2 SU- 6.1 Working Capital What is working capital and types of capital policies What all is included in working capital? Net working capital = What is used to acquire working capital? What is the objective of having working capital? Capital policies include: Conservative = minimize risk = < current ratio & acid test ratio So if you did not conserve current assets what would you do with them? Aggressive = Permanent and Temporary Working Capital Permanent financed with long-term debt Why?
3 Working Capital Question 1 Question 1 - CMA2 Study Unit 6: Managing Current Assets During the year, Mason Company s current assets increased by $120,000, current liabilities decreased by $50,000, and net working capital A. Increased by $70,000. B. Did not change. C. Decreased by $170,000. Increased by $170,000.Correct Answer: D Net working capital is the excess of current assets over current liabilities. An increase in current D. assets or a decrease in current liabilities increases working capital. Thus, net working capital increased by $170,000 ($120,000 + $50,000).
4 Working Capital Answer 1 Correct Answer: D Net working capital is the excess of current assets over current liabilities. An increase in current assets or a decrease in current liabilities increases working capital. Thus, net working capital increased by $170,000 ($120,000 + $50,000). Incorrect Answers: A: Both the increase in current assets and the decrease in current liabilities increase working capital. B: Net working capital did change. C: Net working capital increased.
5 Working Capital Question 2 Question 2 - CMA2 Study Unit 6: Managing Current Assets Mason Company s board of directors has determined 4 options to increase working capital next year. Option 1 is to increase current assets by $120 and decrease current liabilities by $50. Option 2 is to increase current assets by $180 and increase current liabilities by $30. Option 3 is to decrease current assets by $140 and increase current liabilities by $20. Option 4 is to decrease current assets by $100 and decrease current liabilities by $75. Which option should Mason choose to maximize net working capital? A. Option 1. B. Option 2. C. Option 3. D. Option 4.
6 Working Capital Answer 2 Net working capital is the excess of current assets over current liabilities. An increase in current assets or a decrease in current liabilities will increase net working capital. Option 1 maximizes Mason Company s net working capital, increasing it by $170 ($120 + $50). Incorrect Answers: B: Option 2 increases net working capital by $150. C: Option 3 decreases net working capital by $160. D: Option 4 decreases net working capital by $25.
7 Working Capital Question 3 Question 3 - CMA2 Study Unit 6: Managing Current Assets Starrs Company has current assets of $400,000 and current liabilities of $300,000. Starrs could increase its net working capital by the A. B. C. D. Prepayment of $50,000 of next year s rent. Refinancing of $50,000 of short-term debt with long-term debt. Acquisition of land valued at $50,000 through the issuance of common stock. Purchase of $50,000 of trading securities for cash.
8 Working Capital Answer 3 Correct Answer: B Net working capital is defined as the excess of current assets over current liabilities. Refinancing short-term debt with long-term debt decreases current liabilities with no effect on current assets, resulting in an increase in working capital. Incorrect Answers: A: A prepayment of expenses does not change current assets or current liabilities. Cash decreases by the same amount that prepaid rent increases. C: The acquisition of land (a noncurrent asset) for common stock (an equity interest) does not affect either current assets or current liabilities. D: The purchase of trading securities does not affect total current assets. Cash is replaced by trading securities, another current asset.
9 Working Capital Question 4 Question 4 - CMA2 Study Unit 6: Managing Current Assets If a firm increases its cash balance by issuing additional shares of common stock, net working capital A. Remains unchanged and the current ratio remains unchanged. B. Increases and the current ratio remains unchanged. C. Increases and the current ratio decreases. D. Increases and the current ratio increases.
10 Working Capital Answer 4 Correct Answer: D Net working capital is the excess of current assets over current liabilities. The current ratio equals current assets divided by current liabilities. Selling stock for cash increases current assets and stockholders equity, with no effect on current liabilities. The result is an increase in working capital and the current ratio. Incorrect Answers: A: Both working capital and the current ratio increase. B: Both working capital and the current ratio increase. C: Both working capital and the current ratio increase.
11 SU 6.2 Cash Management Read Gleim Success Tip on page 218 Managing the cash levels Motives What is the firms optimal cash? EOQ As applied to cash Forecasting future cash flows (see examples on page 219, very typical test questions!) Methods to Speed up cash flows (see example 1 & 2 page 220) Slow down cash flows
12 Cash Management Question 1 Question 1 - CMA2 Study Unit 6: Managing Current Assets The economic order quantity (EOQ) formula can be adapted in order for a firm to determine the optimal split between cash and marketable securities. The EOQ model assumes all of the following except that A. The cost of a transaction is independent of the dollar amount of the transaction. Interest rates are constant over the short B. run. There is an opportunity cost associated C. with holding cash, beginning with the first dollar. D. Cash flow requirements are random.
