Term
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Definition
| the length of time from the point at which a company pays for raw materials until the point at which it receives cash from the sale of finished goods made from those materials |
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Term
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Definition
| the time between when a customer makes a payment and when the cash becomes available to the firm |
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Term
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Definition
| short-term debt in the form of promissory notes issued by large, financially secure firms with high credit ratings |
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Term
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Definition
| bank balances that firms must maintain to at least partially compensate banks for loans or services rendered |
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Term
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Definition
| credit extended by a business to consumers |
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Term
| economic order quantity (EOQ) |
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Definition
| order quantity that minimizes the total costs incurred to order and hold inventory |
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Term
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Definition
| an individual or a financial institution, such as a bank or a business finance company, that buys accounts receivable without recourse |
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Term
| flexible current asset management strategy |
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Definition
| current asset management strategy that involves keeping high balances of current assets on hand |
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Term
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Definition
| a contractual agreement between a bank and a firm under which the bank has a legal obligation to lend funds to the firm up to a preset limit; also known as revolving credit |
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Term
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Definition
| a verbal agreement between a bank and a firm under which the firm can borrow an amount of money up to an agreed-on limit |
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Term
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Definition
| expenses associated with maintaining inventory, including interest forgone on money invested in inventory, storage costs, taxes, and insurance |
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Term
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Definition
| A system that allows geographically dispersed customers to send their payments to a post office box near them |
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Term
| long-term funding strategy |
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Definition
| financing strategy that relies on long-term debt and equity to finance both fixed assets and working capital |
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Term
| maturity matching strategy |
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Definition
| financing strategy that matches the maturities of liabilities and assets |
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Term
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Definition
| the average time between receipt of raw materials and receipt of cash for the sale of finished goods made from those materials |
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Term
| permanent working capital |
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Definition
| the minimum level of working capital that a firm will always have on its books |
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Term
| restrictive current asset management strategy |
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Definition
| current asset management strategy that involves keeping the level of current assets at a minimum |
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Term
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Definition
| costs incurred because of lost production and sales or illiquidity |
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Term
| short-term funding strategy |
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Definition
| financing strategy that relies on short-term debt to finance all seasonal working capital and a portion of permanent working capital and fixed assets |
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Term
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Definition
| credit extended by one business to another |
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Term
| Which one of the following statements is NOT true? |
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Definition
Working capital management involves making decisions regarding the use and sources of current assets.
Net working capital (NWC) refers to the difference between current assets and current liabilities.
Working capital efficiency refers to the length of time between when a working capital asset is paid for and when it is converted into cash.
XX Gross working capital is the funds invested in a company's current liabilities. |
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Term
| Which one of the following statements is NOT true? |
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Definition
The economic order quantity (EOQ) mathematically determines the minimum total inventory cost.
XX The EOQ ignores reorder costs and inventory carrying costs.
The optimal order size is determined by the EOQ model.
All of these. |
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Term
| Operating cycle: Trend Foods distributes its products to more than 100 restaurants and delis. The company's collection period is 32 days, and it keeps its inventory for 10 days. What is Trend's operating cycle? |
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Definition
DSI = 10 days
DSO = 32 days
Operating Cycle = DSO + DSI
= 32 + 10 = 42 days |
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Term
| Operating cycle: Le Baron Company, a men's designer firm, has an operating cycle of 123 days. The firm's days' sales in inventory is 73 days. How much does the firm have in receivables if it has credit sales of $433,450? (Round to the nearest dollar.) |
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Definition
Operating cycle = 123 days
DSI = 73 days
Operating cycle = DSO + DSI
DSO = OC – DSI = 123 – 73 = 50 days
Credit sales = $433,450
DSO = Accounting receivables/(credit sales/365)
= AR/($433,450/365)= 50 days
AR = 50 x $1,187.53 = $59,376.71 |
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Term
| Cash conversion cycle: Wolfgang Electricals estimates that it takes the company 31 days on average to pay off its suppliers. It also knows that it has days' sales in inventory of 54 days and days sales' outstanding of 34 days. What is its cash conversion cycle? |
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Definition
DPO = 31 days
DSI = 54 days
DSO = 34 days
Cash conversion cycle = DSO + DSI - DPO
= 34 + 54 - 31 = 57 days |
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Term
| Formal line of credit: Gibbs, Inc., has just set up a formal line of credit of $1 million with First National Bank. The line of credit is good for up to five years. The bank will be charging them an interest rate of 6.25 percent on the loan, and in addition the firm will pay an annual fee of 50 basis points on the unused balance. The firm borrowed $600,000 on the first day the credit line became available. What is the firm's effective interest rate on this line of credit? |
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Definition
Line of credit limit = $1,000,000
Loan rate = 6.25%
Annual fee on unused balance = 0.5%
Amount borrowed = $600,000
Unused balance = $400,000
Annual fee = $400,000 x 0.005 = $2,000
Interest expense = $600,000 x 0.0625 = $37,500
Effective interest rate =
interest expense + annual fee/
borrowed amount
= ($37,500 + $2,000)/$600,000
= 6.58% |
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Term
| Lockbox: Rocky Corp. has daily sales of $18,100. The financial manager determined that a lockbox would reduce the collection time by 2.2 days. Assuming the company can earn 6 percent interest per year, what are the savings from the lockbox? (Round to the nearest dollar.) |
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Definition
Average daily sales = $18,100
Collection time saved = 2.2 days
Savings from mail float = 2.2 days × $18,100 = $39,820
Savings if invested = $39,820 x 0.06 = $2,389.20 |
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Term
| Factoring: A firm sells $125,000 of its accounts receivable to factors at 3 percent discount. The firm's average collection period is one month. What is the dollar cost of the factoring service? |
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Definition
Accounts receivables sold = $125,000
Factor discount = 3%
Average collection period = 30 days
Dollar cost of factoring per month = $125,000 x 0.03 = $3,750 |
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Term
Economic order quantity: Jensen Autos, one of the largest car dealers in Eau Claire, sells about 700 vehicles a year. The cost of placing an order with their supplier is $1,100, and the inventory carrying costs are $120 for each car. Most of their sales are in late fall of each year.
