LOS b Session 11 - Reading 48 Working Capital Management

CFA Level 1 - Corporate Finance Session 11 - Reading 48 Working Capital Management - LOS b (Notes, Practice Questions, Sample Questions) 1. A firm has average days of receivables outstanding of 22 compared to an industry average of 29 days. An analyst would most likely conclude that the firm: A) may have credit policies that are too strict. B) has better credit controls than its peer companies. C) has a lower cash conversion cycle than its peer companies {Explanation}: The firm’s average days of receivables should be close to the industry average. A significantly lower average days receivables outstanding, compared to its peers, is an indication that the firm’s credit policy may be too strict and that sales are being lost to peers because of this. We can not assume that stricter credit controls than the average for the industry are “better.” We cannot conclude that credit sales are less, they may be more, but just made on stricter terms. The average days of receivables are only one component of the cash conversion cycle 2. Alton Industries will have better liquidity than its peer group of companies if its: A) average trade payables are lower. B) quick ratio is lower. C) receivables turnover is higher. {Explanation}: Higher receivables turnover is an indicator of better receivables liquidity since receivables are converted to cash more rapidly. A lower quick ratio is an indication of less liquidity. Lower trade payables could be related to better liquidity, but could also be consistent with very poor liquidity and a requirement from its suppliers of cash payment 3. Which of the following is NOT a limitation to financial ratio analysis? A) The need to use judgment. B) A firm that operates in only one industry. C) Differences in international accounting practices {Explanation}: If a firm operates in multiple industries, this would limit the value of financial ratio analysis by making it difficult to find comparable industry ratios 4. In a recent staff meeting, David Hurley, stated that analysts should understand that financial ratios mean little by themselves. He advised his colleagues to evaluate financial ratios carefully. During the discussion he made the following statements: Statement 1: A company can be compared with others in its industry by relating its financial ratios to industry norms. However, care must be taken because many ratios are industry-specific, but not all ratios are important to all industries. Statement 2: Comparing a company to the overall economy is useless because overall business conditions are constantly changing. Specifically, it is not the case that financial ratios tend to improve when the economy is strong and weaken during recessionary times. Are statements 1 and 2 as made by Hurley regarding financial ratio analysis CORRECT? Statement 1 Statement 2 A) Incorrect Correct B) Correct Correct C) Correct Incorrect {Explanation}: Financial ratios are meaningless by themselves. To have meaning an analyst must use them with other information. An analyst should evaluate financial ratios based on industry norms and economic conditions. Statement 1 is correct. However, statement 2 is not because financial ratios tend to improve when the economy is strong and weaken when the economy is in a recession. So, financial ratios should be reviewed in light of the current stage of the business cycle 5. Which of the following is least likely an indicator of a firm’s liquidity? A) Inventory turnover. B) Amount of credit sales. C) Cash as a percentage of sales. {Explanation}: No inferences about liquidity are warranted based on this measure. A firm may have higher credit sales than another simply because it has more sales overall. Cash as a proportion of sales and inventory turnover are indicators of liquidity 6. The quick ratio is considered a more conservative measure of liquidity than the current ratio because the quick ratio excludes: A) inventories, which are not necessarily liquid. B) short-term marketable securities, which may need to be sold at a significant loss. C) accounts receivable, which may not be collectible in the short term. {Explanation}: The quick ratio is usually defined as (current assets – inventory) / current liabilities. It is a more restrictive measure of liquidity than the current ratio, which equals current assets / current liabilities. The numerator of the quick ratio includes cash, receivables, and short-term marketable securities