SU 9: Working Cap 1 - Cash and Receivables

Question 1

Compare the cost and the default risk between short-term financing and long-term financing.

Answer 1

Question 2

What is a conservative financing policy?

Answer 2

A firm that adopts a conservative financing policy seeks to minimize liquidity risk by financing its temporary working capital mostly with long-term debt. Firms adopting a conservative financing policy tend to have higher current ratios.

Question 3

What is an aggressive financing policy?

Answer 3

A firm that adopts an aggressive financing policy seeks to increase profits by financing its permanent working capital mostly with short-term debt. Firms adopting an aggressive financing policy tend to have lower current ratios.

Question 4

How is working capital calculated?

Answer 4

Working cap = Current assets – Current liabilities

Question 5

Define current assets. List common examples in order of descending liquidity.

Answer 5

Current assets are the most liquid assets. Firms can expect to convert them to cash, sell them, or consume within 1 year or the operating cycle, whichever is longer. Ratios involving current assets measure a firm’s ability to continue operations in the short run.
Current assets include:
1) Cash and equivalents
2) Marketable securities
3) Receivables
4) Inventories
5) Prepaid items

Question 6

Define current liabilities. List common examples in order of settlement expectations.

Answer 6

Current liabilities are the liabilities with the earliest due dates. Firms expect to settle these liabilities or convert them to other liabilities within 1 year or the operating cycle, whichever is longer.
Current liabilities include:
1) Accounts payable
2) Notes payable
3) Current maturities/payable portions of LT debt
4) Unearned revenues
5) Taxes payable
6) Wages payable
7) Other accruals

Question 7

How should working capital function in principle? Why is this approach oversimplified?

Answer 7

In principle, current liabilities should finance current assets. This oversimplifies working capital management requirements because:
1) firms must maintain some liquid current assets to meet the minimum LT needs regardless of activity levels or profitability. (Permanent working capital)
2) As the firm’s need for current assets changes seasonally, temporary working capital is increased or decreased.
Both elements tend to increase as the firm grows.

Question 8

Define spontaneous financing. List examples of sources.

Answer 8

Financing is spontaneous when current liabilities like trade payables and accruals occur naturally in the course of business.
Examples include trade credit (accounts payable), accrued expenses like salaries, wages, interest, dividends, and taxes payable

Question 9

Why do companies use financing? How do short-term and long-term financing compare?

Answer 9

Spontaneous financing typically cannot cover a firm’s temporary working capital needs entirely. Thus, a firm must use ST or LT financing.
Interest rates on LT debt are usually higher than on ST debt, making LT debt more expensive.
The shorter maturity schedule on ST debt increase the risk that the firm will default on principal and interest payments.
Tldr; ST debt is riskier and less expensive than LT debt

Question 10

What is maturity matching?

Answer 10

Ideally, a firm should offset each temporary working cap element with a ST liability with the same maturity. This ideal practice is called maturity matching or hedging, but firms often cannot achieve it because of uncertainty.

Question 11

What is the conservative policy?

Answer 11

A firm that adopts a conservative financing policy seeks to minimize liquidity risk by financing its temporary working cap mostly with LT debt.

Question 12

What are the advantages and disadvantages of a conservative financing policy?

Answer 12

Advantages: certainty is inherent in LT debt
Locked-in interest rate mitigates interest rate risk (risk of rising short-run rates). LT maturity date mitigates liquidity risk.
Disadvantages: 1) working cap is idle during periods when it is not needed, but inefficiency is partially mitigated by investing in ST securities; 2) LT debt is more expensive

Question 13

What is an aggressive policy?

Answer 13

To increase profits, an aggressive financing policy reduces liquidity and accepts a higher risk of ST cash flow shortages by financing part of its permanent working cap with ST debt

Question 14

What are the advantages and disadvantages of an aggressive policy?

Answer 14

Advantages: it avoids the opportunity cost of idle funds incurred under the conservative policy
Disadvantages: it risks either unexpectedly high interest rates or total unavailability of financing in the short run

Question 15

Relate working capital components with debt types in terms of risk.

Answer 15

Question 16

Define liquidity. Give examples of the measures of liquidity.

Answer 16

Liquidity is a firm’s ability to pay its current obligations as they come due and remain in business in the short run. Liquidity measures the easy with which a firm can convert assets to cash. Measures of liquidity include
* Net working capital
* Current ratio (working capital ratio)
* Quick (acid-test) ratio
* Operating cash flow ratio

Question 17

Define net working capital. How is it calculated?

Answer 17

NWC equals the resources the firm must have to continue operating in the short run if it must liquidate all of its current liabilities.
Current assets – Current liabilities = Net working capital

Question 18

What is the most common liquidity ratio? How is it calculated?