What is the number of cars per order? |
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Definition
Annual sales = 700 units
Cost of placing an order = $1,100
Inventory carrying cost = $120
EOQ = sqrt(2 x reorder cost x sales per period/carrying costs)
sqrt(2 x $1,100 x 700/$120) = 113.3
Economic order quantity = 113 cars |
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Term
| Ticktock Clocks sells 10,000 alarm clocks each year. If the total cost of placing an order is $65 and it costs $85 per year to carry the alarm clock in inventory, use the EOQ formula to calculate the optimal order size. |
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Definition
EOQ = sqrt(2 x reorder cost x sales per period/carrying costs)
sqrt(2 x $98 x 10,000/$85) = 123.7
Economic order quantity = 124 clocks |
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Term
| What two fundamental questions does working capital management involve? |
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Definition
1. What is the appropriate amount and mix of current assets for the firm to hold?
2. How should these current assets be financed? |
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Term
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Definition
cash and other assets that the firm expects to convert into cash in a year or less
*usually listed on balance sheet in order of liquidity
include cash, marketable securities (sometimes also called short-term investments), accounts receivable, inventory, and others, such as prepaid expenses |
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Term
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Definition
(or short-term liabilities) are obligations that the firm expects to repay in a year or less
*They may be interest-bearing, such as short-term notes and current maturities of long-term debt, or noninterest bearing such as accounts payable, accrued expenses, or accrued taxes and wages |
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Term
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Definition
(also called gross working capital) includes the funds invested in a company's cash and marketable security accounts, accounts receivable, inventory, and other current assets
**Note that working capital is defined in terms of current assets, so the two terms are one and the same. |
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Term
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Definition
the difference between current assets and current liabilities
*measures a firm's liquidity
amount of WC left over after its paid off all short-term liabilities
**Larger the firm's NWC, the greater its liquidity |
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Term
| Working capital management |
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Definition
involves management of current assets and their financing.
The financial manager's responsibilities include determining the optimum balance for each of the current asset accounts and deciding what mix of short-term debt, long-term debt, and equity to use in financing working capital.
usually fast paced as they reflect the pace of the firm's day-to-day operations. |
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Term
| Working capital efficiency |
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Definition
a term that refers to how efficiently working capital is used
commonly measured by a firm's cash conversion cycle
The shorter a firm's cash conversion cycle, the more efficient is its use of working capital. |
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Term
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Definition
| the ability of a company to convert assets—real or financial—into cash quickly without suffering a financial loss. |
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Term
| The working capital accounts that are the focus of most working capital management activities are as follows: |
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Definition
1. Cash (including marketable securities)
2. Receivables
3. Inventory
4. Payables |
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Term
| What are the trade-offs of cash? |
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Definition
The more cash on hand, the more likely it will be able to meet financial obligations if an unexpected expense occurs.
If cash balances become too small, the firm runs the risk that it will be unable to pay its bills -- bankruptcy
Holding too much cash produces low returns even when invested in an interest-paying bank account or highly liquid short term money market instrument such as Treasury securities. |
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Term
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Definition
| The accounts receivable at a firm represent the total unpaid credit that the firm has extended to its customers. Accounts receivable can include trade credit (credit extended to another business) or consumer credit (credit extended to a consumer), or both. |
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Term
| What are the trade-offs of receivables? |
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Definition
Providing trade or consumer credit increases sales and is a competitive necessity to match the credit terms offered by competitors.
