Working Capital Management

Question 1

Define working capital

Answer 1

A company’s current assets and liabilities

Question 2

What do most projects require the firm to invest in?

Answer 2

Net working capital

Question 3

What is net working capital?

Answer 3

Current assets - current liabilities

Question 4

What are the main component s of working capital?

Answer 4

Cash
Inventory
Receivables
Payables

Question 5

What is Europe’s average working capital ratio?

Answer 5

Around 20%

Question 6

What is an operating cycle?

Answer 6

The average length of time between when a firm originally purchases its inventory and when it receives the cash back from selling its product

Question 7

What is a cash cycle?

Answer 7

The length of time between when a firm pays cash to purchase its initial inventory and when it receives cash from the sale of the output produced from that inventory

Question 8

What are the 4 key dates in the production cycle that influence the firm’s investment in working capital?

Answer 8

Raw material inventory
Finished goods inventory
Receivables
Cash

Question 9

What is the cash conversion cycle?

Answer 9

The length of time between the firm’s payment for its raw materials and the collection of payment from the customer

Question 10

What are all the periods of the cash conversion cycle?

Answer 10

Look at slides

Question 11

In a formula, what is the cash conversion cycle?

Answer 11

CCC = operating cycle - accounts payable period = (inventory period + receivables period) - accounts payable period

Question 12

What can reduce the amount of time between the cash investment and the receipt of that cash investment?

Answer 12

Buying inventory on credit

Question 13

What does any reduction in working capital requirement generate?

Answer 13

A positive free cash flow that the firm can distribute immediately to shareholders

Question 14

What can efficiently managing working capital increase?

Answer 14

The firms’s value

Question 15

What does terms of sale concern?

Answer 15

Credit, discount, and payment terms offered on sale

Question 16

Are terms of sale industry specific?

Answer 16

Yes

Question 17

How is terms of sale quoted?

Answer 17

Example: 5/10 net 30

5 = 5% of discount of early payment
10 = number of days discount is available
net 30 = number of days company allows for payment

Question 18

Assume a firm sells a product for £100 on terms of 2 /10, net 45. If the customer takes advantage of the discount and pays within the 10-day discount period, the customer pays only £98 for the product. the customer has the option to use the £98 for an additional 35 days (and repay the full price of £100)
What is the interest rate for the 35-day term loan?

Answer 18

2 / 98 = 2.04%

Question 19

How do you calculate the implied EAR for trade credit?

Answer 19

Look at slides

Question 20

What are the benefits of trade credit?

Answer 20

Trade credit is simple and convenient to use, and it therefore has lower transaction costs than alternative sources of funds.

It is a flexible source of funds, and can be used as needed.

It is sometimes the only source of funding available to a firm

Question 21

Trade Credit Versus Standard Loans: why offer trade credit?

Answer 21

Providing financing at below-market rates is an indirect way to lower prices for only certain customers.

Relationship lending

If the buyer defaults, the supplier may be able to seize the inventory as collateral

Question 22

What is credit analysis?

Answer 22

Procedure to determine likelihood customer will pay bills:
- Reports by credit agencies
- Financial ratios

Question 23

What is credit policy?

Answer 23

Standards set to determine amount and nature of credit extended to customers:
- Credit standards
- Credit terms

Question 24

What is credit scoring?

Answer 24

Procedure to determine eligibility of borrower:
- Extending credit
- Denying credit

Question 25

How can a firm use accounts receivable days to monitor accounts?

Answer 25

A firm can compare the accounts receivable days to the credit terms- E.g. if the credit terms specify “net 30” and the accounts receivable days outstanding is 45 days: customers are paying 15 days late, on average.

A firm can look at the trend in accounts receivable days

Question 26

What is an ageing schedule?

Answer 26

Categorizes a firm’s accounts by the number of days they have been on the firm’s books

Question 27

When should a firm borrow using accounts payable?

Answer 27

only if trade credit is the least expensive source of funding.

Question 28

What determines the cost of trade credit?

Answer 28

The higher the discount percentage offered, the greater the cost of forgoing the discount.

The shorter the loan period, the greater the cost of forgoing the discount.

Question 29

What are the benefits of holding inventory?

Answer 29

Prevent stock-outs
Seasonality in demand

Question 30

What are the costs of holding inventory?

Answer 30

Acquisition costs
Order costs
Carrying costs
Obsolete items

Question 31

What are the motivations for holding cash?

Answer 31

Transaction balance
Precautionary balance
Compensating balance

Question 32

What is the transactions balance?

Answer 32

The amount of cash a firm needs to be able to pay its bills

Question 33

What is the precautionary balance?

Answer 33

The amount of cash a firm holds to counter the uncertainty surrounding its future cash needs

Question 34

What is the compensating balance?

Answer 34

An amount a firm’s bank may require the firm to maintain in an account at the bank as compensation for services the bank may perform