Working Capital Management

Question 1

Define “working capital” (also called “net working capital”).

Answer 1

The difference between a firm’s current assets and its current liabilities; expressed as: Current assets - Current liabilities = Working capital.

Question 2

Define “current assets”.

Answer 2

Cash and other resources expected to be converted to cash, sold, or consumed within one year (e.g., Accounts receivable, Inventory, some Prepaid items, etc.).

Question 3

Define “current liabilities”.

Answer 3

Obligations due to be settled within one year or which will require the use of current assets to satisfy (e.g., Accounts payable, other short-term Payables, some Unearned revenue, etc.).

Question 4

What is the objective of Working Capital Management?

Answer 4

To maintain adequate working capital so as to:

1. Meet on-going operating and financial needs of the firm;
2. Not over invest in net working capital which provide low returns or increase costs.

Question 5

Give examples of over-investing in working capital.

Answer 5

1. Maintaining excess cash in low-return accounts;
2. Having excessive (large/old) accounts receivable which don’t earn interest;
3. Maintaining more inventory than needed and thus incurring storage costs and increasing the risk of obsolete inventory.

Question 6

Describe a payment through draft.

Answer 6

Payment is made with a legal instrument, called a “draft,” that is drawn on an account of a bank and is guaranteed payment by the bank. Examples include bank drafts, cashier’s checks, certified checks and money orders.

Question 7

Describe the uses of zero-balance accounts.

Answer 7

A bank account with no real balance. Two variations exist:

1. Checks written on account overdraw the account, but by agreement with the bank the overdrawn amount is paid automatically from another account.
2. Only the known amount of payments from an account is deposited into the account (e.g., payroll account).

Question 8

Define “float”.

Answer 8

The time between when a payment is initiated and when the related cash is available for use by the recipient.

Question 9

Describe the operation of a lock-box system.

Answer 9

Customers remit payments to firm’s post office box where they are collected and then processed and deposited by firm’s bank; may reduce the float by several days.

Question 10

Identify the advantages of using a lock-box system.

Answer 10

1. Cash is available for use sooner than it would be if receipts were routed through the firm;
2. Firm’s handling of collections is greatly reduced;
3. Reduced likelihood of dishonored checks and earlier identification of those that are.

Question 11

Describe the use of preauthorized checks.

Answer 11

Payment/collection of an amount due through the use of checks that are authorized in advance.

Question 12

Describe concentration banking.

Answer 12

Funds collected in multiple local banks are transferred regularly and (usually) automatically to firm’s primary bank; used to accelerate the flow of cash to a firm’s principal bank.

Question 13

What are the major considerations in selecting short-term securities as investments?

Answer 13

1. Safety of principal;
2. Price stability of the investment;
3. Marketability or Liquidity of the investment.

Also, taxability, diversification, and cost of administration

Question 14

What are United States Treasury Bills (also called T-Bills)?

Answer 14

Debt investment instruments that are the direct obligation of the U.S. Government; considered to be virtually risk-free and commonly used as the basis for the risk-free rate of return in many financial analysis.

Question 15

Define “banker’s acceptance”.

Answer 15

A draft (or order to pay) drawn on a specific bank by a firm which has an account with the bank. If bank “accepts” the draft, it becomes a negotiable debt instrument of the bank.

Question 16

Define “commercial paper”.

Answer 16

Short-term unsecured promissory notes issued by large, established firms with high credit ratings as a form of short-term financing (i.e., 270 days or less).

Question 17

Define “repurchase agreement” (also called a “Repo”).

Answer 17

A debt investment instrument with a commitment by the buyer to resell the instrument to the seller at a specified price, which includes the original principal plus an interest or fee factor, at a specified time.

Question 18

Define “default risk”.

Answer 18

A measure of the likelihood that the issuer will not be able to make future interest and/or principal payments to a security holder.

Question 19

Describe the accounts-receivable management function.

Answer 19

Management functions concerned with the conditions leading to the recognition and collection of accounts receivables.

Question 20

Identify the general credit-related factors that must be determined by an entity if it sells on account.