13 Cash Management Answer 1 Correct Answer: D The EOQ formula is a deterministic model that requires a known demand for inventory or, in this case, the amount of cash needed. Thus, the cash flow requirements cannot be random. The model also assumes a given carrying (interest) cost and a flat transaction cost for converting marketable securities to cash, regardless of the amount withdrawn. Incorrect Answers: A: Use of the EOQ model assumes that the cost of a transaction is independent of the dollar amount of the transaction. B: Use of the EOQ model assumes that interest rates are constant over the short run. C: Use of the EOQ model assumes that there is an opportunity cost associated with holding cash, beginning with the first dollar.
14 Cash Management Question 2 Question 2 - CMA2 Study Unit 6: Managing Current Assets What is the benefit for a firm with daily cash receipts of $15,000 to be able to speed up collections by 2 days, assuming an 8% annual return on short-term investments and no cost to the company to speed up collections? A. $2,400 daily benefit. B. $2,400 annual benefit. C. $15,000 annual benefit. D. $30,000 annual benefit.
15 Cash Management Answer 2 Correct Answer: B Speeding up collections by 2 days will raise the firm s average cash balance by $30,000. At 8% interest, the benefit will be $2,400 annually [($15,000 2 days).08]. Incorrect Answers: A: This figure is the annual, not the daily, benefit. C: This figure is the amount of daily cash receipts. D: This figure is the reduction in receivables.
16 Cash Management Question 3 Question 3 - CMA2 Study Unit 6: Managing Current Assets DLF is a retail mail order firm that currently uses a central collection system that requires all checks to be sent to its Boston headquarters. An average of 6 days is required for mailed checks to be received, 3 days for DLF to process them, and 2 days for the checks to clear through its bank. A proposed lockbox system would reduce the mailing and processing time to 2 days and the check clearing time to 1 day. DLF has an average daily collection of $150,000. If DLF adopts the lockbox system, its average cash balance will increase by A. $1,200,000 B. $750,000 C. $600,000 D. $450,000
17 Cash Management Answer 3 Correct Answer: A Checks are currently tied up for 11 days (6 for mailing, 3 for processing, and 2 for clearing). If that period were reduced to 3 days, DLF s cash balance would increase by $1,200,000 ($150,000 per day 8 days). Incorrect Answers: B: The decrease is 8 days, not 5. C: The amount of $600,000 represents only a 4-day savings. D: The lockbox system will result in an additional 8 days of savings, not 3.
18 Cash Management Question 4 Question 4 - CMA2 Study Unit 6: Managing Current Assets A firm has daily cash receipts of $300,000. A commercial bank has offered to reduce the collection time by 2 days. The bank requires a monthly fee of $3,000 for providing this service. If the money market rates will average 11% during the year, the annual pretax income (loss) from using the service is A. $(30,000) B. $30,000 C. $66,000 D. $63,000
19 Cash Management Answer 4 Correct Answer: B The additional annual income (loss) from using the bank s proposed service is the excess (deficit) of interest earned on the early deposits over (under) the cost of the service. If the plan is adopted, the firm s average cash balance will increase by $600,000 ($300,000 2 days). Benefit (loss) = Interest earned Cost = ($600,000 11%) ($3, months) = $66,000 $36,000 = $30,000 Incorrect Answers: A: This figure results from subtracting the interest earned from the cost. C: This figure results from failing to subtract the $36,000 cost of the service. D: This figure results from subtracting the service charge for only a single month.
20 SU 6.3 Marketable Securities Management Types of Marketable Securities U.S. Treasury obligations T-bills T-notes T-bonds Repos Federal agency securities Bankers acceptances Commercial paper CD s Eurodollars Others Money-market mutual funds and state and muni shortterm securities
21 SU 6.4 Receivable Management Overview A firm must balance default risk and sales maximization Basic Receivable Formulas Average collection period (see example on page 224) Accounts Rec. days vs. dollars (see page 224) Assessing impact of a credit term change (see example page 225)
22 Receivable Management Question 1 Question 1 - CMA2 Study Unit 6: Managing Current Assets A change in credit policy has caused an increase in sales, an increase in discounts taken, a reduction in the investment in accounts receivable, and a reduction in the number of doubtful accounts. Based upon this information, we know that A. Net profit has increased. B. The average collection period has decreased. C. Gross profit has declined. D. The size of the discount offered has decreased.
