WORKING CAPITAL MANAGEMENT

Question 1

OPERATING CYCLE

Answer 1

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 2

CASH CYCLE

Answer 2

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

Question 3

CASH CONVERSION CYCLE (CCC)

Answer 3

= Inventory Days + A/R Days - A/P Days

Question 4

INVENTORY DAYS

Answer 4

= Inventory / Average Daily Cost of Goods Sold

Question 5

ACCOUNTS RECEIVABLE DAYS

Answer 5

Accounts receivable / Average daily sales

Question 6

ACCOUNTS PAYABLE DAYS

Answer 6

Accounts payable / Average daily cost of goods sold

Question 7

How is firm value affected by working capital?

Answer 7

Any reduction in working capital requirements generates a positive free cash flow that the firm can distribute immediately to shareholders.

Question 8

TRADE CREDIT

Answer 8

The difference between receivables and payables that is the net amount of a firm’s capital consumed as a result of those credit transactions.

The credit that a firm extends to its customers.

Question 9

Example of trade credit terms:

2/10, Net 30

Answer 9

Cash Discount: a 2% cash discount is taken if paid during the discount period.

Discount period: in this example, 10 days.

Credit period:
The total length of time credit is extended to the buyer, in this example it is 30 days.

Question 10

COST OF TRADE CREDIT

Answer 10

EAR = (1+2)^n - 1

Question 11

What are the benefits of trade credit?

Answer 11

• It is simple and convenient to use, and it 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 12

Why do firms offer trade credit?

Answer 12

• Providing financing at below-market rates is an indirect way to lower prices for certain customers.
• A supplier may have an ongoing business relationship with its customer, it may have more information about the credit quality of the customer than a traditional outside lender such as a bank would have.
• If the buyer defaults, the supplier may be able to seize the inventory as collateral.

Question 13

MANAGING FLOAT

Answer 13

COLLECTION FLOAT
Mail float - customer mails check

Processing float - firm receives check

Availability float - firm deposits check

Finally, funds are credited to firm’s account.

DISBURSEMENT FLOAT

Question 14

What three steps are involved in establishing a credit policy?

Answer 14

1. Establishing credit standards.
2. Establishing credit terms.
3. Establishing a collection policy.

Question 15

What are the 5 C’s of credit?

Answer 15

• Character
• Capacity
• Capital
• Collateral
• Conditions

Question 16

ACCOUNTS RECEIVABLE DAYS

Answer 16

The average number of days that it takes a firm to collect its sales.

Question 17

AGEING SCHEDULE

Answer 17

• Categorises accounts by the number of days they have been on a firm’s books.
• Can be prepared using either the number of accounts or the dollar amount of the accounts receivable outstanding.

Question 18

PAYMENTS PATTERNS

Answer 18

Provides information on the percentage of monthly sales that the firm collects in each month after the sale.

Question 19

How does a firm determine the accounts payable days outstanding?

Answer 19

Firms should monitor their accounts payable to ensure they are making their payments at an optimal time.

Question 20

STRETCHING ACCOUNTS PAYABLE

Answer 20

When a firm ignores a payment due to period and pays later.

Question 21

COD

Answer 21

Cash on delivery

Question 22

CBD

Answer 22

Cash before delivery

Question 23

What are the benefits of holding inventory?

Answer 23

• Inventory helps minimise the risk that the firm will not be able to obtain an input it needs for production and helps avoid stock outs.
• Factors such as seasonality and demand mean that customer purchases do not perfectly match the most efficient production cycle.

Question 24

What are the costs of holding inventory?

Answer 24

• Acquisition costs
• Order costs
• Carrying costs
• “Just In Time” (JIT) Inventory management.

Question 25

What is the motivation for holding cash?

Answer 25

• Transactions balance (to meet its day-to-day needs)
• Precautionary balance (to compensate for the uncertainty associated with its cash flows)
• Compensating Balance (To satisfy bank requirements)

Question 26

What short term money market investments can a firm with excess cash invest in?

Answer 26

• Treasury bills
• Certificates of Deposit
• Repurchase Agreements

Question 27

TREASURY BILLS

Answer 27

Short term debt of the US government.

MATURITY:
Four weeks, three months (91 days), six months (182 days), or 52 weeks when newly issued.

RISK:
Default risk free

LIQUIDITY:
Very liquid and marketable.

Question 28

CERTIFICATE OF DEPOSIT (CDs)

Answer 28

Short term debt issued by banks.
Minimum denomination of $100,000.

