1
Q
What is net working capital?
A
The difference between current assets and current liabilities.
2
Q
What are the components of net working capital?
A
- Cash and cash equivalents
- Other short-term investments
- Net accounts receivable
- Inventory
- Other current assets such as prepaids
- Minus current liabilities such as accounts payable, current accruals, and short-term financing
3
Q
What is the primary objective of working capital management?
A
To minimize the cost of maintaining sufficient liquidity while guarding against financial insolvency.
4
Q
What are the two main sources of short-term financing?
A
- Bank loans
- Factoring of receivables
5
Q
What is the operating cycle?
A
The amount of time between the acquisition of inventory and the receipt of cash from the sale of the inventory.
Operating Cycle = Days’ Sales in Receivables + Days’ Sales in Inventory
6
Q
What is the cash cycle?
A
The length of time it takes to convert an investment of cash in inventory back into cash, recognizing that some purchases are made on credit.
Cash Cycle = Operating Cycle – Days’ Purchases in Accounts Payable
Or
Cash Cycle = Days’ Sales in Receivables + Days’ Sales in Inventory − Days’ Purchases in Accounts Payable
7
Q
What is the difference between the operating cycle and the cash cycle?
A
The difference is the number of days of sales in payables.
8
Q
What is permanent working capital?
A
The minimum amount of working capital maintained at all times to support the company’s day-to-day sales and activities.
9
Q
What is temporary working capital?
A
It refers to the increases in working capital that occur from time to time, often due to seasonal business activities.
10
Q
What is a conservative working capital policy?
A
It seeks to minimize liquidity risk by increasing the amount of working capital held, increasing the current ratio.
A company with a conservative working capital policy gives up the potentially higher returns available from using some of the working capital to acquire long-term assets, but it is in a safer position with respect to liquidity and the risk of insolvency.
11
Q
What is an aggressive working capital policy?
A
It reduces the amount of working capital and the current ratio, preferring to increase investment in long-term assets.
A company pursuing an aggressive working capital policy accepts a higher risk of short-term cash flow problems in exchange for a greater return on investment.
12
Q
How can a company increase its net working capital?
A
- By increasing current assets
- By decreasing current liabilities
13
Q
How can a company decrease its net working capital?
A
- By decreasing current assets
- By increasing current liabilities
14
Q
What effect does the sale of inventory have on net working capital?
A
The sale of inventory increases net working capital because the receivable created or cash received is greater than the carrying value of the sold inventory.
The difference is gross profit on the sale.
15
Q
What are the main classifications of current assets?
A
- Cash and cash equivalents
- Current marketable securities
- Accounts receivable
- Inventory
16
Q
What are the primary reasons for a company to hold cash?
A
- As a medium of exchange for business transactions
- As a precautionary measure for unforeseen situations
- For speculation to be able to act quickly on opportunities
- As a compensating balance for bank requirements, to support borrowing
17
Q
What determines the level of cash needed by a company?
A
The speed with which inventory is sold and accounts receivable are collected.
18
Q
What is a cash forecast and its purpose?
A
Financial tool used to show the planned sources and uses of cash and to estimate future cash inflows and outflows to determine cash needs and timing for short-term financing for the forecast period.
Cash forecasting helps businesses plan for liquidity needs and ensure they have sufficient cash to meet obligations.
19
Q
What are the two key goals of cash flow management?
A
- Collect cash as quickly as possible
- Delay the payment of cash for as much time as possible
20
Q
What is float in the context of cash management?
A
The total time between the mailing of a check by a customer and the availability of the cash to the receiving company.
Float exists when payment is made by paper check.
21
Q
What are the components of total collection float?
A
- Mail float
- Processing float
- Clearing float
Float exists when payment is made by paper check.
22
Q
What is disbursement float?
A
The difference between what is in the company’s bank account according to the company’s books and what the bank shows to be in the account. The difference is uncleared checks written by the company.
However, maximizing disbursement float is not as easy as it was just a few years ago. Banks have speeded up their check collection process to a great extent, and the opportunity to take advantage of the time required to clear a check is virtually gone.
