FM: Working capital

Answer: D. Working capital is current assets less current liabilities — the net short-term funds tied up in day-to-day operations. Its elements are inventory, trade receivables and cash (current assets) set against trade payables and short-term borrowings such as overdrafts (current liabilities). Option A is long-term debt, option B is non-current assets, and option C is equity — none of which is working capital. Managing working capital well keeps the business liquid without tying up excessive funds.

Answer: B. Working capital management requires a balance. Higher current assets — more cash, larger inventories, more generous customer credit — reduce the risk of running short of funds (better liquidity) but earn little or no return, which lowers profitability. Holding lean working capital lifts returns but raises the risk of illiquidity. Option A and option C are false generalisations (the relationship is a trade-off, not one-directional), and option D wrongly equates two distinct concepts.

Answer: C. Overtrading occurs when a business expands its sales volume too quickly without raising enough long-term finance to support the larger working-capital requirement. The classic signs are fast revenue growth alongside swelling inventory and receivables, a draining cash position, and growing dependence on short-term finance such as overdrafts and stretched payables. Option A describes the opposite circumstances, and options B and D are not associated with overtrading.

Answer: A. The cash operating cycle is the average length of time between the cash outflow to pay suppliers for inventory and the cash inflow when customers pay for the goods. It is normally measured as inventory holding days plus the receivables collection period minus the payables payment period. The longer the cycle, the more cash is tied up in working capital. Options B, C and D describe unrelated time periods.

Answer: D. Cash operating cycle = inventory days + receivables collection period − payables payment period = 60 + 45 − 35 = 70 days. Option A (140) adds all three components, forgetting that the payables period is deducted. Option B (50) wrongly deducts the receivables period as well. Option C (20) mishandles the signs. The payables period is subtracted because credit taken from suppliers finances part of the cycle, reducing the cash the business itself must tie up.

Answer: B. Current ratio = current assets ÷ current liabilities = £240,000 ÷ £120,000 = 2.0:1. Option A inverts the ratio (current liabilities ÷ current assets). Options C and D do not follow from the figures. A current ratio of 2.0 means the company holds £2 of current assets for every £1 of current liabilities; whether that is comfortable depends on the industry, since a very high ratio can also signal excessive, low-return working capital.

Answer: C. The quick ratio strips out inventory, the least liquid current asset: (current assets − inventory) ÷ current liabilities = (£240,000 − £90,000) ÷ £120,000 = £150,000 ÷ £120,000 = 1.25:1. Option A is the current ratio (inventory not removed). Options B and D do not follow from the figures. The quick ratio tests whether short-term liabilities could be met without having to sell inventory, which may be slow to convert into cash.

Answer: A. Inventory holding period = (inventory ÷ cost of sales) × 365 = (£80,000 ÷ £584,000) × 365 = 50.0 days. Option B inverts the calculation, option C misplaces the decimal point, and option D uses revenue instead of cost of sales. Cost of sales is the correct denominator because inventory is carried at cost; using revenue would distort the ratio by including the profit margin.

Answer: D. Receivables collection period = (trade receivables ÷ credit sales) × 365 = (£150,000 ÷ £1,095,000) × 365 = 50.0 days. Option A misplaces the decimal point, option B inverts the ratio, and option C does not follow from the figures. This ratio shows how long, on average, customers take to pay; a rising figure can indicate weakening credit control or customers experiencing financial difficulty.

Answer: B. Payables payment period = (trade payables ÷ credit purchases) × 365 = (£96,000 ÷ £876,000) × 365 = 40.0 days. Options A and D do not follow from the figures, and option C inverts the calculation. This ratio shows the average time taken to pay suppliers. Taking longer to pay is a source of essentially free short-term finance, but stretching it too far risks losing supplier goodwill, early-settlement discounts or future credit.

Answer: C. Sales to net working capital = revenue ÷ net working capital = £1,200,000 ÷ £150,000 = 8.0 times. This shows how much revenue is supported by each pound of net working capital, a measure of working-capital efficiency; an unusually high ratio can be a warning sign of overtrading (too little working capital for the level of sales). Options A, B and D either invert the relationship or misplace the decimal point.

Answer: A. EOQ = √(2 × annual demand × cost per order ÷ holding cost per unit) = √((2 × 40,000 × 36) ÷ 2) = √1,440,000 = 1,200 units. Option B (600) is the average inventory level (half the EOQ). Option D (1,697) omits the division by the holding cost (√2,880,000). Option C does not follow from the formula. The EOQ is the order size that minimises the sum of annual ordering and holding costs.

