Working Capital Management Flashcards
What is working capital (also called Net Working Capital)? Express it in a formula.
The difference between a firm’s current assets and its current liabilities.
Formula: Currents assets - current liabilities
Working capital management is only concerned about what types of assets and liabilities? It does not include what?
WCM only includes current assets and current liabilities. Not include long-term (fixed) assets or liabilities.
If a firm over invests in net working capital, what are the consequences and outcomes of this?
- Earn LOWER RETURNS than would be possible if assets were invested in capital projects
- Excess idle cash - low rate of return
- Excess accounts receivable - does not earn interest
- Excess inventory - Incurs storage costs and risks becoming obsolete
- Excessive current assets that exceed immediate needs
- Net assets not being used effectively
If a firm under invests in net working capital, what are the consequences and outcomes of this?
- Unable to meet current operating and financial needs
2. Inadequate cash and inventory shortages
What is the objective of working capital?
Maintain adequate working capital in order to meet ongoing and financial needs of the firm.
Inventory - Meet production requirements
Cash - Meet obligations as they’re due
What is a risk when management decides to minimize a firm’s investment in current assets?
Inventory Shortage may increase. Excessive reductions in inventory may result in inventory shortages.
When investments in current fixed assets are reduced, how would this effect inventory spoilage, accounts receivable defaults, and inventory obsolescence?
These would all likely decrease.
What is the current ratio expressed in a formula?
Current Assets/Current Liabilities
If a firm increases cash balance by issuing additional shares, how does this effect working capital and current ratio? This scenario would increase common stock as well as cash.
Increases both ratios. This is because cash (ASSET) is increasing.
If a company A uses debt financing and company B uses more equity financing. How will debt financing impact net earnings variability, financial leverage, and operating earnings compared to equity financing?
Debt financing provides
- Higher net earnings variability - Greater fixed charges in the form of interest (more volatile net earnings)
- Greater financial leverage
- No effect on operating earnings variability because operating income is computed prior to interest expense.
The main reason to retain working capital is to meet the firm’s ___________?
Financial obligations.
Determining the appropriate level of working capital requires?
Offsetting the benefit of current assets and current liabilities against the probability of technical insolvency.
Explain the hedging principle of finance.
Asets are acquired with financing that matches the life of the asset. Thus, short-term assets would be financed with short-term liabilities and long-term assets would be financed with long-term liabilities or equity.
Provide an example of financing that would be considered too aggressive. This is in regards to the hedging principle of finance.
Financing long-term needs with short-term funds.
In regards to hedging principle of financing, short-term liabilities should be used to finance short-term assets. Which of the following should short-term liabilities finance? A. Plant machinery B. Payment of bond at maturity C. Inventory D. Patent
C. Inventory. This is because it’s a short term asset. Plant machinery and patent are long-term assets which require long-term liabilities. Short-term liabilities should not repay bond principal at maturity.
What are three examples of long-term financing?
- Issuing bonds
- Issuing preferred stock
- Issuing common stock
An increase in merchandise inventory (short-term asset) would be best financed by?
Increase in current liabilities (short-term liability)
What is the formula to calculate annual rate on the discount lost? Also known as the annual cost of not taking the discount offered.
Discount percentage/(100% - Discount %) x 360 days/(Total pay period - Discount Period)
When you are offered credit terms from three different banks, what factors should you look for when deciding on choosing the credit terms that are best for the company?
- Choose the terms where you purchase in the # of days that give the discount. Don’t pick the ones where you can’t get a discount.
- Once you’ve selected the options that offer a discount, use the annual cost of not taking discount formula to see what options gives you the highest value
- Choose the option that gives you the highest value
- If you take the discount, more than likely you borrow from a bank and you will need to subtract that percentage from your amount.
If a firm purchases raw materials from its supplier on a 2/10, net 40, cash discount basis, the equivalent annual interest rate (using a 360-day year) of forgoing the cash discount and making payment on the 40th day is?
How do you solve this problem?
Use annual rate on discount lost formula
Discount %/(100% - Discount %) x 360 days/(total pay period-discount period)
Discount % = 2%
Total pay period = 40
Discount period = 10 days
Equation = 2%/(100%-2%) x 360/(40-10) = 24.49%
When a firm has excess cash it can make short-term investments. What are the three major considerations when selecting these short-term investments?
- Safety of principal - little risk of default by issuer
- Price Stability - market price declines resulting in significant losses
- Ready Marketability/Liquidity - ability to readily convert the investment to cash without undue cost.
What short-term investment provides the greatest safety of principal?
U.S. Treasury bills
This short-term investment is a debt obligation of the U.S. government, has a maturity of one year or less, and is backed by the full faith and credit of U.S. government. What is this investment?
U.S. Treasury bills
What are three important characteristics of U.S. treasury bills? (Hint: major considerations of short-term investments)
- Safety of principal
- Price stability
- Marketability/liquidity
This short-term investment is security which is an obligation of a federal government agency (ex. Fannie Mae). Not backed by good faith and credit of U.S. government.
- More risk than treasury
- Less marketable than treasury
- Higher yields
Federal agency securities
This short-term investment is a security issued by banks in return for a fixed time deposit with the bank. Pay a fixed rate of interest and are available in different denominations.
- High safety of pricinpal
- Less marketability than treasury
Negotiable certificates of deposit.
These short-investments are orders to pay (a draft) drawn on a bank by an entity that has an account with the bank. If the bank accepts the draft, it accepts responsibility for payment to the holder of the acceptance.
- Safety of principal
- Higher risk
- Less marketability
Bankers’ acceptances
This short-term investment is a short-term unsecured promissory notes issued by established firms with outstanding credit ratings. However, since these promissory notes are not backed by collateral (security), they carry a risk of default.
- Lack of marketability
- Higher yield
- More risk
Commercial paper
In this short-term investment, firm makes an investment (loan) and enters into a commitment to resell the security at the original contract price plus an agreed interest income.
Repurchase agreements (Repos)
Out of the four options below, which investment option would be expected to have the highest yield? And why?
Corporate bonds, US treasury bills, municipal bonds, and federal agency securities.
Corporate bonds because they are the riskiest investment. Municipal bonds are tax free so they yield less than corporate bonds.
What risk is associated with the ability to sell an investment in a short period of time without having to make significant price concessions is liquidity risk? Two possible elements are implied in the risk: (1) the inability to sell for cash in the short term, and (2) the inability to receive fair value in cash in the short term.
Liquidity risk
What risk derives from the possibility that the issuer of the investment security will not be able to make future interest and/or principal payments?
Default risk
What risk derives from the possibility that the market rate of interest will increase, resulting in a decrease in the market value of already existing debt?
Interest rate risk
What risk derives from the possibility that a rise in the general price level will result in a reduction in the purchasing power of cash received in the future?
Purchasing power risk
What is the primary concern regarding cash and short-term investments? Two key things.
Liquidity and safety.
The coefficient of variation provides a measure of the relative variability of investments. The lower the CV, the better its total risk-return trade off. Lower CV means less risk. What is the formula for to calculate CV?
CV = Standard Deviation (SD)/Average rate of return on investment (AR)
Lower CV is better. Means less risk
When you are given the standard deviation and expected rate of return for two companies, how do you know what company’s stock is riskier?
Company with higher coefficient of variation. CV = SD/AR.
Investment 1 Expected Return: 16% Standard Deviation: 10% Investment 2 Expected Return: 14% Standard Deviation: 10% How do you know which investment has least amount of risk?
The investment with lowest coefficient of variation. CV = SD/AR.