It is expensive to evaluate customers' credit applications to ensure that they are creditworthy and then to monitor ongoing credit performance
Firms not diligent in managing their credit operations can suffer large losses from bad debts |
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Term
| What are the trade-offs of inventory? |
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Definition
Item will likely be in stock for customers. Reduce the chance that the firm will not have access to raw materials when needed - which can cause costly interruptions in the manufacturing process.
Large inventories are expensive to finance, can require warehouses that are expensive to build and maintain, must be protected against breakage and theft, and run a greater risk of obsolescence. |
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Term
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Definition
| Accounts payable are trade credits provided to firms by their suppliers. |
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Term
| What are the trade-offs of payables? |
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Definition
Trade credit is an attractive source of financing because suppliers typically grant a grace period before payables must be repaid.
Tend to provide strong incentives for on time payments.
Besides incurring monetary penalties, a manager who is consistently late in making payments runs the risk that the supplier will no longer sell to his or her firm on credit |
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Term
| What is likely to happen if a financial manager decides to increase working capital? |
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Definition
| Good things are likely to happen to the firm - sales should increase, relationships with vendors and suppliers should improve, and work or manufacturing stoppages should be less likely. |
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Term
| What is the downside of increasing working capital? |
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Definition
| The extra working capital costs money and there is no simple formula to determine the "optimal" level of working capital the firm should hold. |
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Term
| Why is the cash conversion cycle important? |
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Definition
| The length of the cash conversion cycle is directly related to the amount of capital that a firm needs to finance its working capital. |
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Term
| What occurs in the cash conversion cycle? |
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Definition
| (1) the firm uses cash to pay for raw materials and the cost of converting them into finished goods (conversion costs), (2) finished goods are held in finished goods inventory until they are sold, (3) finished goods are sold on credit to the firm's customers, and finally, (4) customers repay the credit the firm has extended them and the firm receives the cash. The cash is then reinvested in raw materials and conversion costs, and the cycle is repeated. |
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Term
| What are the goals that financial managers want to achieve in managing the cash conversion cycle? |
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Definition
• Delay paying accounts payable as long as possible without suffering any penalties.
• Maintain the minimum level of raw material inventories necessary to support production without causing manufacturing delays.
• Use as little labor and other inputs to the production process as possible while maintaining product quality.
• Maintain the level of finished goods inventory that represents the best trade-off between minimizing the amount of capital invested in finished goods inventory and the desire to avoid lost sales.
• Offer customers terms on trade credit that are sufficiently attractive to support sales and yet minimize the cost of this credit, both the financing cost and the risk of nonpayment.
• Collect cash payments on accounts receivable as quickly as possible to close the loop. |
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Term
| What is the operating cycle? |
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Definition
| The operating cycle starts with the receipt of raw materials and ends with the collection of cash from customers for the sale of finished goods made from those materials. The operating cycle can be described in terms of two components: days' sales in inventory and days' sales outstanding. |
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Term
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Definition
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Term
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Definition
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Term
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Definition
| Days' payables outstanding |
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Term
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Definition
| Days' sales in inventory (DSI) shows, on average, how long a firm holds inventory before selling it. |
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Term
| What is the formula for calculating DSI? |
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Definition
365 days/Inventory turnover
= 365 days/(COGS/Inventory) |
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Term
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Definition
| Days' sales outstanding (DSO) indicates how long it takes, on average, for the firm to collect its outstanding accounts receivable. |
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Term
| What is the formula for calculating DSO? |
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Definition
365 days/Accounts receivable turnover
= 365 days/(Net sales/Accounts receivable) |
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Term
| What is the formula for calculating Operating cycle? |
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Definition
We can now calculate the operating cycle simply by summing the days' sales outstanding and the days' sales in inventory.
Operating cycle = DSO + DSI |
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Term
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Definition
| Days' payables outstanding (DPO) tells us how long, on average, a firm takes to pay its suppliers. |
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Term
| What is the formula for calculating DPO? |
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Definition
365 days/Accounts payable turnover
= 365 days/(COGS/Accounts payable) |
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Term
| What is the formula for calculating the Cash conversion cycle? |
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Definition
Cash conversion cycle = DSO+DSI-DPO
= Operating cycle - DPO |
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Term
| What does a negative cash conversion cycle mean? |
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Definition
| A negative cash conversion cycle means that the firm receives cash from its customers an average of X amount of days before it pays its suppliers. |
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Term
| Firms that follow a flexible current asset management strategy might: |
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Definition
1. hold large balances of cash, marketable securities, and inventory
2. Offer liberal credit terms to customers, which results in high levels of AR |
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Term
| Describe the trade-offs of the flexible current asset management strategy. |
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Definition
A flexible strategy is generally perceived to be a low-risk and low-return course of action
A principal benefit of such a strategy is that large working capital balances improve the firm's ability to survive unforeseen threats.
