Financial Management - Part 3 Flashcards
Each of the following periods is included when computing a firm's target cash conversion cycle, except the A. Inventory conversion period. B. Payables deferral period. C. Average collection period. D. Cash discount period.
D. Cash discount period.
The cash discount period is not included when computing a firm’s target cash conversion cycle. The cash discount period is the period of time during which a debtor is offered a discount for early payments of an account and does not establish when cash is actually received. The actual collection of cash could be any time during or after the discount period and it is that actual date of collection that enters into the measurement of the cash conversion cycle.
Selected data pertaining to Lore Co. for the calendar year 2003 is as follows:
Net cash sales $ 3,000
Cost of goods sold 18,000
Inventory at beginning of year 6,000
Purchases 24,000
Which one of the following was Lore's average days' sales in inventory? A. 3 days B. 6 days C. 25 days D. 180 days
D. 180 days
The average days’ sales in inventory is calculated as: 360 days/Inventory Turnover.
Inventory Turnover = COGS/Average Inventory
In this problem, average inventory is BI = $6,000 + EI = $12,000 = $18,000/2 = $9,000.
The EI is BI = $6,000 + Purchases = $24,000 = $30,000 - COGS = $18,000 = $12,000.
A company has the following information in its financial records:
Beginning Ending Balance Balance Cash $ 3,900 $ 3,000 Marketable Securities 3,800 4,400 Accounts Receivable 14,600 12,900 Total current assets $ 22,300 $20,300
Net sales $103,200
Expenses 20,430
Net Income $ 82,770
What is the company's receivable turnover ratio? A. 6.0. B. 7.1. C. 7.5. D. 8.0.
C. 7.5.
A company’s accounts receivable turnover ratio measures the number of times that its accounts receivable are incurred and collected (turnover) within a period. It is computed as net sales (or net credit sales) divided by the average of net accounts receivable outstanding for the period. The average accounts receivable for the period normally is determined by summing the beginning and ending accounts receivable balance and dividing by 2. In this question the beginning and ending accounts receivable balances are $14,600 and $12,900, respectively. Thus, the correct calculation would have been net sales $103,200/($14,600 + $12,900/2) = $103,200/$13,750 = 7.5.
Cyco, Inc. determined the following concerning its operating activities:
Accounts receivable conversion cycle 18 days
Accounts payable conversion cycle 21 days
Inventory conversion cycle 24 days
Which one of the following is the length of Cyco's cash cycle? A. 42 days. B. 39 days. C. 21 days. D. 15 days
C. 21 days.
Which one of the following constitutes (measures) the operating cycle of an entity?
A. Accounts payable conversion cycle + accounts receivable conversion cycle.
B. Inventory conversion cycle + accounts payable conversion cycle.
C. Inventory conversion cycle + cash conversion cycle.
D. Inventory conversion cycle + accounts receivable conversion cycle.
D. Inventory conversion cycle + accounts receivable conversion cycle.
The operating cycle measures the average length of time between the acquisition of inventory and the collection of cash from the sale of that inventory. It is measured by the inventory conversion cycle + the accounts receivable conversion cycle.
The controller of Peabody, Inc. has been asked to present an analysis of accounts receivable collections at the upcoming staff meeting. The following information is used:
12/31, year 2 12/31, year 1
Accounts receivable $100,000 $130,000
Allowance, doubtful accounts (20,000) (40,000)
Sales 400,000 200,000
Cost of goods sold 350,000 70,000
What is the receivables turnover ratio as of December 31, year 2? A. 5.0 B. 4.7 C. 3.5 D. 0.6
B. 4.7
Accounts receivable turnover is calculated as: (Net Credit) Sales/Average Net Accounts Receivable.
In this question, it is first necessary to compute average net accounts receivable.
