4.04 Working Capital and Liquidity - Answers

1. Which of the following factors most likely results in a drag, rather than a pull, on a company's liquidity position?
 A. Delinquent customer payments
B. Reduced limits on lines of credit
C. Payments to vendors before the due date
Explanation
Factors that affect liquidity
Drag Pull
(slowdown in cash inflows) (speedup in cash outflows)
Uncollected receivables Shorter payment terms from suppliers

Obsolete inventory Lack of collateral to pledge for loans
Higher borrowing rates Reduced borrowing limits
A company's liquidity position is a measure of its ability to meet short-term cash flow needs. Liquidity is impacted by drags and pulls:
A drag on liquidity refers to slower cash inflows

A pull on liquidity refers to faster cash outflows or limited availability of trade credit
Both pulls and drags reduce a company's available cash balance.
Delinquent customer payments slow the company's receipts of cash, create a drag on liquidity, and increase the likelihood of uncollected accounts
receivable. As a result, the company receives cash more slowly or receives less cash.
(Choice B) A reduction in the company's credit limit is a pull on liquidity: the company will hit the lower limit sooner and more often, accelerating
required repayments (ie, cash outflows).
(Choice C) When a company pays its vendors before the due date, it is speeding up cash outflows, which is a pull on liquidity.
Things to remember:
A company's liquidity position measures its ability to meet short-term cash flow needs. A drag on liquidity indicates slower or smaller cash inflows;
a pull on liquidity refers to faster or greater cash outflows. Both scenarios reduce a company's liquidity.
Explain liquidity and compare issuers’ liquidity levels

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2. A company has a quick ratio of 0.95. If the company reports current liabilities of HKD400 million, deferred tax liabilities due in 14 months of
HKD100 million, and inventory of HKD120 million, its current ratio is closest to:
A. 0.65
B. 0.80
 C. 1.25
Explanation
The current ratio and the quick ratio are two related liquidity metrics for a company's ability to meet short-term (ie, due within a year)
obligations. Both ratios express the relationship between current assets (eg, cash, short-term marketable investments, receivables, inventory) and
current liabilities (eg, accounts payable, accrued liabilities, short-term debt). A higher ratio indicates better liquidity.
The quick ratio is the more conservative liquidity measure because it excludes inventory in the numerator. Inventory is the least liquid current
asset as it requires the longest time to convert to cash.
To calculate the current ratio, first derive the value of current assets by using the given values for the quick ratio, current liabilities, and inventory.
The current asset value is then inserted into the current ratio formula.
(Choice A) In calculating the current ratio, the level of current assets is incorrectly computed by subtracting inventory from the quick assets
(current assets excluding inventory) instead of adding inventory to the quick assets.
(Choice B) The denominator incorrectly includes deferred tax liabilities as a current liability. The deferred tax liabilities are due more than a year
from now, so they are not a current liability.
Things to remember:
The current ratio is equal to the current assets divided by the current liabilities. The quick ratio is equal to the current assets less inventory divided
by the current liabilities. Inventory is excluded from the quick ratio since it is the least liquid of current assets and takes the longest time to convert
to cash.

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3. A company has CAD 50 million of short-term liquidity needs. The company has the following assets and liabilities:
CAD 20 million in marketable securities, which can be sold with a 0.5% brokerage cost
CAD 35 million in bonds, able to be liquidated at 2.5% cost
CAD 50 million in accounts payable with terms of 2/10, net 60
To cover its liquidity needs at lowest cost, which of the following strategies would be most appropriate for the company to use?
A. Issue new equity in secondary offering
B. Sell all the marketable securities and sell bonds
 C. Sell all the marketable securities and delay accounts payable
Explanation
Companies typically have many options for short-term financing, including internal sources and financial intermediaries (eg, lines of credit).
Mismanaging capital can result in higher costs paid or a shortage of funds. When managing funds, a company should ensure that:
sufficient sources of capital are maintained to meet the company's cash needs, especially peak needs, and
market rates for these sources are not excessive compared with market averages.
In this scenario, selling the marketable securities is the company's cheapest option, with a 0.5% fee on sales. The company can free up funds by
delaying its accounts payable payment up to 60 days, forgoing a 2% discount. ("2/10, net 60" means that the company has 60 days to pay but it
can earn a 2% discount if payment is made within 10 days.) This lower cost option is preferable to liquidating bonds at a cost of 2.5% (Choice B).
(Choice A) Issuing new equity in a secondary offering would be inappropriate for a company trying to meet short-term liquidity needs. Equity
issuances typically take time to execute and can have high costs, which makes this option more appropriate to fund long-term needs.
Things to remember:
A company's management should know how different sources of short-term funds can affect its liquidity position and risks. When funds are
managed, sufficient sources of capital must be maintained to meet the company's peak cash needs. In addition, market rates for these sources
must not be excessive compared with market averages.
Describe issuers’ objectives and compare methods for managing working capital and liquidity
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4. Which of the following situations most likely creates a pull on a company's liquidity?
 A. Major suppliers change payment terms from 60 days to 30 days.
B. Obsolete inventory accumulates beyond one normal sales cycle.
C. Interest rates for sources of short-term funding increase by 100 basis points.
Explanation
Drag Pull

