Working Capital Management Pt. 2 Flashcards
What are 3 motives for holding cash?
transaction motive, speculative motive, and precautionary motive
What are 3 disadvantages of high cash levels?
the negative arbitrage effect (interest obligations exceed interest income from cash reserves)
increased attractiveness as a takeover target
investor dissatisfaction with allocation of assets (failure to pay dividends)
Credit policy is one of the major determinants of demand for a firm’s products or services along with price, product quality, and advertising. Credit policy variables include:
credit period - how long credit buyers have to pay (too long = cash shortages…too short = damaged relationships with customers and negatively affect future sales)
credit standards - required financial strength of credit customers (extending credit to only financially strong customers minimizes uncollectible receivables, but also limits potential sales and vice versa)
collection policy - measured by stringency or laxity in collecting delinquent accounts (balancing act between collecting cash quickly and maintaining positive relationships with customers)
discounts - includes the percentage and period (offering discounts to customers who pay early may result in faster collection)
What are 2 common ratios that can be used to evaluate the effectiveness of an entity’s credit policy?
accounts receivable turnover (ART): accounts receivable turnover = net sales / net average accounts receivable
days sales in accounts receivable = (ending net accounts receivable / net sales) * number of days in the period
T/F: discounts foregone represent a higher cost to the customer than a bank loan for similar financing
True
What are 2 ways to expedite deposits?
EFTs and lockbox systems (a bank receives payments from a company’s customers directly via mailboxes to which the bank has access; payments that arrive in these mailboxes are deposited into the company’s account immediately)
What is concentration banking?
the designation of a single bank as a central depository; advantages include: improved controls over inflows and outflows of cash, reduced idle balances, and improved effectiveness for investments
What is factoring?
turning over the collection of accounts receivable to a third-party in exchange for a discounted short-term loan; cash is collected from the factor immediately rather than from the customer according to the credit terms
What is a letter of credit?
a third-party guarantee, generally by a bank, of financial obligations incurred by the company; it represents an external credit enhancement used by a company issuing otherwise unsecured debt to enhance its credit or can be required by a creditor to ensure payment
What is a line of credit?
a revolving loan with a bank, or group of banks, that is up to a specific dollar maximum amount for a defined term and is renewable upon the maturity date; any outstanding balances under the line of credit reduce the future availability of funds that may be drawn by the company under that line; lines of credit that are drawn represent a loan from the bank(s)
What is a debt covenant?
something used by creditors to protect their interests by limiting or prohibiting the actions of debtors that might negatively affect the positions of the creditors; these covenants can be positive (specifies something the borrower will do) or negative (specifies something the borrower will not do)
when a debt covenant is violated, the debtor is in technical default and the creditor can demand repayment of the entire principal, but most of the time, concessions are negotiated and real default, as opposed to technical default, is avoided
Companies use a mix of short-term and long-term financing to meet their capital requirements
short-term financing: rates tend to be lower than long-term rates and presume greater liquidity, and it is classified as a current liability and decreases working capital
Advantages: increased profitability and decreased financing cost
Disadvantages: increased interest rate risk and decreased capital availability
long-term financing: rates tend to be higher than short-term rates and presume less liquidity, and it is classified as non-current and is not included in the calculation of working capital
Advantages: decreased interest rate risk and increased capital availability
Disadvantages: decreased profitability and increased financing costs