23
Q
What are the main tools a company can use to delay the payment of cash?
A
- Make payments to vendors by electronic funds transfer, thus closely controlling when the funds will be deducted from the company’s bank account.
- Payment can be made by credit card if doing so would not incur interest or other fees.
24
Q
What is an overdraft?
A
Occurs when debits to a checking account exceed the balance of funds in the account.
25
What is the formula to calculate the cost of not taking a discount offered by suppliers?
365 × Discount % / (Total Period for Payment − Period of Discounted Payment) × (100% − Discount %)
26
What is **concentration banking**?
A system where branches deposit their daily receipts into local banks, and funds are transferred regularly to one central bank account.
27
What is a **lockbox system**?
A company maintains special post office boxes for customer payments and authorizes local banks with which it maintains deposit relationships to pick up the checks from the post office and process them for deposit the same day.
## Footnote
The shift toward the use of payments made through the Automated Clearing House (ACH), wire transfers, virtual card payments, and real-time payment networks has reduced check volumes overall, which has reduced lockbox usage.
28
How can a company benefit from a **lockbox system**?
If the interest revenue earned on the additional funds or the interest expense avoided on borrowings exceeds the cost of the bank fees for the lockbox service.
29
What is **electronic data interchange**?
| (EDI)
The process of using computers from two different companies to communicate directly for common transactions.
30
What is **electronic funds transfer**?
| (EFT)
A form of electronic data interchange (EDI) commonly used to speed up cash collections. Electronic funds transfer is the process of moving money from one bank account to another using computers.
31
What is the cost of not taking a cash discount?
The cost of not taking a cash discount is the annualized interest rate calculated by comparing the discount percentage to the difference in days between the discount period and the full payment period.
## Footnote
The difference between the amount paid early and the amount paid later can be considered “interest” charged for paying later.
32
When should a company take a cash discount?
If the cost of not taking the discount is higher than the company’s cost of capital.
33
# Define:
Marketable securities
Securities that can be easily converted into cash because they have highly liquid secondary markets on which they can be quickly sold at a reasonable price.
34
Why do companies prefer marketable securities over holding large amounts of cash?
Because they provide some return while maintaining liquidity, unlike cash which usually does not provide any return.
35
What is the **primary purpose** of a marketable securities portfolio?
To provide a store of liquidity.
## Footnote
The return earned on the portfolio is a secondary objective.
36
What are the **types of investments** often used to meet a company’s short-term investment needs.
* Money market instruments
* Treasury bills
* Commercial paper
* Banker's acceptances
* Negotiable bank certificates of deposit
* Repurchase agreements
* Money market funds
37
What are **Treasury bills**?
| (T-bills)
Short-term U.S. government debt securities sold at a discount. Their terms range from a few days to 52 weeks (one year), and they are redeemed at par value at maturity. The difference between the par value and the purchase price is the interest earned.
## Footnote
The owner of a Treasury bill may hold it until its maturity date or sell it in the secondary market; so Treasury bills can be easily converted into cash.
38
How is the effective annual percentage rate (APR) of a Treasury bill (T-bill) calculated?
(Interest earned by the T-bill while it is outstanding × 365) / (Discounted Basis × Days to Maturity).
39
What is **commercial paper**?
A marketable short-term, unsecured debt issued by large companies with solid credit histories.
## Footnote
Commercial paper is usually issued in denominations of $100,000 or more. It is sold at a discount and the face value is paid at maturity. The difference between the face value and the discounted purchase price is the interest earned.
40
What is a **banker’s acceptance**?
A form of payment guaranteed by a bank, often used in international trade. A banker’s acceptance is a bank’s guarantee to an exporter that the exporter will receive payment for goods shipped. It can be sold by the exporter at a discount in secondary money markets.
41
What are negotiable bank certificates of deposit?
| (CDs)
CDs are savings deposits with a bank that may not be withdrawn before their maturity without a high penalty.
## Footnote
Negotiable CDs are CDs of higher denominations ($100,000 and over) issued by banks that can be sold in the national money markets. Negotiable CDs issued by top money center banks are easily marketable, though negotiable CDs issued by other banks may have a poor secondary market.
