Chapter 3: Working capital investment

Question 1

Accounts payable payment period:

Answer 1

Accounts payable payment period = (Average trade payables/Purchases or Cost of sales) × 365 days

Question 2

Average inventory

Answer 2

Average inventory = buffer safety inventory + (re-order/2)

Question 3

Cash operating cycle:

Answer 3

The period of time that elapses between the point at which cash begins to be expended on the production of a product or service and the collection of cash from a customer.

Question 4

Factoring:

Answer 4

An arrangement to have debts collected by a factor company, which advances a proportion of the money it is due to collect.

Question 5

Maximum inventory level:

Answer 5

Maximum inventory level = re-order level + re-order quantity – (minimum usage × minimum lead time)

Question 6

Minimum inventory or buffer safety inventory:

Answer 6

Minimum inventory or buffer safety inventory = re-order level – (average usage × average lead time)

Question 7

Net working capital

Answer 7

The net working capital of a business is its current assets less its current liabilities.

Question 8

Non-recourse factoring

Answer 8

The debt factor has no recourse to the client in the event of non-payment, ie bad debts insurance is being provided by the debt factor

Question 9

Overtrading

Answer 9

A situation where a business has inadequate cash to support its level of sales (also known as undercapitalisation).

Question 10

Re-order level:

Answer 10

Re-order level = maximum usage × maximum lead time

Question 11

The economic order quantity (EOQ):

Answer 11

The optimal ordering quantity for an item of inventory which will minimise inventory related costs.

Question 12

Working capital finance:

Answer 12

The approach taken to financing the level, and fluctuations in the level, of net working capital.

Question 13

What is the quick ratio if the Company’s policy for inventory is to keep it three times lower than prepayments received, if the company has the following balances (in thousands of dollars):

prepayment received for services 120
cash deposit with maturity on demand 30
cash on hand 25
short-term prepayment issued for polygraphic products 20
outstanding bank loan with maturity in 3 years 80

Answer 13

0.625
The quick ratio is calculated as follows = (30+25+20)/120=0.625. Inventory should be ignored as it is excluded for calculation of quick ratio. Bank loan balance should be ignored as it is long term liability. Please keep in mind that the deposit should be included into calculation as it has maturity on demand.

Question 14

Which of the following actions will increase quick ratio?

Answer 14

Sell inventory on credit term

Question 15

The following are extracts from company Green accounts for the year ended 30 June 2016: Investments in subsidiaries - $310,000; Trade receivables - $150,000; Raw materials - $25,000; Finished goods - $40,000; Bank loan (maturity on 31 December 2017) - $200,000; Trade payables - $95,000; Sales for the year ended 30 June 2016 - $1,140,000; Cost of sales for the year ended 30 June 2016 - $730,000. Inventory amounts didn’t fluctuate much during the year. Which of the following statement is TRUE?

Answer 15

Each $1 invested in working capital by Green generates $9.5 of revenue

Working capital of company Green is calculated as follows: Receivables + Finished goods + Raw materials - Payables = 150,000 + 40,000 + 25,000 - 95,000 = 120,000 Net working capital ratio is in its turn calculated as follows: Sales / Working capital = 1,140,000 / 120,000 = 9.5 Please take into account that investments in subsidiaries and bank loan are long-term items, so not taken into account in the calculations.

Question 16

Which of these statements about economic order quantity (EOQ) of inventory is true?

Answer 16

The higher the EOQ level the higher is the inventory cycle

The higher the EOQ level the higher is the inventory cycle. EOQ = √(2 x order cost x demand/holding cost). From this we can see that EOQ is directly proportional to both demand and order costs and inversely proportional to holding costs. Inventory cycle (in weeks) = 52 x (EOQ/demand), so the higher the level of EOQ the higher will be the inventory cycle.

Question 17

As a firm’s cash operating cycle increases, the firm:

Answer 17

Increases its investment in working capital;

Question 18

Given the following information about a company, calculate its inventory turnover ratio.

Sales revenue 600,000
Gross profit 200,000
Net profit 40,000
Average inventory 50,000
Ending inventory 80,000

Answer 18

8.0

Inventory turnover = Cost of sales/Average inventory. Cost of sales = Sales revenue – Gross profit. Cost of sales = 600,000 – 200,000 = 400,000. Inventory turnover = 400,000/50,000 = 8

Question 19

Working capital can be best described as:

Answer 19

Net current assets or current assets minus current liabilities;

Working capital is short term investment that companies make in a day-to-day operating infrastructure and can be calculated as current assets minus current liabilities.