23 D: The discount may have been increased, which has led to quicker payments. Receivable Management Answer 1 An increase in discounts taken accompanied by declines in receivables balances and doubtful accounts all indicate that collections on the increased sales have been accelerated. Accordingly, the average collection period must have declined. The average collection period is a ratio calculated by dividing the number of days in a year (365) by the receivable turnover. Thus, the higher the turnover, the shorter the average collection period. The turnover increases when either sales (the numerator) increase or receivables (the denominator) decrease. Accomplishing both higher sales and a lower receivables increases the turnover and results in a shorter collection period. Incorrect Answers: A: No statement can be made with respect to profits without knowing costs. C: No statement can be made with respect to profits without knowing costs.
24 Receivable Management Question 2 - CMA2 Study Unit 6: Managing Current Assets A change in credit policy has caused an increase in sales, an increase in discounts taken, a decrease in the amount of bad debts, and a decrease in the investment in accounts receivable. Based upon this information, the company s Question 2 A. Average collection period has decreased. B. Percentage discount offered has decreased. C. Accounts receivable turnover has decreased. D. Working capital has increased.
25 Receivable Management Correct Answer: A Answer 2 An increase in discounts taken accompanied by declines in receivables balances and doubtful accounts all indicate that collections on the increased sales have been accelerated. Accordingly, the average collection period must have declined. The average collection period is a ratio calculated by dividing the number of days in a year (365) by the receivable turnover. Thus, the higher the turnover, the shorter the average collection period. The turnover increases when either sales (the numerator) increase, or receivables (the denominator) decrease. Accomplishing both higher sales and a lower receivables increases the turnover and results in a shorter collection period. Incorrect Answers: B: A decrease in the percentage discount offered provides no incentive for early payment. C: Accounts receivable turnover (sales average receivables) has increased. D: No information is given relative to working capital elements other than receivables. Both receivables and cash are elements of working capital, so an acceleration of customer payments will have no effect on working capital.
26 Receivable Management Question 3 - CMA2 Study Unit 6: Managing Current Assets Clauson, Inc., grants credit terms of 1/15, net 30 and projects gross sales for next year of $2,000,000. The credit manager estimates that 40% of their customers pay on the discount date, 40% on the net due date, and 20% pay 15 days after the net due date. Assuming uniform sales and a 360-day year, what is the projected days sales outstanding (rounded to the nearest whole day)? Question 3 A. 20 days. B. 24 days. C. 27 days. D. 30 days.
27 Receivable Management Correct Answer: C Answer 3 The days sales outstanding can be determined by weighting the collection period for each group of receivables by its collection percentage. Hence, the projected days sales outstanding equal 27 days [(15 days 40%) + (30 days 40%) + (45 days 20%)]. Incorrect Answers: A: Average receivables are outstanding for much more than 20 days. B: Twenty-four days assumes 40% of receivables are collected after 15 days and 60% after 30 days. D: More receivables are collected on the 15th day than on the 45th day; thus, the average must be less than 30 days.
28 Receivable Management Question 4 - CMA2 Study Unit 6: Managing Current Assets A firm averages $4,000 in sales per day and is paid, on an average, within 30 days of the sale. After they receive their invoice, 55% of the customers pay by check, while the remaining 45% pay by credit card. Approximately how much would the company show in accounts receivable on its balance sheet on any given date? Question 4 A. $4,000 B. $48,000 C. $54,000 D. $120,000
29 Receivable Management Correct Answer: D Answer 4 The average balance of receivables is $120,000 ($4, days). Whether customers pay by credit card or check, collection requires 30 days. Incorrect Answers: A: The amount of $4,000 is only 1 day s sales. B: Invoices are outstanding for 30 days, not 12 days. C: The amount of $54,000 is based on the 45% of collections via credit card.
30 SU 6.5 Inventory Management Overview Inventory costs Inventory Replenishment Models (see example on page 228)
31 SU 6.6 Short-term Financing Sources Spontaneous Forms of Financing Cost of not taking a discount (see example page 230) Short-term bank loans Simple interest loans Effective Interest Rate on a Loan Discounted Loans Continued
32 SU 6.6 Short-term Financing Loans with Compensating Balances Lines of Credit with Commitment Fees Market-Based Instruments Secured Financing Factoring Receivables Maturity Matching
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