Average Net Accounts Receivable = [Beginning Net Accounts Receivable ($130,000 - $40,000 = $90,000) + Ending Net Accounts Receivable ($100,000 - $20,000 = $80,000)]/2 = ($90,000 + $80,000 = $170,000)/2 = $85,000
Accounts Receivable Turnover = $400,000/$85,000 = 4.705
A corporation manages inventory performance by monitoring its inventory turnover. Selected financial records for the corporation are as follows:
Year 1 Year 2 Year 3
Annual sales $1,262,500 $1,062,500 $1,459,000
Gross annual profit percentage 45% 30% 40%
The beginning finished goods inventory for year 2 was 20% of year 2 sales. The ending finished goods inventory for year 2 was 18% of year 3 sales. What was the corporation's inventory turnover for year 2? A. 1.34 B. 2.83 C. 3.03 D. 3.13
D. 3.13
Inventory turnover measures the number of times that inventory is acquired and sold or used during a period. It is calculated as: Cost of Goods Sold/Average Inventory (i.e., beginning inventory + ending inventory/2). In this question, the cost of goods sold is determined using the inverse of the gross annual profit percentage (which is the gross annual cost percentage), or $1,062,500 x (1.0 - .30) = $1,062,500 x .70 = $743,750, the cost of goods sold. The average inventory is determined using the percentage of sales that constitutes inventory as give in the facts. Specifically, year 2 beginning inventory is $1,062,500 x .20 = $212,500 and year 2 ending inventory is $1,459,000 x .18 = $262,620. The average is the sum of beginning plus ending divided by 2, or $212,500 + 262,620 = $475,120/2 = $237,560, the average inventory. Therefore, the inventory turnover is: $743,740/$237,560 = 3.13 - the inventory turned over 3.13 times during year 2.
Barr Co. has total debt of $420,000 and stockholders’ equity of $700,000. Barr is seeking capital to fund an expansion.
Barr is planning to issue an additional $300,000 in common stock and is negotiating with a bank to borrow additional funds. The bank is requiring a debt-to-equity ratio of .75.
What is the maximum additional amount Barr will be able to borrow if the stock is issued? A. $225,000 B. $330,000 C. $525,000 D. $750,000
B. $330,000
Barr’s implied balance sheet and related calculations are:
Total Assets $1,120,000
Total Debt 420,000
Owners’ Equity 700,000 + New Issue $300,000 = $1,000,000
Debt + Equity $1,120,000 Debt to Equity Ratio .75
Total Possible Debt $ 750,000
Less: Current Debt 420,000
Maximum Additional Debt $ 330,000
In summary, if Barr issues $300,000 in new common stock, it would have $1,000,000 in common stock outstanding.
With a maximum debt to equity ratio of .75, the maximum debt is .75 x $1,000,000 = $750,000. Since it now has total debt of $420,000, a maximum additional $330,000 in debt could be incurred.
Stent Co. had total assets of $760,000, capital stock of $150,000, and retained earnings of $215,000. What was Stent's debt-to-equity ratio? A. 2.63 B. 1.08 C. 0.52 D. 0.48
B. 1.08
The debt-to-equity ratio is computed as: Total Liabilities/Total Equity. In this question, it is first necessary to compute both total liabilities and total equity.
Total Equity = Capital Stock ($150,000) + Retained Earnings ($215,000) = $365,000
Total Liabilities = Assets ($760,000) - Total Equity ($365,000) = $395,000
Debt-to Equity Ratio = Total Liabilities ($395,000)/Total Equity ($365,000) = 1.0821.
Echo Company has a long-term, variable-rate note payable outstanding, for which it does not elect the fair value option. Early in its fiscal year, the interest rate on its note increased as a result of changes in the market.
What effect will the increase in interest rate on its note payable have on its net income for the fiscal year and on its debt to equity ratio at the end of its fiscal year (compared to no change in the interest rate)? Net Income Debt to Equity Ratio Increase Increase Increase Decrease Decrease Increase Decrease Decrease
Decrease Increase
The increase in the interest rate will increase Echo’s interest expense for the year and decrease it net income for the year. While the change in interest rate will not change the carrying value of the note payable, the decrease in net income for the year will result in lower retained earnings (than if the interest rate had not changed).
Since retained earnings is an element of equity, the debt to equity ratio will increase - there will be less equity relative to the same debt.