Businesses manage liquidity by controlling cash inflows and outflows effectively in the near term. Certain events may drain liquidity through drags
and pulls. A drag on liquidity generally refers to a slowdown in cash inflows. A pull on liquidity generally refers to a speedup in cash
outflows. Both pulls and drags reduce a company's available cash balance.
In this scenario, a company's major suppliers shortening payment terms from 60 to 30 days means that the company must disburse cash earlier
to satisfy payables. This situation creates a pull on liquidity.
(Choice B) Excess buildup of obsolete inventory negatively affects a company's ability to generate sales. This creates a drag on liquidity.
(Choice C) An increase in short-term borrowing rates makes it more difficult for a company to obtain funds. This creates a drag on liquidity.
Things to remember:
Businesses manage liquidity by controlling cash inflows and outflows effectively in the near term. A drag on liquidity generally refers to a
slowdown in cash inflows. A pull on liquidity generally refers to a speedup in cash outflows.

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5. An analyst gathers the following information about a company:
Based on this information, the company's inventory turnover ratio is closest to:
A. 8.0
 B. 9.6
C. 12.0
Explanation
Inventory turnover is a liquidity metric that measures how many times inventory has been bought (eg, acquired, created), sold, and
replenished in a given period. All else being equal, the faster a company sells its inventory, the quicker it can convert its assets back to cash and
repeat the cycle. For example, everyday consumable products (eg, milk, bread) tend to turn over rapidly, while more durable items (eg, TV,
washing machine) tend to turn over more slowly.
Inventory turnover is particularly useful when comparing similar businesses as a means of contrasting operating and asset efficiency. In this case,
inventory turnover is 9.6 times:
(Choice A) 8.0 results from subtracting accounts receivable from COGS and then dividing by average inventory.
(Choice C) 12.0 results from using credit sales instead of COGS as the numerator. This answer could also have been calculated by dividing
COGS by ending inventory instead of average inventory.
Things to remember:
Inventory turnover is a liquidity metric that measures how many times inventory has been bought (eg, acquired, created), sold, and replenished in
a given period. Inventory turnover is calculated as COGS divided by average inventory.
Explain the cash conversion cycle and compare issuers’ cash conversion cycles
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6. An analyst gathers the following data for a company:
Based on this information, the days of inventory on hand (DOH) is closest to:
A. 36.5
B. 40.6
 C. 48.7
Explanation
Days of inventory on hand (DOH), also referred to as number of days of inventory, measures the average number of days it takes a company
to sell its inventory. DOH is an activity ratio that indicates management's effectiveness in managing its inventory, with fewer days usually
indicating more efficiency as capital is tied up in inventory for a shorter time. DOH is particularly useful as a means of contrasting operating and
asset efficiency when comparing similar businesses.
DOH is calculated as average inventory for the period divided by daily COGS. In this case, DOH equals 48.7.
(Choice A) 36.5 is credit sales, not average inventory, divided by daily COGS.
(Choice B) 40.6 is ending inventory, not average inventory, divided by daily COGS.
Things to remember:
The number of days of inventory (DOH), also referred to as days of inventory on hand, measures the average number of days that it takes a
company to sell its inventory. DOH is calculated as average inventory for the period divided by daily COGS.
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7. An analyst gathers the following data for a company for 20X1:
Based on this information, the company's day's sales outstanding (DSO) in 20X1 is closest to:
 A. 47.5
B. 51.1
C. 68.5
Explanation
Days sales outstanding (DSO), also referred to as number of days of receivables, is one of several activity ratios used to measure operational
efficiency. DSO represents the average number of days it takes for a company to collect cash from credit sales.
DSO performance is particularly useful for evaluating operating and asset efficiency when conducting trend analysis or comparing similar
businesses. Faster collection of receivables enhances liquidity and results in a lower DSO; a higher DSO indicates that customers are slower to
pay invoices and are more of a drag on liquidity.
DSO equals average accounts receivable divided by daily credit sales:
(Choice B) 51.1 results from using ending accounts receivable, not average accounts receivable.
(Choice C) 68.5 is equal to daily credit sales.
Things to remember:
Days sales outstanding (DSO) is used to measure the average time needed for a company to collect cash from credit sales. A lower DSO value is
generally desirable and can improve a company's liquidity position. DSO is calculated as average accounts receivable divided by daily credit
sales.
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8. An analyst is evaluating the performance of inventory management across several manufacturing companies. The analyst gathers the following
data:
Based on the data, and assuming all companies manufacture the same product, which of the following best describes the improvements in the
number of days of inventory (DOH) from the previous year?
 A. Company X shows the most improvement.
B. Company Z shows more improvement than Company Y.
C. The industry average shows more improvement than Company Y.
Explanation
The number of days of inventory (DOH), also referred to as days of inventory on hand, measures the average number of days that it takes a
company to sell its inventory. Analysts can use DOH to evaluate a company's inventory management. Shorter DOH indicates greater speed
and efficiency in selling inventory. In contrast, longer DOH can lead to inventory obsolescence and extra storage costs.
Calculate the changes in DOH between FY18 and FY17:
Company X improved the most (by 3.4 days) over the previous year. On average, it took Company X 3.4 fewer days to sell its inventory compared
to the prior year.
(Choice B) Compared with the previous year, Company Z's DOH increased by 2.1 days while Company Y's DOH decreased by 2.2 days. This
means that Company Z's DOH worsened by 2.1 days while Company Y's DOH improved by 2.2 days.
(Choice C) Compared with the previous year, the industry's DOH decreased by 1 day while Company Y's DOH decreased by 2.2 days. This
means that the industry's DOH improved by only 1 day while Company Y's DOH improved by 2.2 days.
Things to remember:
The number of days of inventory (DOH) measures the average number of days that it takes a company to sell its inventory. Fewer days indicate
greater speed and efficiency in turning inventory into sales.
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9. An analyst is evaluating the performance of three manufacturers with the following information:
Which company has the highest inventory turnover?
 A. Company X
B. Company Y
C. Company Z
Explanation
The inventory turnover ratio represents the number of times, on average, inventory is sold and replenished during a fiscal period. It is calculated
by dividing the cost of goods sold (COGS) by the average inventory. Average inventory is used since inventory fluctuates throughout the year.
COGS, or the cost at which the inventory was acquired or manufactured, is recorded when an item is sold.
Higher inventory turnover can imply stronger sales relative to inventory levels whereas lower inventory turnover can imply slower sales or
excess inventory. The faster a company sells its inventory, the quicker it can convert its assets to cash and improve liquidity. In addition, long
inventory storage times can lead to obsolete inventory.
Company X has the highest inventory turnover ratio of 4.3.
(Choice B) Company Y has a lower inventory turnover ratio than Company X, meaning that Company Y was less efficient in converting its
inventory into sales.
(Choice C) Company Z has the lowest inventory turnover ratio.
Things to remember:
The inventory turnover ratio is calculated as cost of goods sold divided by average inventory. It represents the number of times, on average,
inventory is sold during the fiscal period. Higher inventory turnover can imply stronger sales relative to inventory levels.