MATURITY:
Varying maturities up to one year.

RISK:
If issuing bank is insured by the FDIC, any amount up to $250,000 is free of default risk because it is covered by the insurance. Any amount in excess of $250,000 is not insured and is subject to default risk.

LIQUIDITY:
Unlike CDs purchased by individuals, these CDs sell on the secondary market, but are less liquid than Treasury bills.

Question 29

REPURCHASE AGREEMENTS

Answer 29

DESCRIPTION:
Essentially a loan agreement wherein a securities dealer is the “borrower” and the investor is the “lender”. The investor buys securities, such as U.S. Treasury bills, from the securities dealer, with an agreement to sell the securities back to the dealer at a later date for a specified higher price.

MATURITY:
Very short term, ranging from over night to approximately 3 months.

RISK:
The security serves as collateral for the loan, and therefore the investor is exposed to very little risk. However, the investor needs to consider the creditworthiness of the securities dealer when assessing the risk.

LIQUIDITY:
No secondary market for repurchase agreements.

Question 30

BANKER’S ACCEPTANCES

Answer 30

Drafts written by the borrower and guaranteed by the bank on which the draft is drawn. Typically used in international trade transactions. The borrower is an importer who writes the draft in payment for goods.

MATURITY:
Typically 1-6 months.

RISK:
Because both the borrower and a bank have guaranteed the draft, there is very little risk.

LIQUIDITY:
When the exporter receives the draft, he may hold it until maturity and receive its full value or he may sell the draft at a discount prior to maturity.

Question 31

COMMERCIAL PAPER

Answer 31

Short term, unsecured debt issued by large corporations. The minimum denomination is $25,000, but most commercial paper has a face value of $100,000 or more.

MATURITY:
Typically 1-6 months.

RISK:
Default risk depends on the creditworthiness of the issuing corporation.

LIQUIDITY:
No active secondary market, but issuer may repurchase commercial paper.

Question 32

SHORT TERM TAX EXEMPTS

Answer 32

Short term debt of state and local governments. These instruments pay interest that is exempt from federal taxation, so their pretax yield is lower than that of a similar risk, fully taxable investment.

MATURITY:
Typically 1-6 months.

RISK:
Default risk depends on the creditworthiness of the issuing government.

LIQUIDITY:
Moderate secondary market.

Question 33

AGGRESSIVE FINANCING POLICY

Answer 33

• Financing part or all of the permanent working capital with short-term debt.
• Funding risk

Question 34

CONSERVATIVE FINANCING POLICY

Answer 34

• Financing short-term needs with long-term debt.

- Non-productive of cash

Question 35

SHORT TERM FINANCING WITH BANK LOANS: Promissory note

Answer 35

-Single, end of period payment loan (benchmark rate, such as prime rate or LIBOR)

-Line of credit
Uncommitted
Committed
Revolving
Evergreen

-Bridge Loan
Often discount loan with fixed interest rate.
With a discount loan, borrower pays interest at the beginning of the loan period.

Question 36

COMMON LOAN REQUIREMENTS

Answer 36

Commitment fees

Loan origination fee

Compensating balance requirements

Question 37

DIRECT PAPER

Answer 37

Firm sells directly to investors

Question 38

DEALER PAPER

Answer 38

Dealers sell to investors in exchange for a spread (or fee) for their services.

The spread decreases the proceeds that the issuing firm receives, increasing effective cost.

Question 39

SECURED LOANS

Answer 39

Loans collateralised with short-term assets (account receivable/inventory)

Most common sources:

• Commercial banks
• Finance companies
• Factors - firms that purchase the receivables of other companies.

Question 40

ACCOUNTS RECEIVABLE AS COLLATERAL

Answer 40

-Pledging of accounts receivable:
Lender reviews the invoices and decides which credit accounts it will accept as collateral, based on its own credit standards.

Factoring of accounts receivable:

• Firm sells receivables to the lender (i.e. the factor)
• Lender pays the firm the amount due from its customers at the end of the firm’s payment period less a factor’s fee.

Question 41

INVENTORY AS COLLATERAL

Answer 41

-Floating lien, general lien, or blanket lien:
All of the inventory is used to secure the loan.

-Trust receipts loan or floor planning:
Distinguishable inventory items are held in a trust as security for the loan.

-Warehouse arrangement:
Inventory that serves as collateral is stored in a separated warehouse.