO

Question 20

Payment cycle

Answer 20

DPO

Question 21

The longer the CCP

Answer 21

the more financing is required for inventory and receivables

A lengthening cycle could signal liquidity issues

Question 22

The CCP is generally

Answer 22

positive

Question 23

cost of working capital

Answer 23

credit terms (in days) x avg daily sales x cost of capital

• a firm with 30 day credit terms, avg daily sales of $200,000 and cost of capital of 10%, would have a $600,000 annual cost of extending trade credit*
• At 10% cost of capital is important b/c it tells you that if you didnt offer trade credit, the $6,000,000 could be used elsewhere to generate $600,000*

Question 24

short term financial decisions can impact firm value by;

Answer 24

Altering operating cash flows (amount).
Changing the length of the cash conversion cycle period (timing).
Changing the company’s risk posture.
Impacting interest income (or interest expense).