Liquidity risk Flashcards
Lack of liquidity can lead to which of the following?
a) Limit management’s freedom of action
b) Increase the potential for profitable investment opportunities
c) Force managers to divest profitable businesses with a substantial discount
d) Reduce financial expenses
e) Lead to suspension of payment and possible bankruptcy
a, c + e)
b + d would be true if oppositely stated
TRUE or FALSE
The number of days it takes to convert working capital to cash is an indicator of short-term liquidity risk
TRUE
How is the liquidity cycle calculated?
Liquidity cycle=365/((Cost of goods sold)/Inventory)
+
365/(Revenue/(Accounts receiveable))
-
365/((Purchase,material)/(Accounts payable))
All other things being equal companies should strive to_______ the length of the liquidity cycle since it improves cash flows
reduce
What does the rule of thumb for the current ratio state?
a) current ratio<2⇒ low liquidity risk
b) current ratio>2⇒ high liquidity risk
c) current ratio>2⇒ low liquidity risk
d) current ratio>1⇒ low liquidity risk
c)
Does a service company typically have a high or low current ratio, and why?
Low
Service companies are typically characterised by low levels of inventory. Current liabilities often exceed current assets
Which of the following are drawback of the current ratio?
a) Relies on financial data describing the net working capital position, hence many aspects of a company’s financial position are not covered by the ratio
b) Doubtful whether current net working capital is able to predict the development of future cash tied up in working capital level of activity may be a better indicator of the development in working capital
c) In the event of liquidation, it is doubtful whether asses can be realised at book value (ex. Inventory that are recognised at cost in the balance sheet)’
d) Rule of thumb not applicable across industries with various business models
e) All of the above
e)
How can the convertibility-to-cash problem of the current ratio be avoided?
a) It cannot be avoided
b) Looking at long-term assets
c) FCFO to Assets ratio
d) FCFO to short term debt ratio
e) Quick ratio
d)
FCFO to short term debt ratio=(Cash flow from operations)/(Current liabilities)
Which financial ratio is typically used for companies with negative earnings?
a) Cash burn rate
b) Quick rate
c) Current ratio
d) FCFO to short term debt ratio
e) You cannot calculate valuable financial ratios for companies with negative earnings
a)
Measures how long a company is able to fund projected costs without any further cash contribution from shareholders or creditors
Cash burn rate=(Cash and cash equivalents+securities+receiveables)/EBIT
When are the following ratios indicators of long-term liquidity risk?
a) High financial leverage and high solvency ratio
b) Low financial leverage and high solvency ratio
c) High financial leverage and low solvency ratio
d) Low financial leverage and low solvency ratio
c)
Financial leverage=(Total liabilities)/Equity
Solvency ratio=Equity/(Total liabilities+equity)
How does the interest coverage ratio affect long-term liquidity risk?
The higher the ratio, the lower the long-term liquidity risk
How is the interest coverage ratio typically calculated?
Interest coverage raito=EBIT/(Net financial expenses)
What are typical shortcomings of financial ratios as a measure for liquidity risk?
a) Based on historical accounting information and, as a result, backward-looking
b) Only describing parts of a company’s financial position
c) Less useful in the absence of an appropriate benchmark
d) Less useful if they are not used together
e) All of the above
e)
