Question 1

If a firm sells on terms of 2/10 net 30 days, and its DSO is 28 days, then the fact that the 28-day DSO is less than the 30-day credit period tells us that the credit department is functioning efficiently and there are no past-due accounts.

Accepted Answer

A DSO of 28 days, while within the 30-day credit period, does not necessarily indicate the absence of past-due accounts or that the credit department is functioning efficiently. It simply means that, on average, it takes 28 days to collect on sales. Some accounts could still be paying earlier, and others could be past due, affecting the average.

Question 2

Long-term loan agreements always contain provisions, or covenants, that constrain the firm's future actions.Short-term credit agreements are just as restrictive in order to protect the interest of the lender.

Accepted Answer

Short-term credit agreements are generally less restrictive than long-term loan agreements because they are for shorter periods and involve smaller amounts of money, thus posing less risk to the lender.

Question 3

Which of the following statements is CORRECT?

Accepted Answer

Short-term debt carries greater risk due to potential changes in interest rates and market volatility. Therefore, heavy use of short-term debt is a more aggressive strategy.

Option B and D are incorrect as they are related to matching maturities which is not the concept being discussed here.

Option C and E are incorrect as the explanation of net working capital and its relation to the current ratio is incorrect. An increase in the current ratio does not automatically indicate an increase in net working capital. It only means that the company has a larger proportion of current assets to current liabilities.

Question 4

The risk to the firm of borrowing using short-term credit is usually greater than if it used long-term debt.Added risk stems from (1)the greater variability of interest costs on short-term than long-term debt and (2)the fact that even if its long-term prospects are good, the firm's lenders may not be willing to renew short-term loans if the firm is temporarily unable to repay those loans.

Accepted Answer

The statement accurately describes the added risk associated with borrowing using short-term credit compared to long-term debt.

Question 5

Because money has time value, a cash sale is always more profitable than a credit sale.

Accepted Answer

Department stores, auto dealers, and many others sell on credit, using interest bearing notes payable.the interest rate on this credit can exceed the firm's cost of capital, making credit sales more profitable than cash sales.

Question 6

Firms generally choose to finance temporary current operating assets with short-term debt because

Accepted Answer

Matching the maturities of assets and liabilities reduces risk in some circumstances, and short-term debt is often less expensive than long-term capital. Additionally, temporary current operating assets tend to be short-term in nature, making them more suitable for financing with short-term debt.

Question 7

A firm constructing a new manufacturing plant and financing it with short-term loans, which are scheduled to be converted to first mortgage bonds when the plant is completed, would want to separate the construction loan from its current liabilities associated with working capital when calculating net working capital.

Accepted Answer

Since the short-term loans for construction are scheduled to be converted to long-term debt (first mortgage bonds) when the plant is completed, it is appropriate to separate the construction loan from current liabilities associated with working capital when calculating net working capital. This is because the construction loan will not be due within the next year, unlike other current liabilities associated with working capital such as accounts payable and accrued expenses. Separating the construction loan will help provide a more accurate picture of the company's liquidity and working capital position.

Question 8

A firm's collection policy, i.e., the procedures it follows to collect accounts receivable, plays an important role in keeping its average collection period short, although too strict a collection policy can reduce profits due to lost sales.

Accepted Answer

A firm's collection policy does have an impact on its average collection period, but if the policy is too strict, it may discourage customers from making purchases and lead to lost sales, which can ultimately harm profits.

Question 9

A revolving credit agreement is a formal line of credit.The firm must generally pay a fee on the unused balance of the committed funds to compensate the bank for the commitment to extend those funds.

Accepted Answer

A revolving credit agreement typically involves a fee charged by the bank on the unused portion of the committed funds, in exchange for the bank's commitment to extend those funds whenever needed.

Question 10

A lockbox plan is most beneficial to firms that

Accepted Answer

A lockbox plan is most beneficial for firms that have customers spread out over various parts of the country. This system helps in reducing the time it takes for a company to receive and process payments, thereby improving cash flow. It is particularly useful for companies with a geographically diverse customer base, as it allows for quicker deposit of checks into the company's account.

Question 11

Which of the following is NOT commonly regarded as being a credit policy variable?