Question 20

Given the following information about a company, find its average safety inventory (assume 50-week year)

Reorder level 15,000 units
Reorder size 35,000 units
Demand for coming year 300,000 units
Average lead time 2 weeks

Answer 20

20,500

First calculate the buffer safety inventory = Reorder level – (average usage x average lead time). Buffer safety = 15,000 - (300,000 / 50) x 2 = 15,000 - 12,000 = 3,000. Average inventory = buffer safety + re-order amount / 2 = 3,000 + (35,000 / 2) = 20,500 units.

Question 21

Given the data, find the number of orders that need to be placed every year and the inventory cycle if inventory costs are to be minimized. Demand = 10,000 units. Holding costs = 2.5/unit. Order cost = 500/order.

Answer 21

5 orders and 10.4 weeks

EOQ =√[2C0D/Ch] = √[(2 x 500 x 10,000)/2.5] = 2,000 units. Number of orders = 10,000/2,000 = 5. Inventory cycle = 52/5 = 10.4 weeks.

Question 22

Given the following information about a company, find its buffer safety inventory (assume 50-week year)

Reorder level 10,000 units
Reorder size 30,000 units
Demand for coming year 300,000 units
Average lead time 1 week

Answer 22

4,000

Buffer safety = Re-order level – (average usage x average lead time). Average usage per week = 300,000 / 50 = 6,000 units/week. Buffer safety = 10,000 - (6,000 x 1) = 4,000 units.

Question 23

benefit of ‘Just in time’ inventory procurement

Answer 23

Reduction in inventory holding costs
Reduced manufacturing lead time
Reduced scrap rework

Question 24

Which of the following are objectives of working capital

Answer 24

Profitability
Liquidity

Question 25

A manufacturing company requires rubber as a raw material for its products. Placing an order to acquire rubber costs the company $22.05/order and holding costs are $ 0.1 per unit per year. If the company has a demand of 20,000 units per year and every unit uses 2 units of rubber, find the economic order quantity for the company. Answer: EOQ is

Answer 25

4200 units

EOQ = √[2CoD/Ch] = √[(2 x 22.05 x 20,000 x 2)/0.1] = 4,200

Question 26

A supplier offers a client a 5% discount if it orders at least 5,000 units at a time. Given the following information about the client, what would be the difference in the costs for the client of taking up the discount offer? Price per unit = $23. Demand = 10,000 units per year. Ordering cost = $600. Holding cost = $1.92 per unit. Answer: $ (round the answer to nearest $

Answer 26

10,300

First find the EOQ = √(2 x order cost x demand/holding cost) = √(2 x 600 x 10,000/1.92) = 2,500. The without discount the annual costs will be: Cost of purchases = 23 x 10,000 = 230,000. Ordering costs will be = 600 x (10,000/2,500) = 2,400. Holding costs will be = 1.92 x (2500/2) = 2,400. Total costs = 230,000 + 2,400 + 2,400 = 234,800. With discount the costs will be: Cost of purchases = 23 x 10,000 x 0.95 = 218,500. Ordering costs will be = 600 x (10,000/5,000) = 1,200. Holding costs will be = 1.92 x (5,000/2) = 4,800. Total costs = 218,500 + 1,200 + 4,800 = 224,500. So the savings are = 234,800 – 224,500 = 10,300.

Question 27

If the inventory re-order level for a company is 5,000, what is the number (in units) of expected stock- outs if the probability of the actual demand during the lead time being 5,500 is 0.1 and that of it being 6,000 is 0.05?

Answer 27

100

(The number of expected stocks outs will be = [(5,500 - 5,000) x 0.1] + [(6,000 - 5,000) x 0.05] = 100

Question 28

Calculate the EOQ and the total inventory costs (excluding purchase price) given the following data: Demand = 4,900 units. Order cost = 100/order. Holding costs = 2/unit.

Answer 28

700 units and $ 1,400

EOQ = √[2C0D/Ch] = √[(2 x 4,900 x 100)/2] = 700 units.
Number of orders = 4,900/700 = 7.
Total costs = (7 x 100) + [(700/2) x 2] = 1400.