42
What is a **repurchase agreement**?
A sale of government or high-quality corporate debt securities with an agreement to repurchase them at a specific future date at a higher price. They are a form of borrowing for the seller and a form of investment for the buyer.
## Footnote
The difference between the repurchase price and the sale price is interest income to the buyer and interest expense to the seller.
43
What are **money market funds**?
Investment vehicles that pool investment monies from many investors to invest in portfolios of short-term money market securities.
44
What is **interest rate risk**?
The risk of a change in value of a fixed income security due to a change in market interest rates.
45
What is **default risk**?
The risk that a receipt of money due in the future may not be received. For a fixed income security, default risk is the risk that the issuer will not be able to make interest payments or repay the principal.
46
What are the two main ways an investor receives returns from an investment?
* The value of the investment increases, allowing the investor to sell it for a higher price.
* The investment pays a return in the form of dividends or interest.
47
What is the relationship between **investment risk** and **return**?
Higher-returning investments carry more risk than lower-returning investments. Investments with little or no risk offer a lower rate of return.
48
What should funds needed for operating costs be invested in?
Marketable securities with negligible risk.
49
What does a security's **liquidity** describe?
How quickly the security can be converted into cash and how safe the investment is from loss of value.
50
What is the tax status of bonds issued by cities, states, or other local governments?
They are usually federally tax-exempt.
51
What is the **Baumol Cash Management Model** used for?
Calculating the optimal amount of cash to be received every time the company converts current marketable securities to cash.
52
What does the **Miller-Orr Model** provide guidance on?
How much cash a company should hold.
53
What are accounts receivable?
Money that customers owe to the company for goods or services they have received on credit.
54
What are the three elements of a company's credit policy?
* **Credit standards** - determine to whom the company grants credit
* **Credit terms** - the payment period allowed, whether a discount is offered for early payment or a penalty is assessed for late payment, and the size of any discount or penalty
* **Collection efforts** - the amount of time and money spent on trying to collect past due accounts before writing them off as credit losses
55
How do credit policies affect accounts receivable balances?
Credit policies determine the terms of credit extended to customers, impacting the size and turnover of accounts receivable balances.
## Footnote
The company must balance the trade-off between the benefits of credit sales (additional sales that would not be made if only cash sales were accepted) and the costs of carrying and collecting the corresponding accounts receivable (collection costs, foregone interest on uncollected balances, credit loss costs).
56
What is the purpose of an **aging schedule** in accounts receivable management?
To classify accounts and their balances according to the amount of time each has been outstanding.
57
What is the purpose of a **cash discount** (sales or prompt payment discount)?
To encourage early payment of the amount due by giving a discount if the payment is made before the final due date.
58
What does "**Terms: 2/10, n/30**" on an invoice mean?
If the customer pays within 10 days of the invoice date, the customer can pay 2% less than the invoiced amount, and the invoice will be considered paid in full. However, if the customer does not pay within 10 days, the full undiscounted amount is due within 30 days.
59
How is the accounts receivable turnover ratio calculated, and what does it indicate?
The accounts receivable turnover ratio is Net Annualized Credit Sales / Average Accounts Receivable.
It indicates the efficiency of a firm’s accounts receivable collections and the amount of investment in receivables needed to maintain the firm’s level of sales.
60
What does an increase in the accounts receivable turnover ratio mean?
It means that receivables are being collected more rapidly.
61
How is the **Days' Sales in Receivables** calculated, and what does it indicate?
Days' Sales in Receivables = 365 / Accounts Receivable Turnover Ratio
It indicates how many days an average receivable is outstanding before it is collected.
62
What is the purpose of collections procedures?
They aim to ensure timely payment of accounts receivable and minimize credit loss exposure.
## Footnote
Effective collections procedures help maintain cash flow and reduce the risk of credit losses.
63
Why is **inventory management** critical for companies?
Because inventory is often one of the largest items on a company's balance sheet, and changes in inventory costs can significantly impact net income.
64
What are the **types** of inventory a manufacturing company needs to manage?
