Working Capital Metrics Flashcards
T/F: working capital policy and working capital management involve managing cash so that a company can meet its short-term obligations
True; it includes all aspects of the administration of current assets and current liabilities; the goal of working capital management is shareholder wealth maximization
Formula for net working capital
net working capital = current assets - current liabilities
T/F: the net amount of working capital measures the amount by which current assets exceed current liabilities, and the current ratio measures the number of times current assets exceed current liabilities and is a way of measuring short-term solvency
True; the current ratio also demonstrates a firm’s ability to generate cash to meet its short-term obligations
formula: current ratio = current assets / current liabilities
T/F: the current ratio measures liquidity at a point in time, but it is not indicative of future cash flows
True; in general, a higher current ratio is better; unless short-term liquidity is a relevant issue, the current ratio is not necessarily the best measure of health of a business
Deteriorating and Improving Current Ratio
deteriorating - a decline in the current ratio, which implies a reduced ability to generate cash, can be attributable to increases in short-term debt, decreases in current assets, or a combination of both
improving - an increase or improvement in the current ratio implies an increased ability to pay off current liabilities and may be attributable to using long-term borrowing to repay short-term debt (in cases in which a firm lacks cash to reduce current assets)
T/F: the quick ratio is a more rigorous test of liquidity than the current ratio because inventory and prepaids are excluded from current assets
True; inventory is the least liquid of current assets; the ability to meet current obligations without liquidating inventory is important; the higher the quick ratio (aka acid-test ratio), the better
formula: quick ratio = (cash and cash equivalents + short-term marketable securities + net receivables) / current liabilities
T/F: turnover ratios generally use average balances for balance sheet components
True; however, some CPA exam questions instruct to use year-end balances instead; be sure to read the question carefully
T/F: the cash conversion cycle (aka net operating cycle) is the length of time from the date of the initial expenditure for production to the date cash is collected from the customers offset by the length of time it takes to pay vendors for the initial expenditures
True; see formula below
cash conversion cycle = days in inventory + days sales in accounts receivable - days of payables outstanding
days in inventory
these two formulas measure the effectiveness of an entity’s inventory management
inventory turnover = cost of goods sold / average inventory
days in inventory = ending inventory / (cost of goods sold / 365)
days sales in accounts receivable
these two formulas measure the effectiveness of a company’s credit policy
accounts receivable turnover = net sales / average net accounts receivable
days sales in accounts receivable = ending net accounts receivable / (net sales / 365)
days of payables outstanding
these two formulas measure the effectiveness of a company’s attempt to delay payment to creditors
accounts payable turnover = cost of goods sold / average accounts payable
days of payables outstanding = ending accounts payable / (cost of goods sold / 365)
Fact: a company should minimize the amount of time it takes to convert inventory to cash while maximizing the amount of time it takes to pay vendors
the lower the cash conversion cycle, the better; each component of the cash conversion cycle should be analyzed individually: days in inventory, days sales in accounts receivable, and days of payables outstanding
What is the working capital turnover formula?
working capital turnover - sales / average working capital
average working capital –> the beginning-of-period plus end-of-period working capital divided by 2
working capital turnover is a measure of how effective a company is at generating sales based on funds used in operations
Fact: a higher working capital turnover ratio implies that a company is doing a relatively good job converting its working capital into sales
too low of a ratio implies too much money is invested in current assets such as receivables and inventory relative to the amount of sales a company is generating from that capital; too high of a ratio implies that there may not be enough capital in place to continue to support operations and sales