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Based on this information, days payable outstanding (DPO) is closest to:
 A. 45.6
B. 46.8
C. 49.0
Explanation
Days payable outstanding (DPO), also called number of day's payables, is one of several activity ratios used to measure operational efficiency.
DPO is used to measure the average number of days it takes a company to pay its suppliers, which is one indicator of the company's
effectiveness in managing its suppliers, cash disbursements, and operating cycle. A larger DPO, resulting from slower payments to suppliers, is
desirable since it enhances liquidity. DPO, like all activity ratios, is most useful when comparing against peers or an industry benchmark.
DPO is the ratio of average accounts payable to average daily purchases. Average daily purchases is calculated as (COGS + Ending inventory –
Beginning inventory) / 365.
(Choice B) 46.8 results from dividing average accounts payable by COGS.
(Choice C) 49.0 results from using ending payables instead of average payables.
Things to remember:
Days payable outstanding (DPO) is used to measure the average number of days it takes a company to pay its suppliers. DPO is the ratio of
average accounts payable to average daily purchases. Average daily purchases is calculated as (COGS + Ending inventory – Beginning
inventory) / 365.
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11. All else being equal, which of the following changes to pulls and drags on liquidity most likely decreases a company's liquidity?
 A. Increased pulls and drags
B. Decreased pulls and drags
C. Decreased pulls and increased drags
Explanation
Factors influencing a company's liquidity (ie, ability to generate cash to meet short-term obligations) are described as pulls and drags. Pulls are
factors affecting cash outflows, and drags are factors affecting cash inflows.
Liquidity decreases with:
increased pulls: larger/more rapid outflows such as paying employees weekly rather than monthly; and
increased drags: smaller/slower inflows such as a reduction of credit lines from lenders.
(Choice B) Liquidity increases with reduced pulls (ie, smaller/slower outflows), such as deferring payments to vendors to a later date, and
reduced drags (ie, larger/more rapid inflows), such as faster inventory turnover.
(Choice C) Increased drags decrease liquidity. However, decreased pulls favorably affect liquidity.
Things to remember:
Pulls are factors that accelerate the flow of liquidity out of a company. Drags are factors that slow the flow of liquidity into a company. Increased
pulls and drags decrease liquidity, and reduced pulls and drags increase liquidity.

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12. An analyst gathers the following information for 20X1 for a Brazilian company (in BRL millions):
Credit sales 135
Cost of goods sold (COGS) 108
Purchases 127
Accounts receivable 12
Beginning inventory balance 15
Ending inventory balance 17
Accounts payable 8
If the average length of the cash conversion cycle for the industry is 58 days, then the cash conversion cycle for the company is most likely:
A. better than that of the industry.
B. the same as that of the industry.
 C. worse than that of the industry.
Explanation
The cash conversion cycle (CCC) is the average number of days it takes a company to collect the cash from a sale of goods after paying
suppliers. The CCC consists of the number of days of inventory (ie, days of inventory on hand, DOH) plus the number of days of receivables (ie,
days of sales outstanding, DSO) less the number of days of payables (ie, days of payables outstanding, DPO).
DOH measures the average time needed for a company to sell its inventory. DSO measures the average time needed to collect cash from the
sales. DPO measures the average time needed to pay suppliers for the materials used to make the goods.
In this scenario, it takes the company 5.52 (63.52 − 58) more days than the industry, on average, to convert its inventory to cash after paying
suppliers. This indicates a worse CCC relative to the industry since it takes longer for the company to convert inventory to cash (Choices A and
B).
Things to remember:
The cash conversion cycle (CCC) is the average number of days it takes a company to collect the cash from a sale of goods after paying
suppliers. CCC is calculated by adding the number of days of inventory and the number of days of receivables, and then deducting the number of
days of payables. A longer CCC can be detrimental to a company's cash position.
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13. All else equal, a firm increasing its accounts receivables turnover will most likely:
 A. decrease its operating cycle.
B. increase its days of sales outstanding.
C. increase its ending accounts receivables.
Explanation
Accounts receivable turnover is a liquidity measure that approximates the number of times, on average, a company converts its accounts