Question 29

Which one of the following actions should be made by manager to decrease cash operating cycle?

Answer 29

Decrease the period of time for which credit is granted to customers;
Working capital cycle in days is calculated as follows: Receivables days + inventory days - Payables days. Therefore, decrease in receivables days directly affect the amount necessary to be invested in working capital.

Question 30

Given the following information about a company, find its average inventory (assume a 50-week year). Reorder level = 9,000 units. Re-order size = 32,000 units. Demand for coming year = 200,000 units. Average lead time = 2 weeks.

Answer 30

17,000

First calculate the buffer safety inventory = reorder level – (average usage x average lead time). Buffer safety = 9,000 – (200,000/50 x 2) = 9,000 – 8,000 = 1,000. Average inventory = buffer safety + (re-order amount/2) = 1,000 + (32,000/2) = 17,000

Question 31

The time period between paying for raw materials and collecting receivables on sales of finished goods is known as:

Answer 31

Cash operating cycle

Question 32

A manufacturing company buys materials from its suppliers, and is allowed a credit of 3 months. On average, the material is kept in inventory for 1.5 months and production takes another 2 months. Assuming goods are sold immediately after production and customers are allowed 2 months to pay their debts, what is the cash operating cycle of the company? Answer: Operating Cycle is

Answer 32

2.5

The operating cycle is the time between when the supplier is paid and when the cash is received from customers. The suppliers are paid after 3 months. The goods are prepared in 1.5 + 2 = 3.5 months and are sold immediately. After that it takes 2 months to get the cash back. The cash is received in 3.5 + 2 = 5.5 months. So the operating cycle is 5.5 - 3 = 2.5.

Question 33

Given the following information about a company, find its buffer safety inventory (assume a 50-week year). Reorder level = 5,000 units. Re-order size = 25,000 units. Demand for coming year = 150,000 units. Average lead time = 1 week

Answer 33

2,000

Buffer safety = re-order level – (average usage x average lead time). Average usage per week = 150,000/50 = 3,000 units/week. Buffer safety = 5,000 – (3,000 x 1) = 2,000 units

Question 34

The longer the firm’s accounts payable period, the:

Answer 34

Less the firm must invest in working capital

Question 35

Which of the following are inventory holding costs?

Answer 35

Insurance
Cost of capital
Obsolescence

When a company holds inventory it ties up the capital used to procure the inventory. It also insures its inventory and this is a holding cost. Moreover there is always the danger that goods will become obsolete while held in inventory. Extra cost for emergency inventory on the other hand is a cost that results due to shortage of inventory.

Question 36

What is the difference between the current ratio and the quick ratio?

Answer 36

The current ratio includes inventories and the quick ratio does not;

Question 37

Which of the following is correct regarding invoice discounting?

Answer 37

When the customer pays, the invoice discounter recovers the amount lent and also receives interest and charges
If a company is short of cash, it can approach an invoice discounter who will lend cash against the security of a few invoices that customers still have to pay

If a company is short of cash, it can approach an invoice discounter who will lend cash against the security of one or a few invoices that customers still have to pay. For example, the invoice discounter may advance 75% of the outstanding amounts. In some invoice discounting deals, the invoices/debts are legally sold to the invoice discounter; in others, they are not. When the customer finally pays, the invoice discounter recovers the amount lent and also receives interest and charges

Question 38

Which of the following is usually the last resort when a debt remains unpaid from a customer? This option usually means that we will lose that customer.

Answer 38

Legal action

Legal action would be a costly but last resort available to the company. However, this would mean that the company would lose the customer.

Question 39

______ is a form of a barter arrangement, where instead of exchanging goods or services for money, the companies exchange goods and services for other goods and services.

Answer 39

Countertrading

Countertrading can be seen as a form of a barter arrangement, where instead of exchanging goods or services for money, the companies exchange goods and services for other goods and services. As no foreign currency exchange is involved, this exposure is eliminated. However, this process is quite complex, subjective, and difficult to arrange.

Question 40

Which of the following is correct regarding invoice discounting

Answer 40

With invoice discounting, the company continues to run its own sales ledger
One of the advantages of invoice discounting is that customers do not usually know about the invoice discounting arrangement
Invoice discounting usually consists of one-off deals to cover temporary cash shortages

With invoice discounting, the company continues to run its own sales ledger. Additionally, while factoring is an ongoing arrangement, invoice discounting consists of one-off deals to cover temporary cash shortages. One of the advantages of invoice discounting is that, because the company retains control of the sales ledger, customers do not usually know about the invoice discounting arrangement.

