CHAPTER 17: WORKING CAPITAL MANAGEMENT QUESTIONS

1. What are some pros and cons of holding high levels of current assets in relation to sales?
Use the DuPont equation to help explain your answer.
 Relaxed policy indicates a high level of assets (hence, a low total assets turnover ratio),
which lowers Return on Equity. This policy minimizes operating problems such as work
stoppages, unhappy customers, and serious long-run problems.

2. Define the cash conversion cycle (CCC) and explain why, holding other things constant, a
firm’s profitability would increase if it lowered its CCC.
 Cash conversion cycle is the length of time funds are tied up in working capital, or the
length of time between paying for working capital and collecting cash from the sale of
the working capital.
 If a firm could sell goods faster, collect receivables faster, or defer its payables longer,
without hurting sales or increasing operating costs, its CCC would decline, its interest
expense would be reduced, and its profits and stock price would be improved.

3. What are two definitions of cash, and why do corporate treasurers often use the second
definition?
 The two definitions of cash are: 1) Cash means currency (paper money and coins) in
addition to bank demand deposits; and 2) Cash means currency and demand deposits in
addition to very safe, highly liquid, marketable securities that can be sold quickly at a
predictable price, and thus be converted to bank deposits.
 Corporate treasurers use the second definition because cash in the balance sheet also
includes short-term securities, which are often called cash equivalents (readily
convertible to cash).

4. What is a cash budget, and how can this statement be used to help reduce the amount of
cash that a firm needs to carry? What are the advantages and disadvantages of daily over
monthly cash budgets, and how might a cash budget be used when a firm is negotiating a
loan from its bank?
 Cash budget is a table and a forecasting tool that shows cash receipts, disbursements and
balances over some period. It generally helps an entity to forecast their cash flows. If they
are likely to need additional cash, they should line up funds in advance. On the other
hand, if they are likely to generate surplus cash, they should plan for its productive use.
 The daily cash budget gives a more precise picture of the actual cash flows and is good
for scheduling actual payments on a day-by-day basis.
 The treasurer uses or shows the cash budget to the bankers when negotiating for the line
of credit. Lenders would want to know how much an entity expects to need, when the
funds will be needed, and when the loan will be repaid.

5. What are four key factors in a firm’s credit policy? How would a relaxed policy differ from
a restrictive policy? Give examples of how the four factors might differ between the two
policies. How would the relaxed versus the restrictive policies affect sales? Profits?
 The four key factors in a firm’s credit policy are credit period (the length of time
customers have to pay for purchases), discounts (price reductions given for early
payment), credit standards (the financial strength customers must exhibit to qualify for
credit) and collection policy (degree of toughness in enforcing the credit terms).
 When receivables are high, the firm has a liberal credit policy, which results in a high
level of accounts receivable (relaxed investment policy). When a firm has restricted
investment policy (or tight or “lean-and-mean”), holdings of current assets are minimized
or constrained.
  Credit period – for example, an entity sets credit period for 30 days, with this, the policy
being exercised is relaxed. Customers prefer longer credit periods, so lengthening the
period will stimulate sales and a higher amount of accounts receivable.
 Relaxed policy stimulates more sales compared to restrictive policies. However, being in
a relaxed policy includes additional costs, such as bad debts, which eventually results to
lower revenues compared to restrictive if a customer defaults on its payment.

6. What does it mean to adopt a maturity matching approach to financing assets, including
current assets? How would a more aggressive or a more conservative approach differ from
a maturity matching approach, and how would each affect expected profits and risk? In
general, is one approach better than the others?
 Maturity matching approach or “Self-liquidating” approach is a financing policy that
matches the maturities of assets and liabilities which is defined as moderate current assets
financing policy.
 All of the current assets – both permanent and temporary – and part of the fixed assets
were financed with short-term credit. This policy would be a highly aggressive,
extremely non-conservative position, and the firm would be subject to dangers from loan
renewal as well as problems with rising interest rates. While a very safe, conservative
approach means that long-term capital is used to finance all the permanent assets and to
meet some of the seasonal needs. Aggressive approach is riskier than conservative
approach because it encompasses short-term debt.
 It is impossible to state that that long-term or short-term financing is better than the other.
The firm’s specific conditions will affect the choice and the preference of managers.

7. Why are some trade credit called free while other credit is called costly? If a firm buys on
terms of 2/10, net 30, pays at the end of the 30th day, and typically shows $300,000 of
accounts payable on its balance sheet, would the entire $300,000 be free credit, would it be
costly credit, or would some be free and some costly? Explain your answer. No calculations
are necessary.
 Trade credit may be free, or it may be costly because of the discounts offered by the
seller.
 With the terms of 2/10, n/30, if the firm pays at the 10th day, it will get a 2% discount.
But it decided to pay on the 30th day, meaning, there is no discount available. The first 10
days of the trade credit will be free and the remaining 20 days will be costly because of
the implicit cost. Thus, 100,000 will be of free credit and 200,000 would be a costly
credit.

8. Define each of the following loan terms, and explain how they are related to one another:
the prime rate, the rate on commercial paper, the simple interest rate on a bank loan calling
for interest to be paid monthly and the rate on an instalment loan based on add-on interest.
If the stated rate on each of these loans was 4%, would they all have equal, effective annual
rates? Explain.
 Prime rate – a published interest rate charged by commercial banks to large, strong
borrowers.
 Rate on commercial paper – rate on unsecured, short-term promissory notes of large
firms, usually issued in denominations of $100,000 or more with an interest rate
somewhat below the prime rate.
 Regular or Simple interest rate – the situation when interest only is paid monthly.
 Add-on interest – interest that is calculated and added to funds received to determine the
face amount of an instalment loan.
 They would not have equal effective interest rates because the effective interest rate on a
loan depends on how frequently interest must be paid – the more frequently interest is
paid, the higher the effective rate.
9. Why are accruals called spontaneous sources of funds, what are their costs, and why don’t
firms use more of them?
 Accruals generally arise from a firm’s operation that is why they are called spontaneous
sources of funds. Accruals include accrued wages and accrued taxes and are “free” in the
sense that no interest is paid on them.
 However, firms cannot control their accruals because the timing of wage payments is set
by contract or industry custom and tax payments are set by law. Thus, firms use all the
accruals they can, but they have little control over their levels.

10. (+) – Increase A/R, Sales and Profits

(-) – Decrease A/R, Sales and Profits
(0) – Uncertain

Accounts Receivable Sales Profits

The firm restricts its credit standards. - - 0
The terms of trade are changed from
0 + 0
2/10, net 30, to 3/10, net 30.
The terms are changed from 2/10, net 30, 0 + 0
to 3/10, net 40.
The credit manager gets tough with past- - - 0
due accounts.
 Kingfisher School of Business and Finance
Dagupan City, Pangasinan
Academic Year 2019-2020
First Semester

Financial Markets including Working Capital

(Finance 12)

Chapter 17: Working Capital Management

Group Assignment no. 6

Submitted by:

BRIAN, Cindy P.
CASTILLO, Mary Rose H.
Leal, Mary Joy P.
Regatcho, Sofia Rev
URAYAN, Djohamie Denise V.
VALDEZ, Aaron B.
Block 23
Group 5

Submitted to:

Mr. KIVIN B. BERNABE

Finance 12 Instructor

August 23, 2019