receivables (AR) from credit sales to cash, within a reporting period. All else equal, higher AR turnover can signal more efficient working capital
management.
A related measure, derived from AR turnover, is Days Sales Outstanding (DSO) (also known as "days receivable"). DSO measures the average
time in days it takes to collect cash from customers after making credit sales. Higher AR turnover results in lower (shorter) DSO, which can
decrease the operating cycle (Choice B).
The operating cycle (OC) measures the average time in days it takes a company to convert its inventory to cash. The OC is the sum of days of
inventory on hand (DOH), which measures the average time in days to sell inventory, and DSO.
(Choice C) All else equal, higher AR turnover suggests that receivables are turned into cash more frequently. This most likely leads to lower
levels of ending AR, not higher.
Things to remember:
Accounts receivable turnover measures the number of times, on average, a company converts its accounts receivables (AR) from credit sales to
cash, within a reporting period. All else equal, a higher AR turnover results in lower days sales outstanding, which ultimately shortens the
operating cycle.
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14. A company improved its operating cycle this fiscal year. If the company significantly increased its days of inventory on hand (DOH) over the
same period, then the company most likely decreased its:
A. days payable outstanding (DPO).
 B. days of sales outstanding (DSO).
C. accounts receivables turnover ratio.
Explanation
The operating cycle (OC) measures the time required to convert inventory to cash. The OC consists of the days of inventory on hand (DOH),
and the days of sales outstanding (DSO). The DOH measures the average time needed for a company to sell its inventory. The DSO measures
the average time needed for a company to collect cash from the sales. Decreasing the OC improves a company's overall cash position.
The company improved its OC by reducing the number of days. The OC is the sum of DOH and DSO, so an increase in DOH must be offset by a
greater decrease in DSO for the overall OC to decrease. Essentially, the company offsets an increase in its sales cycle with a greater decrease in
its collections cycle. This results in a shorter OC, and the company receives cash faster.
(Choice A) The OC, unlike the cash conversion cycle (CCC), is not impacted by changes to days payable outstanding (DPO). The CCC is the
difference between the OC and the DPO.
(Choice C) The accounts receivable (AR) turnover ratio (credit sales ÷ AR) gauges the collection frequency over a period. AR turnover is
inversely related to DSO. A decrease in AR turnover indicates that fewer collections are made over a set period, which indicates an increase in
the DSO in each collection cycle.
Things to remember:
The operating cycle (OC) measures the time required to convert inventory to cash. The OC consists of days of inventory on hand (DOH) and days
of sales outstanding (DSO). A company can offset an increase in DOH with a decrease in DSO in order to reduce the overall impact to OC.
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15. A consultant is evaluating several companies and has collected the following information for the fiscal year:
Which company has the best accounts receivable turnover?
 A. Company 1
B. Company 2
C. Company 3
Explanation
The accounts receivable (AR) turnover ratio measures the number of times, on average, accounts receivable is generated by credit sales and
collected as cash during a fiscal period. Credit sales occur when companies allow customers to defer sales invoice payments for a short period of
time (commonly 30-60 days). Companies then record the amount owed from the customers as AR.
A higher AR turnover ratio implies greater efficiency in converting receivables to cash and indicates better liquidity. This efficiency can result from
a firm's effectiveness in receivables collection or from its credit-extension policies (eg, granting trade discount incentives for early payment).
AR turnover for the three companies are as follows:
Company 1 has the highest AR turnover ratio of 3.64, which means that it is the most efficient in collecting its AR among the three companies.
(Choice B) Company 2 has collected on its AR 2.50 times on average during the year. This means that it was less efficient than Company 1 at
converting receivables to cash.
(Choice C) Company 3 has collected on its AR 3.04 times on average during the year. This means that it was less efficient that Company 1 at
converting receivables to cash.
Things to remember:
The accounts receivable (AR) turnover ratio is calculated by dividing credit sales by average AR. A higher AR turnover ratio indicates higher
efficiency in a company's credit collections.