Answer 20

1. Total period for which credit will be extended for sales on account;
2. Discount terms, if any, granted for early payment of credit sales;
3. Penalty for failure to pay according to credit terms;
4. Nature and extent of documentation required for sales on account.

Question 21

Identify two major approaches to determining a customer’s creditworthiness.

Answer 21

1. Use of credit-rating service;

2. Financial analysis of prospective credit customer.

Question 22

Identify some measures (averages and ratios) useful in assessing accounts-receivable management.

Answer 22

1. Average collection period;
2. Day’s sales in accounts receivable;
3. Accounts receivable turnover;
4. Accounts receivable to current or total assets;
5. Bad debt to sales.

Question 23

Describe an aging of accounts receivable schedule.

Answer 23

A schedule which shows for each credit customer how long each amount due from the customer has been owed. For example, amounts may be classified as being: not due, 1 - 30 days overdue, 31 - 60 days overdue, 61 - 90 days over due, over 90 days overdue.

Question 24

Identify the central objective of inventory management.

Answer 24

To determine and maintain an optimum investment in all inventories. Under investing in inventory can result in shortages and lost sales; over investing in inventory can result in incurring excessive cost for inventory.

Question 25

Identify the characteristics of a traditional materials-requirement-planning inventory system

Answer 25

1. Supply push - Goods are produced in anticipation of there being a demand for the goods;
2. Inventory buffers maintained;
3. Long set-up times and long production runs;
4. Relationships with suppliers are impersonal; suppliers selected through bidding process;
5. Quality standards = Acceptable levels; allows for some defects;
6. Traditional cost accounting is used.

Question 26

Identify the characteristics of a just-in-time inventory system. (Toyota)

Answer 26

1. Demand pull - Goods are produced only when there is an end user demand;
2. Excess inventory is minimized;
3. Production in work centers that carry out a full set of production processes;
4. Relationships with suppliers are close and coordinated;
5. Quality standards = Total control of input quality and production process quality;
6. Simplified cost accounting is used.

Question 27

Identify the benefits of a just-in-time inventory system (when compared with a traditional materials-requirement-planning inventory system).

Answer 27

1. Reduced investment in inventory;
2. Lower cost of inventory transportation, warehousing, insurance, taxes and related costs;
3. Reduced lead time in acquiring inputs;
4. Lower cost of defects;
5. Less complex and more relevant accounting and performance measurement.

Question 28

Describe the economic order quantity (EOQ).

Answer 28

A model (formula) for determining the size of an inventory order that will minimize total inventory cost, both cost of ordering and cost of carrying inventory; formula uses:

1. Total demand for the inventory item;
2. Cost of each order;
3. Cost of carrying each unit of inventory.

Question 29

What assumptions are inherent in using the economic order quantity (EOQ) model?

Answer 29

1. Demand is constant during the period;
2. Unit cost and carrying cost are constant during the period;
3. Delivery is instantaneous.

Question 30

Describe the reorder point.

Answer 30

The level of an inventory item on-hand at which that inventory item should be reordered; takes into account:

1. Inventory needed while ordered items are delivered.
2. Inventory need as “safety stock”– to cover unexpected demand.

Question 31

Identify some measures (averages and ratios) useful in assessing inventory management.

Answer 31

1. Inventory turnover;

2. Number of days’ sales in inventory

Question 32

Describe the characteristics of short-term borrowing

Answer 32

Financing (borrowing or deferred payment) with payment due within one year or less; generally does not require collateral and does not impose restrictive covenants.

Question 33

Give examples of short-term financing that is available only as needed.

Answer 33

1. Line of credit;
2. Revolving credit;
3. Letter of credit.

Question 34

Under what circumstances is the use of short-term financing most appropriate?

Answer 34

The use of short-term liabilities for financing purposes is most appropriate when the related assets financed will generate cash in the short-run to be able to repay the liabilities.

Question 35

What is the impact of being required to maintain a compensating balance on the cost of short-term borrowing?

Answer 35

Required compensating balances result in:

1. Less funds available than the amount borrowed and, therefore
2. Effective cost of borrowing is greater than the stated cost.