Accepted Answer

Payments deferral period is not commonly regarded as a credit policy variable. Credit policy typically includes credit standards, credit terms (which may include cash discounts and credit period), and collection policy. Payments deferral period is more related to the terms of payment after the credit period has expired, rather than a direct component of initial credit policy setting.

Question 12

If the yield curve is upward sloping, then short-term debt will be cheaper than long-term debt.Thus, if a firm's CFO expects the yield curve to continue to have an upward slope, this would tend to cause the current ratio to be relatively low, other things held constant.

Accepted Answer

An upward sloping yield curve indicates that long-term interest rates are higher than short-term interest rates. This means that short-term debt will be cheaper for firms than long-term debt. Therefore, firms with an upward sloping yield curve tend to rely more on short-term debt to finance their operations, which would lower their current ratio (current assets divided by current liabilities).

Question 13

Which of the following will cause an increase in net working capital, other things held constant?

Accepted Answer

Selling merchandise on credit increases accounts receivable, which is a component of net working capital.

Question 14

If one of your firm's customers is "stretching" its accounts payable, this may be a nuisance but it does not represent a real financial cost to your firm as long as the customer periodically pays off its entire balance.

Accepted Answer

Even if the customer periodically pays off the entire balance, "stretching" accounts payable represents a real financial cost to the firm in the form of lost interest income and potential cash flow problems.

Question 15

Summary balance sheet data for Greener Gardens Co.is shown below (in thousands of dollars).The company is in a highly seasonal business, and the data show its assets and liabilities at peak and off-peak seasons:

From this data we may conclude that

Accepted Answer

The peak and off-peak data suggest that Greener Gardens follows a conservative approach to current asset financing, as some of its short-term needs are met by permanent capital. The company maintains a relatively stable level of current assets throughout the year, indicating that it does not rely solely on short-term financing to support its operations during the peak season. Without income statement data, we cannot determine the impact of the company's financing policy on profitability, and without cash flow data, we cannot assess the sustainability of the policy. The data do not suggest that Greener Gardens matches asset and liability maturities, as the company has a significant amount of long-term debt that does not coincide with the seasonal nature of its operations.

Question 16

For a zero-growth firm, it is possible to increase the percentage of sales that are made on credit and still keep accounts receivable at their current level, provided the firm can shorten the length of its collection period sufficiently.

Accepted Answer

If a zero-growth firm can shorten the length of its collection period, it can receive payments more quickly and reduce the amount of time its accounts receivable are outstanding. This means the firm can increase the percentage of sales made on credit and still maintain its current accounts receivable balance. However, this assumes that the firm can effectively collect payment from its customers in a shorter period of time.

Question 17

Which of the following actions should Reece Windows take if it wants to reduce its cash conversion cycle?

Accepted Answer

Reece Windows can reduce its cash conversion cycle by taking steps to reduce the days sales outstanding (DSO), which means it should try to collect payment from its customers more quickly. This will increase its cash inflows and reduce the time it takes to convert its inventory into cash. The other options will not necessarily reduce the cash conversion cycle.

Question 18

A lockbox plan is

Accepted Answer

A lockbox plan is used to speed up the collection of checks received. It involves a bank setting up a special post office box to receive the payments on behalf of the company, which is then collected and processed quickly by the bank, reducing float time and increasing the speed of funds availability for the company.

Question 19

If a profitable firm finds that it simply must "stretch" its accounts payable, then this suggests that it is undercapitalized, i.e., that it needs more working capital to support its operations.

Accepted Answer

Stretching accounts payable, even for a profitable firm, indicates a cash flow issue, suggesting the firm does not have enough working capital to comfortably cover its short-term liabilities and operational costs.

Question 20

If a firm switched from taking trade credit discounts to paying on the net due date, this might cost the firm some money, but such a policy would probably have only a negligible effect on the income statement and no effect whatever on the balance sheet.

Accepted Answer

By switching from taking trade credit discounts to paying on the net due date, the firm would lose out on the cash discount offered by suppliers, resulting in increased cost of goods sold and lower gross profit on the income statement. This would also affect the balance sheet by reducing cash and increasing accounts payable. Therefore, the statement is false.

Quiz 16: Supply chains and working capital management