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16. Which of the following factors is most likely considered a drag rather than a pull on a company's liquidity position?
 A. Central bank tightening credit
B. Accelerating payments to vendors
C. Lenders reducing company credit lines
Explanation
A company's liquidity position measures its ability to generate cash to meet its short-term obligations. Factors influencing a liquidity position are
described as:
pulls, which make cash flows going out larger and/or faster (eg, paying accounts payable more rapidly), or
drags, which make cash flows coming in smaller and/or slower (eg, collecting accounts receivable more slowly).
Central bank credit tightening is a drag on liquidity since tighter credit implies capital is both less available and more expensive, slowing access to
capital inflows.
(Choice B) Accelerating payments to vendors is an increasing pull on liquidity, as cash flows out of the company more quickly. Companies
typically do not meet payables before the due date to minimize these pulls. However, companies sometimes pay early to receive discounts or to
move recognition of the expense to an earlier tax year.
(Choice C) Lenders reducing credit lines is a pull on liquidity since a credit line's balance must be paid down more often to keep it below a lower
credit limit.
Things to remember:
Pulls are factors that may accelerate the draining of liquidity from a company. Drags are factors that may slow the flow of liquidity into a company.
Central bank credit tightening is a drag on liquidity since tight credit implies capital is both less available and more expensive.

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17. Which of the following events most likely creates a drag on liquidity for a business?
A. A supplier has reduced credit limits for purchases made by the business.
 B. Tightened credit conditions have raised the borrowing costs on new short-term loans.
C. A bank has requested a partial repayment on a line of credit after a covenant violation.
Explanation
Drag Pull

Businesses manage liquidity by managing cash inflows and outflows effectively in the near term. Certain events may drain liquidity through drags
and pulls. A drag on liquidity generally refers to a slowdown in cash inflows. A pull on liquidity generally refers to an acceleration in cash
outflows. Both pulls and drags reduce a company's available cash balance.
A rise in borrowing costs is considered a drag since higher interest rates make obtaining new commercial loans more costly and difficult. Less
borrowing reduces a company's inflow of funds.
(Choice A) When suppliers reduce credit limits on purchases, it forces businesses to make payments earlier. This creates a pull on liquidity by
speeding up cash outflows.
(Choice C) A repayment on the amount drawn from a line of credit represents a pull on liquidity since it requires a cash outflow.
Things to remember:
Businesses manage liquidity by managing cash inflows and outflows effectively in the near term. A drag on liquidity generally refers to a slowdown
in cash inflows. A pull-on liquidity generally refers to a speedup in cash outflows.