Debt-paying ability of a company might be assessed using the "debt ratio" or the "debt to equity ratio" (among others). For each of these ratios, is the company's debt-paying ability (debt position) better if the ratio is higher or lower? Debt Ratio Debt to Equity Ratio Higher Higher Higher Lower Lower Higher Lower Lower
Lower Lower
The debt ratio measures the percentages of a company’s assets that are financed by total debt, both short-term and long-term. The calculation would be:
Debt ratio = Total Debt
Total Assets
The resulting percentage (which must be less than 1.00) shows the extent to which the company’s assets are financed by debt. The reciprocal percent (i.e., 1.00 - debt ratio) would be the percent of assets financed by owners’ equity. (Remember: Assets = Debt + Equity). The lower the existing debt ratio (level of debt relative to assets), the better the firm’s debt-paying ability (or position). The debt to equity ratio measures the relative amounts of financing provided by creditors and owners.
The calculation would be:
Debt to equity ratio = Total Debt
Total Owners’ Equity
The resulting percentage (which could be more or less than 1.00) shows the amount of resource financing provided by creditors relative to owners. The lower the existing debt to equity ratio (level of debt relative to owners’ equity), the better the firm’s debt-paying ability (or position). Therefore, the lower each of these ratios, the better the debt position of a company.
A company has several long-term floating-rate bonds outstanding. The company's cash flows have stabilized, and the company is considering hedging interest rate risk. Which of the following derivative instruments is recommended for this purpose? A. Structured short-term note. B. Forward contract on a commodity. C. Futures contract on a stock. D. Swap agreement.
D. Swap agreement.
A swap agreement would be recommended to hedge interest rate risk on long-term floating-rate bonds. In an interest rate swap agreement one stream of future interest payments (e.g., floating-rate payments) is exchanged for another stream of future interest payments (e.g., fixed-rate payments) for a specified principal amount. In this case, an interest rate swap would hedge (mitigate) exposure to fluctuations in interest rates of the floating-rate bonds by exchanging those payments for a fixed-rate payment.
Which one of the following named risks cannot be mitigated through diversification of investments? A. Unsystematic risk. B. Systematic risk. C. Firm-specific risk. D. Company unique risk.
B. Systematic risk.
Systematic risk, also called non-diversifiable risk or market-related risk, cannot be mitigated or eliminated through diversification of investments. This type of risk is most closely associated with elements of the macroeconomic environment in which a firm operates and would include, for example, interest rate risk and inflation risk.
A firm with cash in excess of its immediate needs is considering a temporary investment in newly issued 10-year treasury obligations, which pay a fixed rate of interest.
If the investment will be for one year, which of the following risks, if any, would be of concern?
Default Risk Interest Risk
Yes Yes
Yes No
No Yes
No No
No Yes
Debt obligations of the U.S. government are considered to be free of the risk of default, therefore risk of default on the debt would not be of concern. Interest rate risk would be of concern. Interest rate risk derives from the effects on market value resulting from changes in the rate of interest in the market. If the interest rate increases relative to the rate at the time the fixed-rate Treasury obligations are acquired, the market value of the Treasury obligations will decrease (and vice versa).
Furthermore, the longer the maturity of the fixed-rate obligations, the greater the influence of a given interest rate change on current market value. Since the Treasury obligation is to be sold in one year, not held to maturity, the value of the obligations at the date of sale will depend on the market interest rate at that time relative to the rate when the obligations are acquired.
If a CPA's client expected a high inflation rate in the future, the CPA would suggest to the client which of the following types of investments? A. Precious metals. B. Treasury bonds. C. Corporate bonds. D. Common stock.
A. Precious metals.
Of the alternative answer choices listed, during a period of high inflation, the best investment is precious metals. Because of their scarcity, precious metals tend to increase in market value during periods of inflation. Treasury bonds and corporate bonds, both of which typically pay fixed rates of return, face market interest rate risk and will lose market value as inflation drives up the general rate of interest. While common stock may provide some protection during a period of high inflation, that inflation causes the costs of productive inputs to increase, therefore, increasing pressure on company profits and returns to common stock shareholders.
