Topic 4 - Chapter 18: Working Capital Management

Question 1

How do you calculate working capital?

Answer 1

Net working capital = Current assets – Current liabilities

Question 2

What are examples of current assets?

Answer 2

Cash, marketable securities, accounts receivable and inventory)

Question 3

What are examples of current liabilities?

Answer 3

Accounts payable, bank overdraft and accruals

Question 4

When managing liquidity, what are some considerations?

Answer 4

A risk-return trade-off arises when managing the firm’s liquidity. Investing in current assets
improves liquidity and reduces the firm’s rate of return on investment. Using current
liabilities to finance assets reduces liquidity. This is known as risk-return trade-off

Question 5

What is the principle of self liquidating debt?

Answer 5

According to this principle maturity the source of financing should be matched with the length of time that the financing is needed. Short-term assets should be financed with short-term borrowings and long-term requirements or investments should be financed with long-term sources of financing.

Question 6

What is the working capital cycle concerned with?

Answer 6

The operating cycle and cash cycle

Question 7

What is the operating cycle?

Answer 7

The operating cycle is the time it takes from acquiring inventory to the time we collect cash
from sales, and it has two distinct periods: the inventory period and the accounts receivable
or average collection period.

Question 8

What are the two distinct periods associated with the operating cycle?

Answer 8

The inventory period and the accounts receivable

or average collection period.

Question 9

What is the accounts payable period?

Answer 9

The period between the purchase of inventory and the cash payment of the inventory. This is involved in the cash cycle.

Question 10

What is the cash conversion cycle?

Answer 10

This the period between when cash has been paid for the inventory until the cash from the sale is collected. It is the operating cycle, less the accounts payable deferral period.

Question 11

What are liquid assets?

Answer 11

Those assets that can be readily converted to cash.

Question 12

What are marketable securities?

Answer 12

Investments in securities that the firm can quickly convert into cash balances (high liquidity)

Question 13

How can liquidity be measured?

Answer 13

Current ratio or Net working capital
Current ratio = current assets/liabilities
Net working capital = current assets-liabilities

Question 14

What are permanent asset investments?

Answer 14

Permanent assets are those that the firms expects to hold for a period longer than one year. This can include a minimum level of current assets (e.g minimum accounts payable). Otherwise, plant, property assets would be an example of a permanent asset.

Question 15

What are temporary assets?

Answer 15

Temporary assets are those current assets that a firm expects to convert to cash in less than one year (and not replaced).

Question 16

What are temporary sources of financing?

Answer 16

These typically consist of current liabilities:
Promissory notes (IOU’s)
Short term finance (unsecured bank loans)

Question 17

What are permanent sources of financing?

Answer 17

Intermediate and long term secured bank loans

Issue of ordinary or preference shares

Question 18

What are spontaneous sources of financing?

Answer 18

These arise naturyaly out of day to day operations. They include:
Accounts payable/trade credit
Accrued wages
Interest and Tax accruals

Question 19

How does the cash cycle differ from the operating cycle?

Answer 19

The cash cycle is different from the operating cycle in that it is only concerned with the period from which cash has been paid and must be recouped. the Operating cycle however, is concerned with the overall cycle from placing an inventory order to receipt of cash from sales of the product.

Question 20

How does investing more heavily in current assets other things remaining the same increase firm liquidity?

Answer 20

Liquidity is the ability of a firm to convert it’s current assets to cash in order to pay it’s bills as they fall due. Investing more heavily in current assets provides access to additional cash in order to service payments as they are due, thus increasing liquidity.

Question 21

How does the use of short term as opposed to long term liabilities affect a firm’s liquidity?

Answer 21

Liquidity is the ability of a firm to convert it’s current assets to cash in order to pay it’s bills as they fall due. The use of short term liabilities increase liquidity as this increases the amount of outgoing cash in relation to the cash available to service the bills as they fall due. Long term liabilities have a longer repayment period and therefore much less impact on cash flow, however they are more expensive. The principle of self liquidating debt suggests that sources of finance should be matched to the period for which the asset is required.

Question 22

What is the inventory conversion period

Answer 22

The number of days a firm uses to convert its inventory into cash or accounts receivable following a sale.

Question 23

Describe the risk return trade off involved in managing working capital

Answer 23

Working capital management involves management of the firms liquidity which involves management of current assets and current liabilities. Each of these involve a risk return trade off. For example, investing in current assets reduces the firms overall risk of illiquidity at the expense of lowering the overall rate of return on it’s investment in assets. Furthermore, reducing the use of short term sources of finance by using long term sources improves liquidity but reduces profitability, as long term debt is more expensive.