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18. Companies can most likely shorten their cash conversion cycle and generate funds internally by increasing days of:
A. inventory.
 B. accounts payable.
C. accounts receivable.
Explanation
Companies can generate funds internally from current assets and liabilities by:
liquidating current assets,

increasing cash inflow from operations, and
improving working capital efficiency.
Working capital efficiency is improved when the amount of time that operations need cash financing is minimized. This occurs when the time
required to receive cash from customers is reduced and the time for paying cash to creditors is extended. A common indicator of working capital
efficiency is the cash conversion cycle. This cycle measures the number of days it takes to convert goods purchased from suppliers into cash
from customers, starting from date of payment to suppliers. Firms seek to shorten their cash conversion cycle by:
increasing trade creditor days,

decreasing the inventory holding period, and
decreasing the accounts receivable collection period.
Increasing trade creditor days means that a company can finance more of its operations with financing from suppliers (ie, trade credit) instead of
the company's own cash. A company can generate internal financing by extending the period between its inventory purchases and the date when
payment is due to suppliers. This allows the company to retain its cash for a longer period.
(Choice A) Increasing days of inventory means goods take longer to sell (ie, inventory takes longer to generate cash).
(Choice C) Increasing days of accounts receivable means the company takes longer to receive cash from sales made on credit.
Things to remember:
Companies can generate funds internally by improving their working capital efficiency through shorter cash conversion cycles. This can be
achieved by shortening the period between inventory purchases and cash collection from customers, and/or extending the period between
inventory purchases and payment to suppliers.
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19. All else being equal, which of the following events most likely improves a company's liquidity position?
 A. Inventory decreases relative to sales
B. Accounts receivable increase relative to sales
C. Accounts payable decrease relative to inventory
Explanation
A company's liquidity position measures its ability to generate cash to meet its short-term obligations. Factors influencing a liquidity position are
described as:
pulls, which make cash flows going out larger and/or faster (eg, high payables turnover), or
drags, which make cash flows coming in smaller and/or slower (eg, low receivables turnover and/or low inventory turnover).
A company's liquidity position improves if pulls and drags are reduced and worsens if pulls and drags increase.
If a company's inventory is declining relative to sales, the company's inventory turnover ratio increases since its inventory is selling faster. All
else being equal, inventory is converted to cash more rapidly, reducing a liquidity drag, which improves liquidity.
(Choice B) All else constant, if accounts receivable increase relative to sales, the average time to collect receivables has increased. This is an
increased drag and indicates worsening of liquidity.
(Choice C) All else constant, if accounts payable decrease relative to inventory, on average accounts payable are being paid faster. This is an
increased pull, which worsens liquidity.
Things to remember:
Pulls relate to factors "pulling" liquidity out of a company. Drags relates to the speed of liquidity flowing into a company. Increased pulls and drags
worsen liquidity. Reduced pulls and drags improve liquidity.

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20. A company has short-term liquidity needs of €50 million. The following sources of liquidity are available:
Liquidity source (€ millions)
Accounts payable with terms of 2/10 net 60 25
Accounts receivable sold to a factor at a

40
3.5% discount
Bonds with a 3% liquidation cost 30
To cover the company's liquidity needs at the lowest cost, which of the following strategies would least likely be useful?
A. Sell bonds
B. Delay accounts payable
 C. Sell accounts receivable
Explanation
Companies typically have access to many choices for short-term funding, including internal and external sources (eg, credit line). Mismanaging
short-term funding can result in paying higher costs or experiencing a shortage of funds. When managing liquidity, a company should ensure that:
available sources of funding are sufficient to meet cash needs, especially peak cash needs, and
the cost of these sources is not excessive relative to market averages.
In this scenario, since the company needs more funding than is available from any one source, it will need to use at least two of these sources.
The terms of 2/10 net 60 indicate that the company can use accounts payable as a 60-day funding source or earn a 2% discount if payment is
made within 10 days. Thus, ranking the costs of funding sources from lowest to highest:
delaying accounts payable costs 2% (ie, forgoing a 2% discount),