- reduces the size of the firm's exposure to fluctuations in business conditions
Downsides include low returns on current assets, potentially high inventory carrying costs, and the cost of financing liberal credit terms. |
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Term
| Explain why current assets have a lower return than long-term assets. |
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Definition
Inventory sitting on the shelf earns no interest income.
Thus, by investing in current assets, management foregoes the higher rate of return it could have earned by investing in long-term assets. |
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Term
| How can flexible current asset management strategy yield large payoffs? |
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Definition
Under certain circumstances such as having enough cash to weather a severe credit crunch that puts a firm's major competitors out of business can yield very large long-run returns.
Similarly, having sufficient cash to take advantage of an unforeseen acquisition opportunity can be very valuable. |
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Term
| Firms that follow a restrictive current asset management strategy might: |
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Definition
1. keep levels of current assets at a minimum
2. invest the minimum possible in cash, marketable securities, and inventory
3. has strict terms of sale intended to limit credit sales and accounts receivable. |
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Term
| Describe the trade-offs of the restrictive current asset management strategy. |
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Definition
A restrictive strategy is a high-return, high-risk alternative to a flexible strategy.
Enables the firm to invest a larger fraction of its money in higher yielding assets.
The high risk comes in the form of exposure to shortage costs, which can be either financial or operating costs. |
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Term
| Explain financial shortage costs. |
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Definition
Arise mainly from illiquidity.
Firms become illiquid when unforeseen circumstances cause them to run out of cash and marketable securities.
If bills come due, the firm can be forced to use expensive external emergency borrowing. Worse yet, if outside funding cannot be secured; the firm may default on some current liability and run the risk of being forced into bankruptcy by creditors. |
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Term
| Explain operating shortage costs. |
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Definition
Results from lost production and sales.
If the firm does not hold enough raw materials in inventory, precious hours may be wasted by a halt in production. If the firm runs out of finished goods, sales may also be lost, and customer satisfaction may be damaged. Having restrictive credit policies, such as allowing no credit sales, will also result in lost sales. |
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Term
| How does a financial manager determine the optimal management strategy for current assets? |
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Definition
Must balance shortage costs against carrying costs.
This is the working capital trade-off.
If the costs of running short of working capital (shortage costs) dominate the costs of carrying extra working capital (carrying costs), a firm will move toward a more flexible policy. Alternatively, if carrying costs are greater than shortage costs, then the firm will maximize value by adopting a more restrictive strategy. |
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Term
| What are account receivables? |
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Definition
Companies frequently make sales to customers on credit by delivering the goods in exchange for the promise of a future payment.
The promise is an account receivable from the firm's point of view. |
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Term
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Definition
| Whenever a firm sells a product, the seller spells out the terms and conditions of the sale in a document called the terms of sale |
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Term
| What is an alternative for terms of sale? |
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Definition
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Term
| What does the terms of sale of “3/10, net 40” mean? |
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Definition
| This firm will grant a 3 percent discount if the buyer pays the full amount of the purchase in cash within 10 days of the invoice date. Otherwise, the buyer has 40 days to pay the balance in full from the date of delivery. |
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Term
| What is the formula for Effective annual rate? |
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Definition
The EAR conversion formula accounts for the number of compounding periods and thereby annualizes the interest rate.
EAR = (1 + Discount/Discounted price)|365/days credit - 1 |
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Term
| Describe end-of-month payment. |
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Definition
EOM
If a firm makes several deliveries to the same customer over the course of a month, it often makes sense to send a single bill at the end of the month for the full amount. Of course, this can be combined with a discount for quick payment.
For example, if the terms are “4/10 EOM, net 30,” the buyer receives a 4 percent discount for paying within 10 days of the end of the month in which the delivery was made. Otherwise, the customer has an additional 20 days in which to make the payment. |
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Term
| What are aging accounts receivables? |
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Definition
| It would be nice if all customers paid their bills when they came due, but we all know that is not what happens. As a result, firms that offer sales on credit need tools to identify and monitor slow payers so that they can be prompted to pay. |
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Term
| What is an aging schedule? |
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Definition
In credit circles, it is well documented that creditors that identify slow payers early and establish contact with them are more likely to be paid in full than those who do not monitor their receivables carefully.
A tool that credit managers commonly use for this purpose is an aging schedule, which organizes the firm's accounts receivable by their age. Its purpose is to identify and track delinquent accounts and to see that they are paid. |
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Term
| What is the formula for calculating the effective DSO? |
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Definition
| = Sum(Age of account category in days x Percent of total accounts receivable outstanding for the account category) |
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Term
| What is the effective DSO? |
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Definition
| The effective DSO is simply a weighted-average measure of DSO where the weights equal the percentage of total accounts receivable outstanding in each account category. |
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Definition
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