* Finished goods inventory
* Raw materials inventory
* Work-in-process inventory
65
What is the objective of **managing inventory**?
To balance the need to have enough inventory on hand so that when a customer wants to buy a product or raw materials are needed for production, the inventory is available, while making certain that the company does not have too much inventory, because inventory has both cash costs and opportunity costs.
66
What are the main types of inventory costs?
* **Purchasing costs** - the cost of the inventory plus shipping-in costs
* **Carrying costs** - storing, insuring, and protecting the inventory, inventory taxes, costs of obsolescence or spoilage, losses due to theft and the opportunity cost of the investment in inventory
* **Ordering costs** - placing orders, receiving orders, inspecting items received, recording the receipt of the inventory, and matching invoices with purchase orders and receiving reports
* **Stockout costs** - lost sales when a company does not have inventory available to sell when customers want to buy it
* **Inventory shrinkage** - the difference between the cost of the inventory as recorded on the books and the cost of inventory when it is counted physically
67
# Define:
Inventory carrying costs
The costs of holding inventory, including storage, insurance, protection, inventory taxes, obsolescence, spoilage, potential theft, and the opportunity cost of the investment in inventory.
## Footnote
Carrying costs can significantly impact a company's profitability if not managed properly.
68
What is the **opportunity cost** of inventory?
The cost of capital, representing the return lost by investing cash in inventory instead of some other longer-term investment that will earn a return, either in the form of profits or in dividends or interest.
## Footnote
If inventory is financed, the opportunity cost includes the interest on borrowed funds.
69
What are **stockout costs**?
Costs that occur when inventory is unavailable to meet customer demand, including:
* Lost contribution margin from lost sales
* Potential future sales lost
* Additional shipping costs
* Loss of customer goodwill
## Footnote
Stockout costs occur when inventory is unavailable to meet customer demand.
70
What is **inventory shrinkage**?
The difference between the recorded cost of inventory and the cost when physically counted, which may be due to theft or errors in recording and tracking the inventory.
## Footnote
Shrinkage can affect financial statements and inventory management decisions.
71
What is **lead time** in inventory management?
The amount of time a company must wait to receive the next shipment of inventory after placing an order.
## Footnote
Longer lead times increase the risk of stockouts.
72
What is safety stock?
The amount of inventory the company plans to have on hand when the next shipment of inventory is due to arrive. The level of safety stock a company carries is one of its protections against stockouts.
73
What factors affect the level of **safety stock** a company needs to hold?
* Variability of lead time
* Variability of demand
* Cost of a stockout
## Footnote
Higher variability or stockout costs necessitate more safety stock.
74
What is the formula for calculating the inventory reorder point?
Reorder point = (Average daily usage × Average lead time) + Safety Stock
## Footnote
The reorder point helps determine when to place a new order to avoid stockouts.
75
What does the **Economic Order Quantity** (EOQ) calculate?
The optimal number of units a company should order to minimize total inventory costs, including ordering and carrying costs.
## Footnote
The EOQ assumes constant demand and incorporates the cost of placing an order and carrying one unit of inventory.
76
What is the Economic Order Quantity formula?
EOQ = the square root of (2*aD* / *k*)
## Footnote
Where:
*a* = Variable cost of placing an order
*D* = Demand in units for a given period
*k* = Carrying cost of one unit for the same period used for D
77
What is the goal of **Just-In-Time** (JIT) inventory management?
To minimize inventory levels at all production stages while meeting customer demand in a timely manner with high-quality products at the lowest possible cost.
## Footnote
JIT systems require close supplier relationships and timely deliveries.
78
# Fill in the blank:
An increase in the denominator of the Economic Order Quantity formula—the carrying cost of one unit (*k*)—will cause a(n) \_\_\_\_\_\_\_\_\_\_\_\_\_ (increase/decrease) in the Economic Order Quantity.
decrease
79
What is the **advantage** of a Just-In-Time (JIT) inventory management system?
Reductions in the cost of carrying the inventory, including reductions in the risk of damage, theft, loss, and a lack of ability to sell the finished goods.
80
What is the "rule of thumb" for evaluating if average inventory is **too high**?