liquidating bonds costs 3%, and
selling accounts receivable to a factor (ie, factoring receivables) costs 3.5%.
Since liquidating accounts receivable has the highest cost, the other two sources would be more useful for this company to fulfill its needs at
minimal cost (Choices A and B).
Things to remember:
Companies must evaluate a range of short-term funding sources to ensure access to sufficient liquidity that meets cash needs (eg, peak cash
needs) at a reasonable cost. Mismanaging short-term funding can result in paying higher costs or experiencing a shortage of funds.
Describe issuers’ objectives and compare methods for managing working capital and liquidity
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21. An analyst is evaluating several companies and has compiled the following information:
From 20X1 to 20X2, which company improved the most in days sales outstanding?
A. Company 1
B. Company 2
 C. Company 3
Explanation
Days sales outstanding (DSO), sometimes referred to as days in receivables, calculates the number of days, on average, for a company to
collect cash from its customers after sales are made on credit. It measures how quickly a company converts its receivables into cash.
Faster collection of receivables results in a lower DSO, and this enhances a company's liquidity. By contrast, a higher DSO indicates that
customers are too slow to pay invoices or that the company has poor credit extension policies (eg, not granting trade discount incentives for early
payment), both of which can act as a drag on liquidity.
It is helpful to gauge a company's DSO performance by comparing it across time, to that of the industry average, or to peers.
Company 3 showed the most improvement from the previous year. It reduced its DSO by 2.4 days, meaning that it collected its receivables, on
average, 2.4 days faster than it did for the previous year.
(Choice A) Company 1 took 5.0 days longer, on average, to collect its receivables compared to its performance the prior year.
(Choice B) Although Company 2 improved its DSO from the previous year (−0.3 days), the improvement was less than that of Company 3.
Things to remember:
Days sales outstanding (DSO) represents the average length in days for a company to collect its receivables following its sales. A smaller DSO
value can improve a company's liquidity position.

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22. A firm increasing its number of days of payables will most likely experience:
 A. fewer days in the cash conversion cycle .
B. the same number of days in the cash conversion cycle.
C. more days in the cash conversion cycle.
Explanation
The cash conversion cycle (CCC), or net operating cycle (OC), measures the number of days between a company's disbursement of cash to
suppliers and receipt of cash from customers. The CCC is equal to the difference between the OC and days payable outstanding (DPO).
The OC measures the time required to convert raw inventory to cash from sales. The company first needs time to sell inventory (measured in
number of days of inventory) and then needs time to collect cash from those sales (measured in number of days of receivables). However, the OC
does not consider the cash benefits from delaying time to pay suppliers (measured in DPO).
The DPO measures the average number of days to pay suppliers. The effect of changes in DPO is reflected in the CCC. When a company
saves cash by delaying payments, it extends its DPO, which reduces (improves) its CCC.
Things to remember:
The cash conversion cycle (CCC) measures the number of days between a company's disbursement of cash to suppliers and receipt of cash from
customers. The CCC is equal to the difference between the operating cycle and the number of days of payables. Extending the DPO reduces
(improves) the CCC.
LOS

23. Which of the following factors will most likely result in a pull, rather than a drag, on a company's liquidity position?
 A. Accelerating payments to suppliers
B. Increasing levels of obsolete inventory
C. Slower collection of accounts receivable
Explanation
A company's liquidity position measures its ability to meet short-term cash flow needs. Both pulls (ie, faster cash outflows) and drags (ie,
slower cash inflows) weaken a company's liquidity position.
Pulls include:
accelerating payments to suppliers.

spending more cash for inventory due to cuts in vendor credit.
Drags include:
less sales due to inventory obsolescence (Choice B).

slower collection of accounts receivable (Choice C).
Things to remember:
A company's liquidity position is a measure of its ability to meet short-term cash flow needs. Both pulls (ie, faster cash outflows) and drags (eg,
slower cash inflows) weaken a company's liquidity position.