Answer 18

The current ratio (also called the working capital ratio) is the most common liquidity measure.
Current ratio = Current assets / Current liabilities

Question 19

What does the current ratio indicate, and at what levels?

Answer 19

A low current ratio indicates a possible lack of liquidity. An overly high current ratio indicates idle capacity or inefficiently used assets. This varies by industry, but often a 2:1 ratio is desirable.

Question 20

Define the quick ratio. How is it calculated?

Answer 20

The quick (acid test) ratio excludes inventory and prepaid items from the numerator as these assets do not liquidate easily at their carrying amounts. It more conservatively measures liquidity than the current ratio.
Quick ratio = (Cash & equivalents + ST marketable securities + Net receivables) / Current liabilities

Question 21

What is the advantage of the quick ratio?

Answer 21

It measures the firms ability to pay ST debts easily and avoids inventory valuation problems. The higher the quick ratio, the more favorable for the firm. A ratio of at least 1:1 is desirable .

Question 22

Define the operating cash flow ratio. How is it calculated?

Answer 22

It measures a company’s ability to settle its current liabilities with cash flows from operations.
Operating CF ratio = CF from operations / Current liabilities

Question 23

What are the effects of an equal change in the numerator and denominator on ratios?

Answer 23

Question 24

Give examples of how a firm can speed up its cash collection.

Answer 24

A firm can speed up its cash collection by
* Using a lockbox system
* Factoring
* Payment discounts

Question 25

What do credit terms of 2/10, net 30 mean?

Answer 25

These terms state that the customer may either
* Subtract a 2% discount if the total invoice is paid within 10 days or
* Pay the entire balance due in 30 days.
In general, credit terms are expressed in the following terms:
“Discount percentage”/“Pay by date to receive discount,” net “Balance must be paid by date”

Question 26

What do higher accounts receivable turnover ratio and days’ sales in receivables indicate about the efficiency of a firm in collecting receivables?

Answer 26

Question 27

What is the goal of receivables management? How is this goal obtained?

Answer 27

The goal is to offer the terms of credit that maximize profits, not sales.
1) Maximizing sales could lead to cash flow shortages (raising discounts, longer pmt pds)
2) Balancing is important because raising credit standards will reduce default risk but could also reduce sales.

Question 28

Define factoring. What is a common example?

Answer 28

Factoring is an arrangement where a firm sells its AR at a discount to a factor (entity that specializes in collections). The seller receives cash and eliminates bad debts. The seller does not need a credit department or AR staff.
Common example: credit card companies. Company remits the cash proceeds to the seller less a fee (usually 1.5% - 4%). CC company assumes the risk that purchasers may not pay their bills.

Question 29

Define float. How do companies manage float?

Answer 29

Float is the period of time from when a payor puts a check in the mail to the availability of the funds in the payee’s bank.
Firms attempt to decrease float for receipts (collection float) and increase float for payments (disbursement float).

Question 30

What is a lockbox system? How does it benefit a firm? When is it appropriate?

Answer 30

A lockbox system allows customers to submit payments to a post office box, managed by bank personnel, usually for a monthly fee.
This system expedites the receipt of funds from cashing checks because the bank receives the payments.
It is appropriate for firms doing nationwide business.

Question 31

What is concentration banking?

Answer 31

Firms using lockbox systems typically use multiple boxes across regions. The regional banks automatically transfer their daily collections to the firm’s principal bank, where it can use funds for payments and ST investments.

Question 32

What is the accounts receivable turnover ratio? How is it calculated? What information does it provide?

Answer 32

The AR turnover ratio is the number of times in a year the firm converts the total AR balance to cash. It measures how often a business collects its average AR per year.
A/R turnover ratio = Net credit sales / Avg net A/R balance
The information indicates how efficient the firm is at obtaining cash from credit sales and provides insights into a firm’s liquidity. The higher the ratio, the easier it is for the firm to generate cash flows, writing off fewer credit sales. A decrease in ratio means firm collected AR less frequently.

Question 33

What is the average collection period (days’ sales in AR)? How is it calculated? What information does it provide?

Answer 33

It measures the average number of days between the time of a sale and receipt of payment. It indicates how well and how quickly a firm converts a credit sale into cash.
Days’ sales in receivables = Ending net A/R / (Net credit sales / Days in year)
OR = Days in year / A/R turnover ratio (uses the average balance)
An increase indicates that company is not collecting cash as quickly. A lower ratio is better, means less time to collect on sales, take advantage of TVM. It also provides insight into credit sales written off. The more written off, the higher the ratio.