Working Capital Management Flashcards
What is the objective of working capital management?
To maintain adequate working capital so as to:
- Meet ongoing operating and financial needs of the firm
- Not over-invest in net working capital, which provides low returns or increases costs.
Define “current liabilities.”
Obligations due to be settled within one year or that will require the use of current assets to satisfy (e.g., accounts payable, other short-term payables, some unearned revenue, etc.)
Give examples of over-investing in working capital.
- Maintaining excess cash in low-return accounts
- Having excessive (large/old) accounts receivable that don’t earn interest
- Maintaining more inventory than needed and thus incurring storage costs and increasing the risk of obsolete inventory.
Define “working capital” (also called net working capital).
The difference between a firm’s current assets and its current liabilities; expressed as: Current assets - Current liabilities = Working Capital
Define “current assets.”
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.)
Describe the operation of a lockbox system.
Customers remit payments to a firm’s post office box, where they are collected and then processed and deposited by the firm’s bank; may reduce the float by several days.
Describe the user of preauthorized checks and preauthorized debit/credit cards.
Payment/collection of an amount due through the use of checks or debit/credit card charges that are authorized in advance.
Define “incoming float.”
The time between when a payment is initiated and when the related cash is available for use by the recipient.
Identify the advantages of using a lockbox system.
- Cash is available for use sooner than it would be if receipts were routed through the firm.
- Firm’s handling of collections is greatly reduced.
- There is a reduced likelihood of dishonored checks and earlier identification of those that are dishonored.
Describe concentration banking.
Funds collected in multiple local banks are transferred regularly and (usually) automatically to a firm’s primary bank; used to accelerate the flow of cash to a firm’s principal bank.
Describe the uses of zero-balance accounts.
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).
Describe a payment through guaranteed draft.
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.
What is the coefficient of variation and how is it computed for investment analysis?
The coefficient of variation is a measure of the relative variation around a mean (average) value.
For investment analysis it is computed as: Standard deviation of investment / Average return of investment.
What is the Sharpe Ratio and how is it computed?
The Sharpe Ratio is a measure of return per unit of risk.
It is computed as: (Average rate of return earned - Risk free rate) / Standard deviation of investment return
Define “default risk.”
A measure of the likelihood that the issuer will not be able to make future contracted interest and/or principal payments to a security holder.
Define “banker’s acceptance.”
A draft (order to pay) drawn on a specific bank by a firm that has an account with the bank. If bank “accepts” the draft, it becomes a negotiable debt instrument of the bank.
Define “commercial paper.”
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).
What are the major considerations in selecting short-term securities as investments?
- Safety of principal
- Price stability of the investment
- Marketability or liquidity of the investment
What are United States Treasury Bills (also called T-Bills)?
Debt investment instruments that are the direct obligation of the U.S. government. They are considered to be virtually risk-free and are commonly used as the basis for the risk-free rate of return in many financial analyses.
Define “repurchase agreement” (also called repo).
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.
Describe the accounts-receivable management function.
Management functions concerned with the conditions leading to the recognition and collection of accounts receivables.
Identify two major approaches to determining a customer’s creditworthiness.
- Use of credit-rating service.
2. Financial analysis of prospective credit customer.
Describe an aging of accounts receivable schedule.
A schedule that 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 overdue, over 90 days overdue.
Identify some measures (averages and ratios) useful in assessing accounts-receivable management.
- Average collection period
- Day’s sales in accounts receivable
- Accounts receivable turnover
- Accounts receivable to current or total assets
- Bad debt to sales
- Aging schedule of accounts receivable
Identify the general credit-related factors that must be determined by an entity if it sells on account.
- Total period for which credit will be extended for sales on account
- Discount terms, if any, granted for early payment of credit sales
- Penalty for failure to pay according to credit terms
- Nature and extend of documentation required for sales on account
Identify the central objective of inventory management.
To determine and maintain an optimum investment in all inventories. Underinvesting in inventory can result in shortages and lost sales; overinvesting in inventory can result in incurring excessive cost for inventory.
Identify the characteristics of a traditional materials-requirement-planning inventory system.
- Supply push - goods are produced in anticipation of there being a demand for the goods.
- Inventory buffers are maintained.
- Setup times and production runs are long.
- Relationships with suppliers are impersonal; suppliers are selected through a bidding process.
- Quality standards = Acceptable levels; allows for some defects.
- Traditional cost accounting is used.
Identify the benefits of just-in-time inventory system (when compared with a traditional materials-requirement-planning inventory system).
- Reduced investment in inventory
- Lower cost of inventory transportation, warehousing, insurance, taxes, and related costs
- Reduced lead time in acquiring inputs
- Lower cost of defects
- Less complex and more relevant accounting and performance measurement