If the inventory turnover ratio multiplied by the gross profit margin is 1.0 or higher, the average inventory is not too high.
## Footnote
This rule helps assess inventory efficiency relative to sales and profitability.
81
What are the characteristics of a **high margin/low turnover** company, particularly for a retail operation?
* Carries unique merchandise
* Provides excellent service
* Marketing emphasizes product quality and uniqueness and high level of service
* Charges high prices
## Footnote
These companies must use good judgment in purchasing inventory for resale to ensure sales will be adequate to cover costs.
82
# Define:
Trade credit
A source of credit that arises from purchasing an item on credit, typically appearing on the balance sheet as "Accounts payable."
## Footnote
Accounts payable is a **spontaneous** source of financing and often the largest source of short-term financing for small and medium-sized businesses.
83
What does the term "**spontaneous source of financing**" mean?
One that arises from the process of purchasing an item on credit and the buyer does not need to arrange financing separately from the process of purchasing.
## Footnote
Accounts payable is a spontaneous source of financing.
84
What are some options for short-term financing?
* Bank loans
* Commercial paper
* Lines of credit
* Factoring
85
What is a short-term commercial loan?
A loan that matures in less than one year, usually in 30, 60, or 90 days. When the loan matures, the borrower pays the accrued interest and either pays off the principal or applies for a renewal of the principal.
86
What should short-term commercial loans be used for?
To finance seasonal needs for cash to build up inventory ahead of a busy season
87
What does "**self-liquidating**" mean in the context of short-term commercial lending?
A short-term commercial loan is self-liquidating if it is repaid from the liquidation of the accounts receivable and inventory that it financed. Cash flow from sold inventory and collected receivables is used to pay off the loan after the busy season.
88
What is a secured loan?
One for which the borrower has pledged an asset as collateral.
## Footnote
If the borrower defaults, the lender can take the collateral, sell it, and use the proceeds to repay the loan and the accrued interest.
89
What is a **floating lien**?
A security interest in property that is constantly changing its structural makeup, such as accounts receivable and inventory, as collateral for a loan. If the borrower defaults, the lender can take possession of the receivables and/or inventory, liquidate them, and use the proceeds to pay off the borrower’s loan balance and accrued interest, which usually puts the borrower out of business.
## Footnote
Whatever specific accounts receivable or inventory items are included on any day in the classification “accounts receivable” or “inventory” that is pledged as collateral serve as the security for the loan.
90
What are the benefits of pledging receivables as collateral?
* Access to immediate cash
* Retention of ownership of receivables
## Footnote
Pledging receivables involves using them as security for a loan, allowing businesses to obtain financing without selling the receivables.
91
# Fill in the blanks:
When a company is privately held, a lender will frequently require the owner's \_\_\_\_\_\_\_\_\_\_\_\_\_ \_\_\_\_\_\_\_\_\_\_\_\_ as a secondary repayment source for a loan, with or without other collateral.
personal guarantee
92
What is the effective annual interest rate on a short-term bank loan?
It's the percentage of the outstanding balance that is really paid per year in interest on the loan based on the amount of interest paid and the actual amount of funds received.
## Footnote
It eliminates distortions caused by loans with compensating balances or withheld interest.
93
What is a **compensating balance**?
A minimum balance that a borrower is required to keep in an account with the lending bank as part of a loan agreement.
## Footnote
It reduces the amount of loan proceeds available to the borrower but not the amount of interest paid, so it increases the borrower's effective annual rate of interest on the loan.
94
How is the effective annual interest rate calculated for a loan with a compensating balance requirement?
Effective annual interest rate = (Annualized interest paid on full amount borrowed – Annualized interest received on cash deposited to meet the requirement) / (Amount of the Loan – Additional amount required to be kept on deposit to meet the requirement)
## Footnote
This calculation considers the impact of the compensating balance on the effective cost of borrowing.
95
What happens when a loan's interest is **discounted**?
The bank deducts the full amount of the interest that will be due on the loan from the loan proceeds, so the interest is withheld and not disbursed to the borrower. The borrower agrees to repay the gross amount of the note, including the withheld interest.
