Working Capital Metrics

Question 1

Net working capital is the difference between:

Answer 1

C. Total assets and total liabilities.

Question 2

What is the relationship between the allowance for doubtful accounts and working capital?

Answer 2

When bad debts expense is recorded for the period, working capital decreases.

A company that records bad debt expense for a period also
recognizes an increase in the contra-account, allowance for doubtful accounts. When this occurs, the company’s net realizable value on outstanding accounts receivables declines, lowering its current assets. Because working capital is current assets less current liabilities, the company’s working capital decreases for the period.

Question 3

Determining the appropriate level of working capital for a firm requires requires offsetting the benefit of:

Answer 3

Current assets and current liabilities against the probability of technical insolvency

Question 4

The working capital financing policy that finances _________ current assets with ________________ debt subjects the firm to the greatest risk of being unable to meet the firm’s maturing obligations.

Answer 4

permanent

short-term

Question 5

The use of _______________ financing produces the SMALLEST risk of being unable to meet maturing obligations.

Answer 5

long-term debt

Question 6

What is the formula for current ratio?

Answer 6

The current ratio is equal to current assets divided by current liabilities.

Question 7

What is the formula for quick ratio?

Answer 7

(Current assets - Inventory) / Current Liabilities

Question 8

The current ratio of a company is 1.5. Which of the following transactions will cause the current ratio to increase?

A. Payment on accounts payable.
B. Cash received from an account receivable.
C. Purchase of inventory on account.
D. Purchase of equipment for cash.

Answer 8

Choice “A” is correct. The current ratio is a measure of working capital that is
calculated by dividing current assets by current liabilities. The current ratio is equal to 1.5, which means that current assets are 50 percent greater than current liabilities.
For example, assume that current assets are 150 and current liabilities are 100. A
payment of accounts payable reduces a current liability and a current asset (cash). If
we assume that the payable was 25, the new current ratio will be 125 / 75 = 1.60. This is higher than the original ratio of 1.50. Note that any numbers could have been used and the current ratio will be higher than its original 1.50.

Question 9

The formula for working capital is

Answer 9

Current Assets - Current Liabilities

Question 10

Which one of the following would increase the working capital of a firm?

A. Cash collection of accounts receivable.
B. Refinancing of accounts payable with a two-year note payable.
C. Cash payment of accounts payable.
D. Payment of a 30-year mortgage payable with cash.

Answer 10

Explanation
Choice “B” is correct. Working capital (WC) increases only if current assets are
increased or current liabilities are decreased. Exchanging accounts payable (current liability) for a two-year note payable (long-term liability) would decrease current liabilities and increase working capital.

Choice “A” is incorrect. This would not impact WC.
Choice “C” is incorrect. This would not have an impact on WC (decrease of both CA
and CL).
Choice “D” is incorrect. This would decrease WC

Question 11

What are considered current assets?

Answer 11

• Cash
• Accounts Receivable
• Short Term Notes Receivable
• Inventory

Question 12

A high ______________ratio is desirable because it indicates the company has more liquid short-term assets on its
balance sheet.

Answer 12

quick ratio (aka acid test ratio)

Question 13

A high _________ratio would not be desirable to a store’s creditors,
as it indicates that the company has high financial leverage on its balance sheet.

Answer 13

debt

Question 14

Having a high ____________________ ratio would not be desirable a store’s creditors because the trade receivables are deemed to have a long collection period.

Answer 14

days’ sales outstanding

Question 15

A low _________________ is not desirable to a store’s creditors because inventory is staying on the store shelves longer and is taking longer to convert to cash.

Answer 15

inventory turnover ratio

Question 16

What is the quick ratio?

Answer 16

Quick Assets / Current Liabilities

Question 17

What are quick assets?

Answer 17

Current assets minus (inventory and prepaids)

Examples/ Cash and Accounts Receivable

Question 18

What is the inventory turnover ratio?

Answer 18

Cost of goods sold / Average inventory

Note: Average inventory = [(beginning inventory + ending inventory) / 2]

Question 19

What kind of transaction would increase the current ratio AND decrease net profit?

Answer 19

Sale of a long term asset (aka land) at less than book value.

(The current ratio is current assets divided by current liabilities. The sale of land would increase cash and therefore current assets without increasing current liabilities. This would increase the current ratio. Furthermore, the sale of land at a loss would decrease net profit)

Question 20

What is the calculation for cost of goods sold with respect to sales?

Answer 20

COG sold = Sales x (1 - Gross Profit Percentage)

Question 21

The cash conversion cycle is equal to ____________________________.

Answer 21

ANSWER : days in inventory
period PLUS days sales in accounts receivable MINUS the days of payables outstanding.

It can be thought of as how long it takes for a company to buy inventory on credit from a vendor, sell that inventory on credit, collect cash for the sale, and use the proceeds to pay the vendor for the purchase.

Question 22

A company purchases inventory on terms of net 30 days and resells to its customers on terms of net 15 days. The days in inventory averages 60 days. What is the company’s cash conversion cycle?

A. 15 days.
B. 45 days.
C. 75 days.
D. 105 days.

Answer 22

Choice “B” is correct. The cash conversion cycle is equal to the days in inventory
period plus days sales in accounts receivable less the days of payables outstanding. It can be thought of as how long it takes for a company to buy inventory on credit from a vendor, sell that inventory on credit, collect cash for the sale, and use the proceeds to pay the vendor for the purchase. For this company, the cash conversion cycle will be
60 + 15 – 30 = 45 days.

Question 23

What is the formula for cash conversion cycle?

Answer 23

Days in inventory plus days sales in accounts receivable minus days of payables outstanding.

Question 24

Financial information about a company is as follows:
Receivables $4,000,000
Inventory 2,600,000
Payables 3,700,000
Sales 50,000,000
Cost of goods sold 45,000,000

Assuming a 365-day year, what is the number of days in the company’s cash conversion
cycle?

A. 18.2 days.
B. 20.3 days.
C. 21.2 days.
D. 23.5 days

Answer 24

ANSWER: B

The cash conversion cycle is equal to the days in inventory plus days sales in accounts receivable minus days of payables outstanding. The calculation is as follows:

2.6M/(45M/365) + 4M/(50M/365) - 3.7M/(45m/365) = 20.3 days

Question 25

What is the formula for accounts receivable turnover?

Answer 25

AR Turnover = Sales / Average Accounts Receivable

Question 26

The main reason that a firm would strive to reduce the days sales in accounts receivable is to increase _______________.

Answer 26

CASH

Question 27

The ___________________ represents the weighted average of the periods that accounts receivable are outstanding.

What’s the formula?

Answer 27

Average collection period

Day customer pays on x the percentage of customer that pay on that day + ………

Note: This is the SAME as the “Day’s sales in accounts receivable”

Question 28

What is the formula for “Day’s Sales in accounts receivable”?

Answer 28

Day’s Sales in accounts receivable = Ending accounts receivable / Average Daily Sales

Question 29

Purchasing inventory (a current asset) with accounts payable (a current liability) is an example of ___________________________.

Answer 29

Aggressive working capital management

NOTE: Aggressive working capital management is when current assets are financed with current liabilities (as opposed to long-term liabilities).