Question 41

ABC INC wants to reduce its terms of credit from 60 days to 30 days. They have $2 million of credit sales annually. However, the sales department say that sales will drop by 10% if they do. What is the impact on the organisations working capital investment if they go ahead with this decision? Round your answer up to the nearest dollar and assume that there are 365 days in the year.

Answer 41

$180,822 reduction

The current policy of 60 days’ needs the following investment: $2,000,000 X (60/365) = $328,767. The proposed policy of 30 days is expected to reduce sales by 10% so $2 million @ 90% = $1.8 million. The proposed policy working capital investment will be: $1,800,000 X (30 / 365) = $147,945. The difference = $328,767 - $147,945 = $180,822

Question 42

Which of the following is correct regarding factoring? (

Answer 42

Factoring usually involves the factor performing the credit control function for the company
In simpler terms, a factoring arrangement provides a form of advance against the company’s trade receivables
One of the primary motivations for factoring arrangements is that instead of waiting for the receivables to pay, the company can get a portion of those debts in advance

Question 43

Under ______ technique of managing foreign receivables, the company can reduce its foreign sales on credit. Naturally, this might reduce the overall sales of the company.

Answer 43

Avoidance

By ‘avoidance’ – what we mean is that the company can reduce its foreign sales on credit. Naturally, this might reduce the overall sales of the company.

Question 44

Which of the following is the LEAST likely option that a company will select when facing problems with debtors?

Answer 44

Recording bad debts

When dealing with defaulting debtors, a company will evaluate all options available based on a cost vs. benefit analysis. Factoring, offering discounts, increasing credit period, or recording bad debts are all valid responses. However, recording bad debts is the least favourable option and will only be selected when the cost of collecting debt is more than the benefit expected.

Question 45

Debt Factoring includes which of the following?

Answer 45

Management of the company’s credit control function
Paying fee to the factor for administrative services provided by the factor
Advancing money invoiced by the company
Protection against the bad debts

Question 46

Amounts owed to a business by its customers in respect of sales made on credit are called:

Answer 46

Debtors

A debtor is a person or entity that owes money to the organisation. A creditor is a person or entity that the organisation owes money to. Debt is a source of financing raised by the organisation that requires a fixed rate or return.

Question 47

ABC INC wants to reduce its terms of credit from 60 days to 30 days. They have $1 million of credit sales annually. How much will this decision reduce their working capital investment?

Answer 47

82,192

The current policy of 60 days’ needs the following investment: $1,000,000 X (60/365) = $164,384. The proposed policy of 30 days will need the following investment: $1,000,000 X (30 / 365) = $82,192. The difference = $164,384 - $82,192 = $82,192

Question 48

ABC Inc has credit sales of $500,000 and Cost of sales of $50,000. It’s inventory days are 70 and trade payable days are 60 and trade receivable days are 45. How much does ABC need to invest in Working capital? Answer:

Answer 48

63,014

Inventory cost = 50,000 X (70/365) = $9,589. Trade Payables = 50,000 X (60/365) = $8,219. Trade Receivables = 500,000 X (45/365) = $61,644. $9,589 + $61,644 - $8,219 = $63,014

Question 49

Which of the following is true regarding Forfaiting

Answer 49

The purchased receivables become a debt instrument, such as bills of exchange
The forfaiter takes on all of the credit risks from the transaction (without recourse).
The forfaiter purchases the receivables at a discount

Under forfaiting the foreign receivable is purchased from the company by a forfaiter. The forfaiter takes on all of the credit risks from the transaction (without recourse). As such, the forfaiter purchases the receivables at a discount. The purchased receivables become a debt instrument (such as bills of exchange) that can be sold on the money market. The incorrect option relates to the letter of credit (LOC), not forfaiting.

Question 50

As with factoring arrangements, invoice discounting arrangements can be ____ or_____.

Answer 50

With recourse and Without recourse

Factoring can be with recourse (where the factor can refer to the company for any bad debt) and non-recourse (where the factor will bear any bad debts). As with factoring arrangements, invoice discounting arrangements can be with recourse or without recourse. The same principles apply.