## Footnote
This results in an effective interest rate higher than the discount interest rate because the borrower receives less than the face value of the note.
96
What is the formula for the effective annual percentage rate of a discounted interest loan, if the loan is for one year?
Effective Annual Percentage Rate = Interest on the Gross Loan Amount / (Gross Loan Amount – Interest Withheld)
## Footnote
This formula calculates the effective cost of borrowing for one year when interest is withheld from the loan proceeds.
97
What is **factoring of receivables**?
It involves transferring title to receivables by selling them to a factor: a commercial finance company that purchases receivables from companies. The factor collects the cash from the company's customers.
The receivables are sold at a discount in exchange for immediate cash.
## Footnote
Factoring provides quick access to cash from receivables but can be costly due to the discount and fees charged by the factor.
98
What are the two types of factoring contracts, and what is the difference between them?
* **Without recourse** - the company selling its receivables has transferred all risk of credit losses to the factor, and the factor cannot require the company to reimburse it for receivables that turn out to be uncollectible.
* **With recourse** - the company selling the receivables retains the credit loss risk and must reimburse the factor for any receivables that are not collected.
## Footnote
The factor's fee charged for a sale without recourse will be higher than it would be for the same receivables sold with recourse.
99
What are the three amounts that reduce the cash received by a company when it factors its receivables?
* Factor’s fee
* Interest
* Allowance for customer returns
100
What are the **benefits** of factoring as a means of financing?
* It is like outsourcing collections activities
* Costs and time for collections are reduced
* The factor can often operate more efficiently in collecting receivables because of the specialized nature of its service
* Eliminating credit losses if sold without recourse
## Footnote
Factoring allows companies to focus on other priorities while the factor efficiently collects receivables.
101
What are the **limitations** of factoring as a means of financing?
* The fees involved with factoring can be high
* The reduction in costs from not needing to collect receivables may not completely offset the factor's fees.
102
What is a revolving line of credit?
A pre-approved loan available to the borrower, usually secured by the company's inventory and/or receivables, allowing the balance to fluctuate as it is drawn on and repaid.
## Footnote
Interest on a revolving line of credit is usually charged on the balance that is outstanding against the line and a commitment fee may be charged on the unused amount.
103
What is the purpose of a **chattel mortgage**?
A loan secured by movable, identifiable personal property such as a vehicle or other equipment.
## Footnote
A chattel mortgage may not be a source of short-term credit.
104
What is **commercial paper**?
A short-term, unsecured promissory note issued by large, creditworthy companies.
## Footnote
Commercial paper is a marketable security. Its secondary market is very small because the term of commercial paper is very short, and buyers of commercial paper usually purchase it with maturities that coincide with when they expect to need their money back from their investment.
105
What is the maturity matching approach to working capital management?
It involves matching each type of asset to be financed with a source of financing that has the same maturity time frame.
## Footnote
Current assets are generally financed with current liabilities, except for the permanent portion of accounts receivable and inventory, which are financed by long-term debt or equity. Long-term assets such as property, plant, and equipment are financed with long-term capital.
CMA® Part 2
flashcards
Decks in class (19)
# Cards
-
A.1. Comparative Financial Statement Analysis11
-
A.2. Financial Ratio Analysis150
-
A.3. Profitability Analysis37
-
A.4. Advanced Financial Topics60
-
B.1. Risk and Return Fundamentals57
-
B.2. Long-Term Financial Management124
-
B.3. Raising Capital and Financial Markets38
-
B.4. Working Capital Management105
-
B.5. Corporate Restructuring and Valuation39
-
B.6. International Finance68
-
C.1. Cost-Volume-Profit (CVP) Analysis52
-
C.2. Marginal Analysis and Decision Making57
-
C.3. Pricing Decisions86
-
D.1. Enterprise Risk Management (ERM)80
-
E.1. Capital Investment Analysis and Cash Flows34
-
E.2. Capital Investment Methods and Risk97
-
F.1. Business Ethics and Fraud30
-
F.2. IMA Code of Ethics and Fraud Triangle14
-
F.3. Organizational Ethics and Culture64
