LM 4: Working Capital & Liquidity

Question 1

What are the 3 main working capital accounts?

Answer 1

1. accounts receivable
2. inventory
3. accounts payable

Question 2

What are activity ratios?

Answer 2

financial metrics used to gauge how efficient a company’s operations are

Question 3

Describe days of sales outstanding, days of inventory on hand, days or payables outstanding.

Answer 3

days of sales outstanding: average number of days taken by customer to settle credit sales in cash

days of inventory on hand: average number of days inventory is held before being sold

days of payables outstanding: average number of days taken by company to pay suppliers for credit sales

Question 4

What is formula for cash conversion cycle?

Answer 4

cash conversion cycle = number of days of inventory + number of days receivables - number of days payables

Question 5

Describe the 3 ways a company can reduce its cash conversion cycle.

Answer 5

1. increase DPO (obtain longer payment terms from suppliers
2. reduce DOH (improve demand forecasts
3. reduce DSO (charging late fees, tightening credit standards)

Question 6

What is the total working capital formula?

Answer 6

total working capital = current assets - current liabilities

Question 7

What is the cost difference between primary sources of liquidity and secondary sources of liquidity?

Answer 7

Primary sources of liquidity are readily accessible at a low cost

Secondary sources are a high cost option.

Question 8

What is cash flow from operations formula?

Answer 8

CFO =
cash received from customers + interest and dividends from investments
- cash paid to employees, suppliers, government for taxes, and lenders for interest obligations

Question 9

What is drag on liquidity?

Answer 9

drag on liquidity occurs when funds are unavailable because assets are not being efficiently converted into cash. eg. Uncollectable receivables

Question 10

What is pull on liquidity?

Answer 10

cash outflows happen too quickly or when a company’s access to commercial or financial credit is limited.

pull on liquidity occurs when disbursements are made before cash can be generated from sales. eg. making payments early or reduced line of credit

Question 11

What are 3 liquidity ratios?

Answer 11

1. current ratio
2. quick ratio
3. cash ratio

Question 12

What is formula for current ratio?

Answer 12

Current ratio = current assets / Current liabilities

Question 13

What is formula for quick ratio?

Answer 13

quick ratio = (cash + marketable securities + receivables) / current liabilities

Question 14

What is the formula for cash ratio?

Answer 14

cash ratio = cash + short-term marketable investments / current liabilities

Question 15

For accounts payable what does the term 1/10, net 20 mean?

Answer 15

indicate a 1% discount if the bill is paid within 10 days. The full amount must be paid within 20 days.

Question 16

What does a negative cash conversion cycle mean?

Answer 16

negative cash conversion cycle means that inventory is sold before you have to pay for it. Or, in other words, your vendors are financing your business operations.