Question 51

CAPA INC has decided to adopt a more aggressive working capital funding policy. Which of the following statement(s) is/are true? (select all that apply)

Answer 51

CAPA Inc’s refinancing risk will increase

Question 52

Which of the following factors is relevant when deciding whether to offer credit to a customer or not

Answer 52

Evaluating credit risk

Factoring, invoicing, and sending reminders are all relevant to debt collection, whereas evaluating credit risk and creditworthiness of customers is done when deciding whether to offer credit to a customer or not.

Question 53

Which of the following is relevant to debt collections?

Answer 53

Generating accurate invoices
Triggering legal action in case of breach of contract terms
Generating timely invoices

Question 54

Which of the following techniques can be used to manage foreign payables?

Answer 54

Line of Credit (LOC)
Countertrading
Avoidance
Hedging

Question 55

Heli Inc has large cash reserves, they ensure that their inventory levels never go below a certain level that is much higher than the industry standard. Most of their finance sources are from retained earnings and investors capital. Which of the following statements are true?

Answer 55

Heli has adopted conservative working capital financing policy

Heli has a conservative approach to working capital financing as they have invested heavily in their short-term assets. This will increase the cost of working capital as their inventory days will be higher than the industry standard. Because the capital is invested in Working Capital and not in developing the organisation they will experience slower growth than an organisation that adopts a more aggressive policy.

Question 56

Which of the following steps does a credit control process comprise of:

Answer 56

Deciding who to offer credit to
Determining whether to offer credit and how much
Debt collection

When a company offers credit sales to its customers, it has a system in place that is used to make sure that the credit is only given to customers who are able to pay, and that they pay on time. This process is called credit control process and comprises of three steps, namely: determining whether to offer credit and how much; deciding who to offer credit to; and debt collection. Factoring is the process of selling debts to third parties. This is usually covered by the debt collection portion of the credit control process

Question 57

Baumol model is best applied when:

Answer 57

The cash flows are certain and predictable

Question 58

The minimum cash level as per Millier – Orr model will be higher in:

Answer 58

A market where borrowing costs are high and getting new funds is difficult

In a market where cash is hard to come by and the borrowing costs are high, the minimum level will be much higher than a market where interest rates are low and borrowing is cheap.

Question 59

The minimum cash balance kept in a company is $10,000. The daily variance of the cash flows is $1,440,000 and the interest rate is 0.03% per day. The transaction cost is $20 per transaction.

Answer 59

14,160

Spread = 3 x [(3/4 x transaction cost x variance) / Interest rate]^(1/3) = 3 x [(3/4 x $20 x $1,440,000) / 0.0003]^(1/3) = $12,481. Return point = Lower limit + (1/3 x spread) = $10,000 + (1/3 x $12,841) = $14,160.

Question 60

The minimum cash balance kept in a company is $10,000. The daily variance of the cash flows is $1,440,000 and the interest rate is 0.03% per day. The transaction cost is $20 per transaction. Calculate the maximum balance. Answer: $

Answer 60

22,481

Spread = 3 x [(3/4 x transaction cost x variance) / Interest rate]^(1/3) = 3 x [(3/4 x $20 x $1,440,000) / 0.0003]^(1/3) = $12,481. Maximum balance = $12,481 + $10,000 = $22,481

Question 61

A business has $20,000 excess cash balance per period. The interest rate is 5%. The transaction cost per transfer is $100. What is the optimal transfer amount?

Answer 61

$8,944

Optimal cash = {2 (Co x D) / Ch}^(1/2). Optimal cash = {2 (100 × 20,000) / 0.05}^(1/2). Optimal cash = $8,944

Question 62

Baumol model is best applied when:

Answer 62

The cash inflows are known and regular

Question 63

A business has $10,000 excess cash balance per period. The interest rate is 3%. The transaction cost per transfer is $50. What is the optimal transfer amount?

Answer 63

$5,774

Optimal cash = {2 (Co x D) / Ch}^(1/2) = {2 (50 × 10,000) / 0.03}^(1/2) = $5,774

Question 64

Baumol model treats cash like:

Answer 64

Inventory

Question 65

The return point in the Miller – Orr model indicates:

Answer 65

Ideal cash level

The return point indicates the ideal cash level in the Miller – Orr model.