Working capital and liquidity

Question 1

What is current capital?

Answer 1

It is current assets minus current liabilities.

Question 2

What are the sources of internal financing?

Answer 2

• CFO
• A/P and A/R
• Inventory and marketable securities

Question 3

Describe the CFO financing option.

Answer 3

If a company has a higher and more predictable after-tax CFO, it has a greater ability to finance itself using internal means.

Question 4

What is trade credit?

Answer 4

It is when a company finances its purchase by delaying the date on which the payment is made.

Question 5

What is the goal of the business regarding A/P and A/R?

Answer 5

The goal is to delay the payment that they owe while receiving what is owned to them as quickly as possible.

Question 6

What is the strategy of the business with inventories and marketable securities?

Answer 6

• Inventory: try to keep a good balance between not too much inventory to minimize cost and not too few to limit shortages.
• Marketable securities: useful because they are highly liquid.

Question 7

What are the sources of external financing?

Answer 7

• Financial intermediaries.
• Capital markets

Question 8

What are the different sources of financial intermediaries?

Answer 8

• Lines of credit
• Loans and factoring

Question 9

What are the different types of lines of credit? Describe them.

Answer 9

• Uncommitted lines of credit: They are the least reliable form of bank borrowing because the bank reserves the right to refuse to honor any request for use of the line.
• Committed lines of credit (regular lines of credit): They are more reliable than uncommitted lines, they are verified through an acknowledgment letter and footnoted in the annual report.
• Revolving credit arrangements (revolver): It is the most reliable form of short-term bank borrowing. It is for a larger amount than regular lines of credit.

Question 10

What are secured loans?

Answer 10

The lender requires the company to provide collateral in the form of an asset. The assets are pledged against the loan, and the lender files a lien against them.

Question 11

Describe the process of the assignment of A/R as collateral for a loan.

Answer 11

A/R are used as collateral for a loan by being securitized by a special purpose vehicle that will issue a bond that is backed by receivables as collateral and is sold to investors.

Question 12

What happens to an A/R assignment with regards to an assignment arrangement of a factoring arrangement?

Answer 12

• Assignment arrangement: the company remains responsible for the collection of the account.
• Factoring arrangement: the company shifts the credit-granting and collection process to the lender or factor.

Question 13

What are the external sources of financing through capital markets?

Answer 13

• Short-term commercial paper: Used by large high-rated companies, they are unsecured, and they are low-risk.
• Long-term debt and equity: more costly, but they provide larger financing.

Question 14

What does the company do with a conservative approach to working capital management?

Answer 14

The firm holds more cash receivables, and inventories relative to sales.

Question 15

What does the company do with an aggressive approach to working capital management?

Answer 15

The firm is substantially less committed to current assets.

Question 16

Which ratio best describes the impact of working capital management on returns?

Answer 16

The total asset turnover.

Question 17

What are the key sources of liquidity?

Answer 17

• Primary sources of liquidity like cash balances.
• Secondary sources of liquidity such as selling assets.

Question 18

What are the primary sources of liquidity?

Answer 18

They are the most readily accessible resources available to the company.

Question 19

What are the primary sources of liquidity? Describe them.

Answer 19

• FCF: the firm’s after-tax CFO less planned short- and long-term investments.
• Ready cash balances: cash available in bank accounts.
• Short-term funds: trade credit, bank lines of credit, and short-term investment.
• Cash management: the company’s effectiveness in cash management systems and practices.

Question 20

What happens when the company has highly decentralized collections?

Answer 20

The more decentralized collections are, the more likely the company will be to have cash tied up in the system and not available for use.

Question 21

What does the use of a secondary source of funding impact?

Answer 21

• It results in a change in the company’s financial and operating position.
• It has a high cost and can signal deteriorating financial condition.

Question 22

What are the secondary sources of liquidity?

Answer 22

• Negotiating debt contracts: relieving pressures from high-interest payments or principal repayments, waiving debt covenants, and negotiating contracts with customers and suppliers.
• Liquidating assets
• Filing for bankruptcy protection and reorganization.

Question 23

What is the reorganization through bankruptcy protection?

Answer 23

It is a liquidity tool that entails significant costs to existing debt and equity holders.

Question 24

What is drag liquidity?

Answer 24

It is when receipts lag, creating pressures from the decreased available funds.

Question 25

What is a pull on liquidity?

Answer 25

It is when disbursements are paid too quickly by the company and/or trade credit availability is limited, both of which cause outflows to increase.

Question 26

What can major drags on receipts involve?

Answer 26

It involves pressures from credit management and deterioration in other assets. It includes uncollected receivables, obsolete inventory, and tight credit.

Question 27

What are the major pulls on payment?

Answer 27

• Making payment early
• Reduced credit limits
• Limits on short-term lines of credit
• Low liquidity position

Question 28

What happens when the company is less liquid?

Answer 28

The risk of experiencing financial distress is increased.

Question 29

What are the objectives that a short-term financing strategy seeks to fulfill?

Answer 29

• Ensure that the company has sufficient funding to handle peak cash needs.
• Maintain sufficient and diversified sources of credit to fund ongoing cash needs.
• Ensure the rates paid for financing are competitive.
• Ensure both implicit and explicit funding costs are considered in the company’s effective cost of borrowing.

Question 30

What are the factors that influence a company’s short-term borrowing strategy?

Answer 30

• Size and creditworthiness
• Legal and regulatory considerations
• Asset nature
• Flexibility of financing position