LOS

24. An analyst gathers the following information about three companies:
Company X Company Y Company Z
Days of inventory on hand 70 72 68
Days of sales outstanding 35 37 35
Days of payables outstanding 27 13 22
The company with the shortest cash conversion cycle is most likely:
 A. Company X.
B. Company Y.
C. Company Z.
Explanation
A cash conversion cycle (CCC) is the average number of days it takes a company to collect the cash from a sale of goods after paying
suppliers for the materials used to make those goods.
The CCC is the sum of the average number of days needed to sell a company's inventory (DOH) and the average number of days needed to
collect receivables (DSO), minus the average number of days needed to pay suppliers (DPO). The DPO is subtracted because deferring
payments to suppliers allows the company to hold cash longer. The lower the CCC, the faster the company turns the purchase of materials into
cash.
In this scenario, the three companies' CCCs are calculated as follows:
Company X Company Y Company Z
DOH 70 72 68
+DSO 35 37 35
−DPO 27 13 22
CCC 78 96 81
Company X has the shortest CCC, 78 days.
(Choice B) Selecting Company Y results from incorrectly adding DPO instead of subtracting it.
(Choice C) Selecting Company Z results from calculating the operating cycle instead of the CCC. The operating cycle is the sum of DOH and
DSO, and it excludes DPO.
Things to remember:
A cash conversion cycle (CCC) is the number of days needed to turn a company's purchase of materials from suppliers to cash from the sale of
goods produced by those materials. The CCC is the sum of the average number of days needed to sell the inventory and the average number of
days needed to collect receivables, minus the average number of days needed to pay suppliers.
LOS

Based on this information, the accounts receivable turnover is closest to:
A. 3.3
 B. 4.0
C. 4.5
Explanation
Accounts receivable (AR) turnover measures the number of times, on average, that AR are generated by credit sales and collected as cash
over a period. AR turnover indicates management's effectiveness in managing credit given to customers. Higher AR turnover implies greater
efficiency in converting receivables to cash and indicates better liquidity.
AR turnover is calculated as credit sales for the period divided by average receivables. In this case, AR turnover is closest to 4.0.
(Choice A) 3.3 results from dividing cost of goods sold, not credit sales, by average receivables.
(Choice C) 4.5 results from dividing credit sales by ending accounts receivable, not average receivables.
Things to remember:
Accounts receivable (AR) turnover measures the number of times, on average, that AR are generated by credit sales and collected as cash over a
period. AR turnover is calculated as credit sales for the period divided by average receivables. A higher AR turnover ratio implies greater
efficiency in converting receivables to cash and indicates better liquidity.
LOS

4.04 Working Capital and Liquidity - Answers

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1. Which of the following factors most likely results in a drag, rather than a pull, on a company's liquidity position?

 A. Delinquent customer payments

B. Reduced limits on lines of credit

C. Payments to vendors before the due date

Factors that affect liquidity

Uncollected receivables Shorter payment terms from suppliers

A drag on liquidity refers to slower cash inflows

Both pulls and drags reduce a company's available cash balance.

Explain liquidity and compare issuers’ liquidity levels

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Explain liquidity and compare issuers’ liquidity levels

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A. Issue new equity in secondary offering

B. Sell all the marketable securities and sell bonds

 C. Sell all the marketable securities and delay accounts payable

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 A. Major suppliers change payment terms from 60 days to 30 days.

B. Obsolete inventory accumulates beyond one normal sales cycle.

Factors that affect liquidity

Uncollected receivables Shorter payment terms from suppliers

Explain liquidity and compare issuers’ liquidity levels

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DSO equals average accounts receivable divided by daily credit sales:

(Choice C) 68.5 is equal to daily credit sales.

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 A. Company X shows the most improvement.

B. Company Z shows more improvement than Company Y.

C. The industry average shows more improvement than Company Y.

Calculate the changes in DOH between FY18 and FY17:

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Which company has the highest inventory turnover?

Company X has the highest inventory turnover ratio of 4.3.

(Choice C) Company Z has the lowest inventory turnover ratio.

Explain liquidity and compare issuers’ liquidity levels

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Based on this information, days payable outstanding (DPO) is closest to:

(Choice B) 46.8 results from dividing average accounts payable by COGS.

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 A. Increased pulls and drags

B. Decreased pulls and drags

C. Decreased pulls and increased drags

Liquidity decreases with:

Explain liquidity and compare issuers’ liquidity levels

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Credit sales 135

Cost of goods sold (COGS) 108

Beginning inventory balance 15

Ending inventory balance 17

A. better than that of the industry.

B. the same as that of the industry.

 C. worse than that of the industry.

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 A. decrease its operating cycle.

B. increase its days of sales outstanding.

C. increase its ending accounts receivables.

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A. days payable outstanding (DPO).

 B. days of sales outstanding (DSO).

C. accounts receivables turnover ratio.

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Which company has the best accounts receivable turnover?

AR turnover for the three companies are as follows: