Principles of Managerial Finance, Brief, 7e (Gitman)
Chapter 14 Working Capital and Current Assets Management
14.1 Understand working capital management, net working capital, and the related trade-off
between profitability and risk.
1) Short-term financial management is concerned with management of a firm’s current assets and
current liabilities to achieve a balance between profitability and risk.
2) Firms are able to reduce financing costs or increase the funds available for expansion by
maximizing the amount of funds tied up in working capital.
3) Working capital refers to a firm’s long-term capital.
4) The more predictable a firm’s cash inflows, the more net working capital it will need.
5) As firms are unable to match cash inflows to outflows with certainty, most of them need
current liabilities.
6) When current assets exceed current liabilities, a firm has negative net working capital.
7) Net working capital can be defined as the portion of a firm’s current assets financed with long-
term funds.
8) A firm that is unable to pay its bills as they come due is said to be insolvent.
9) In general, the greater a firm’s current assets relative to its short-term obligations, the better
able it will be to pay its bills as they come due.
10) As the ratio of current assets to total assets increases, a firm’s risk increases.
11) Too much investment in current assets reduces firm’s profitability, whereas too little
investment in current assets increases the risk of not being able to pay debts as they come due.
12) A firm is said to be insolvent when its total assets is less than its total liabilities and
stockholders’ equity.
13) An increase in current assets increases net working capital, thereby reducing the risk of
insolvency.
14) Assuming that the level of total assets remains unchanged, the effect of a decrease in the
ratio of current assets to total assets is an increase in a firm’s risk of insolvency.
15) The goal of working capital management is to ________.
A) achieve a balance between short-term and long-term liabilities so that they add to the
achievement of a firm’s overall goals
B) achieve a balance between a firm’s non-current assets and non-current liabilities
C) achieve a balance between profitability and risk that contributes positively to a firm’s value
D) achieve a balance between short-term and long-term assets so that they add to the
achievement of a firm’s overall goals
16) The purpose of managing current assets and current liabilities is to ________.
A) achieve a balance between short-term and long-term financing of a firm
B) achieve as low a level of current liabilities as possible
C) achieve a balance between profitability and risk that contributes to a firm’s value
D) achieve as high a level of current liabilities as possible
17) Net working capital is defined as ________.
A) total assets minus total liabilities
B) total liabilities minus total assets
C) current liabilities minus current assets
D) current assets minus current liabilities
18) Which of the following is true of net working capital?
A) When current assets of a firm exceed its current liabilities,a firm is said to have negative net
working capital.
B) When current assets of a firm are less than its total assets,a firm is said to have positive net
working capital.
C) When current assets of a firm exceed its current liabilities,a firm is said to have positive net
working capital.
D) When current assets of a firm exceed its total assets,the firm is said to have negative net
working capital.
19) The conversion of current assets ________.
A) from cash to receivables to inventory provides the cash used to pay non-current liabilities
B) from inventory to receivables to marketable securities provides the cash used to buy plant and
equipment
C) from inventory to receivables to cash provides the cash used to pay current liabilities
D) from cash to receivables to inventory provides the cash used to repurchase stock
20) Current liabilities can be viewed as ________.
A) debts that mature in a period of one year or less
B) liabilities which represent a firm’s long-term financing
C) sources of cash inflows from the operating activities of a firm
D) funds used to finance the noncurrent assets’ portion of a firm
21) Which of the following is true of current assets?
A) The time of conversion of current assets to more liquid form is relatively unpredictable.
B) They are used to fund long-term operations and pay long-term expenses.
C) They are more profitable because they add more value to the product than that provided by
fixed assets.
D) They are sources of short-term financing for a firm.
22) In general, the more net working capital a firm has, ________.
A) the greater its risk
B) the lower its risk
C) the less likely are creditors to lend to the firm
D) the lower its level of long-term funds
23) A(n) ________ in current assets increases net working capital, thereby ________ the risk of
insolvency.
A) decrease; increasing
B) increase; increasing
C) increase; reducing
D) decrease; reducing
24) A decrease in current assets and an increase in current liabilities will ________ net working
capital, thereby ________ the risk of insolvency.
A) increase; increasing
B) decrease; increasing
C) increase; reducing
D) decrease; reducing
25) When a portion of a firm’s fixed assets are financed with current liabilities, ________.
A) the firm will have positive net working capital
B) the net working capital will decrease
C) the current ratio will increase
D) the firm will have negative net working capital
26) Which of the following is true of the impact of cash flows on net working capital?
A) The higher the cash inflows lower is the net working capital.
B) The lower the cash outflows lower is the net working capital.
C) The more predictable the cash inflows of a firm, the more current assets a firm needs.
D) The more predictable the cash inflows of a firm, the easier is the working capital
management.
27) In working capital management, risk is measured by the probability that a firm will be
________.
A) unable to pay annual dividends to stockholders
B) unable to pay its bills as they come due
C) unable to repay its long-term obligations
D) unable to earn profits from day-to-day operations
28) If a firm increases its current assets relative to total assets, ________.
A) it increases return and reduces risk
B) it increases return and increases risk
C) it reduces return and reduces risk
D) it reduces return and increases risk
14.2 Describe the cash conversion cycle, its funding requirements, and the key strategies for
managing it.
1) The cash conversion cycle of a firm is the length of time from the beginning of the production
process to the collection of cash from the sale of finished products.
2) The operating cycle is the recurring transition of a firm’s working capital from cash to
inventories and inventories to receivables and back to cash.
3) The operating cycle is the length of time a firm’s cash is tied up between payment for
production inputs and receipt of payment from the sale of the resulting finished product.
4) By efficiently managing a firm’s operating and cash conversion cycles, the financial manager
can maintain a high level of cash investment and thereby contribute toward maximization of
share value.
5) A firm’s operating cycle (OC) is simply the sum of the average age of inventory (AAI) and the
average payment period (APP).
6) The cash conversion cycle is the total number of days in the operating cycle less the average
payment period for inputs to production.
7) A negative cash conversion cycle (CCC) means the average payment period (APP) exceeds
the operating cycle (OC).
8) The ability to purchase production inputs on credit allows a firm to partially offset the length
of time resources are tied up in the operating cycle.
9) The cash conversion cycle of a firm is the difference between the number of days resources
are tied up in the operating cycle and the average number of days the firm can delay making
payment on the production inputs purchased on credit.
10) A positive cash conversion cycle means that a firm must obtain financing to support the cash
conversion cycle.
11) The cash conversion cycle is the sum of average age of the inventory and average collection
period minus average payment period.
12) Nonmanufacturing firms are more likely to have positive cash conversion cycles; they
generally carry smaller, faster-moving inventories and often sell their products for cash.
13) The aggressive funding strategy is a strategy by which a firm finances its current assets with
short-term funds and its fixed assets with long-term funds.
14) If a firm’s sales are constant, its investment in operating assets should also be constant, and
the firm will have only a permanent funding requirement.
15) The conservative funding strategy is a strategy by which a firm finances at least its seasonal
requirements, and possibly some of its permanent requirements, with short-term funds and the
balance of its permanent requirements with long-term funds.
16) Under an aggressive funding strategy, a firm funds its seasonal requirements with short-term
debt and its permanent requirements with long-term debt.
17) One aspect of risk associated with the aggressive strategy’s maximum use of short-term
financing is the fact that changing short-term interest rates can result in significantly higher
borrowing.
18) The aggressive funding strategy is a strategy by which a firm finances all projected funds
requirements with long-term funds and uses short-term financing only for emergencies or
unexpected outflows.
19) The aggressive funding strategy is risky due to its minimum level of net working capital,
high dependency on short-term sources of funds, and the changing short-term interest.
20) Under conservative funding strategy, short-term financing is used only to finance an
emergency, an unexpected outflow of funds, and the variable portion of a firm’s current assets.
21) The risk of the conservative funding requirements is low because of its high level of net
working capital, and the fact that the strategy does not require a firm to use any of its limited
short-term borrowing capacity.
22) Under a conservative funding strategy, the firm funds both its seasonal and its permanent
requirements with long-term debt.
23) When implementing the cash management strategies, a firm should avoid damaging a firm’s
credit rating by overstretching accounts payable.
24) Tryst Energy Inc. has an average age of inventory of 65 days, an average collection period of
60 days and an average payment period of 65 days. The firm’s total annual outlays for operating
cycle investments are $3.65 million. Assuming a 365-day year, how much financing is required
to support its cash conversion cycle?
A) $600,000
B) $650,000
C) $700,000
D) $559,000
25) A firm has a cash conversion cycle of 60 days. Annual outlays are $12 million and the cost
of financing is 12 percent. If the firm reduces its average age of inventory by 10 days, the annual
savings is ________. (Assume a 365-day year.)
A) $10,400
B) $14,000
C) $28,800
D) $39,452
26) The ________ of a firm is the amount of time required for a company to convert cash
invested in its operations to cash received as a result of its operations.
A) cash turnover
B) cash conversion cycle
C) average age of inventory
D) average collection period
27) The ________ of a firm is the amount of time that elapses from the point when the firm
inputs material and labor into the production process to the point when cash is collected from the
sale of the finished product that contains these production inputs.
A) cash conversion cycle
B) average age of inventory
C) operating cycle
D) average collection period
28) The ________ is the length of time from the point when raw materials are purchased on
account to the point when payment is made to the supplier of the goods.
A) cash conversion cycle
B) average payment period
C) average age of inventory
D) average collection period
29) A firm has an average age of inventory of 90 days, an average collection period of 40 days,
and an average payment period of 30 days. The firm’s operating cycle is ________ days.
A) 110
B) 130
C) 120
D) 70
30) A firm has an operating cycle of 120 days, an average collection period of 40 days, and an
average payment period of 30 days. The firm’s average age of inventory is ________ days.
A) 80
B) 50
C) 90
D) 70
31) A firm has a cash conversion cycle of 80 days, an average collection period of 25 days, and
an average age of inventory of 70 days. Its operating cycle is ________ days.
A) 95
B) 105
C) 60
D) 130
32) A firm has an average age of inventory of 60 days, an average collection period of 45 days,
and an average payment period of 30 days. The firm’s cash conversion cycle is ________ days.
A) 15
B) 45
C) 75
D) 135
33) A firm has a cash conversion cycle of 120 days, an average collection period of 25 days, and
an average payment period of 50 days. The firm’s average age of inventory is ________ days.
A) 45
B) 95
C) 125
D) 145
34) A firm purchased raw materials on account and paid for them within 30 days. The raw
materials were used in manufacturing a finished good sold on account 100 days after the raw
materials were purchased. The customer paid for the finished good 60 days later. The firm’s cash
conversion cycle is ________ days.
A) 10
B) 70
C) 130
D) 190
35) The ________ is the time period that elapses from the point when a firm uses the raw
materials in manufacturing a finished good to the point when the finished good is sold.
A) cash turnover
B) cash conversion cycle
C) average age of inventory
D) average collection period
36) The ________ is the time period that elapses from the point when a firm sells a finished good
on account to the point when the receivable is collected.
A) cash conversion cycle
B) average payment period
C) average age of inventory
D) average collection period
37) A firm has an average age of inventory of 101 days, an average collection period of 49 days,
and an average payment period of 60 days. The firm’s cash conversion cycle is ________ days.
A) 150
B) 90
C) 109
D) 11
38) A firm can reduce its cash conversion cycle by ________.
A) increasing the average age of inventory
B) increasing the average collection period
C) increasing the operating cycle
D) increasing the average payment period
39) A firm with a cash conversion cycle of 175 days can stretch its average payment period from
30 days to 45 days. This will result in a/an ________.
A) decrease of 30 days in the cash conversion cycle
B) increase of 15 days in the cash conversion cycle
C) decrease of 15 days in the cash conversion cycle
D) increase of 30 days in the cash conversion cycle
40) A firm has an average age of inventory of 20 days, an average collection period of 30 days,
and an average payment period of 60 days. The firm’s cash conversion cycle is ________ days.
A) 70
B) 50
C) -10
D) 110
41) Other factors remaining constant, an increase in the average collection period will result in
________.
A) an increase in the operating cycle
B) an increase in the average payment period
C) a decrease in the operating cycle
D) a decrease in the average payment period
42) Other factors remaining constant, an increase in the average payment period will ________.
A) increase the average collection period
B) decrease the operating cycle
C) not affect the cash conversion cycle
D) not affect the operating cycle