Answer: D. At the EOQ, annual holding cost = (EOQ ÷ 2) × holding cost = 600 × £2 = £1,200, and annual ordering cost = (annual demand ÷ EOQ) × cost per order = (40,000 ÷ 1,200) × £36 = £1,200. The two are equal at the EOQ, so the total is £1,200 + £1,200 = £2,400. Option A counts only one of the two costs. Options B and C overstate the total. The equality of ordering and holding cost at the optimum is a defining feature of the EOQ.

Answer: B. When discounts are on offer, the basic EOQ may no longer minimise total cost, because a larger order reduces the purchase price. The correct method is to calculate the total annual cost — purchase cost plus ordering cost plus holding cost — at the EOQ and at each minimum order size that triggers a discount, then select the quantity with the lowest total. Options A, C and D each fixate on a single factor instead of weighing all the relevant costs together.

Answer: C. JIT minimises inventory by scheduling deliveries to arrive exactly when needed for production or sale, which cuts holding costs and frees up cash. It relies on reliable suppliers, accurate demand forecasting and close supplier relationships, and it increases exposure to supply disruption. Option A describes the opposite (high buffer stocks), while options B and D mischaracterise the approach entirely.

Answer: D. The basic EOQ model assumes that demand is constant and known, that the cost per order and the holding cost per unit are constant, that replenishment is instantaneous and that no stockouts occur. These simplifications are also its main limitations, since real demand and costs fluctuate. Option A contradicts the constant-demand assumption, option B contradicts the constant cost-per-order assumption, and option C contradicts the no-stockout assumption.

Answer: A. A longer cash operating cycle widens the gap between paying suppliers and collecting from customers, so cash stays tied up in inventory and receivables for longer and the business must finance a larger working-capital requirement. Shortening the cycle releases cash. Option B describes the opposite effect, option C ignores the cash impact, and option D confuses the timing of cash flows with profitability, which the cycle does not directly determine.

Answer: A. Sound credit assessment draws on objective, verifiable sources: bank references, references from other suppliers (trade references), reports from credit-reference agencies, credit ratings and the customer's own published accounts. These help set an appropriate credit limit and reduce bad debts before credit is granted. Option B is irrelevant to ability to pay, option C is subjective and prone to optimism bias, and option D is meaningless. Gathering good information up front is the first stage of effective receivables management.

Answer: B. An early settlement discount should be evaluated on cost-benefit grounds. The cost is the percentage given up on the sales that take the discount; the benefits are the reduction in receivables (and therefore in financing cost), together with any reduction in bad debts and collection/administration costs. The discount is worthwhile only if the benefits exceed its cost. Option A follows competitors blindly, option C ignores that the discount has a real cost, and option D rules out a tool that can be financially sensible.

Answer: C. Under factoring, the factor usually takes over sales-ledger administration and debt collection, and — where the arrangement is non-recourse — also assumes the bad-debt risk; it is often disclosed to customers. Invoice discounting is normally confidential: the company borrows a percentage of its receivables but continues to run its own ledger and collect the debts itself. Option A is wrong because the services differ, option B describes non-recourse factoring rather than invoice discounting, and option D is untrue.

Answer: D. Foreign receivables carry currency risk because the home-currency value of the eventual receipt can fall before payment is made. This can be managed by invoicing in the home currency (passing the risk to the customer), by fixing the rate with a forward exchange contract or a money-market hedge, or by netting foreign receipts against foreign payments. Option A leaves the exposure unmanaged, option B deliberately increases the company's own exposure, and option C needlessly forgoes profitable export business.

Answer: A. Forgoing the discount means paying 2% more in order to delay payment by an extra 30 days (40 − 10). The effective annual cost = [1 ÷ (1 − 0.02)] raised to the power (365 ÷ 30), minus 1 = (1.0204)^12.17 − 1 ≈ 27.9%. As this far exceeds normal short-term borrowing rates, the company should usually take the discount. Option B is merely the nominal 2% discount, option C wrongly uses the 40-day period instead of the 30 days saved, and option D mistakes the number of periods (365 ÷ 30) for the cost. (The simpler approximation gives about 24.8%.)

Answer: B. Trade credit is convenient, flexible and, as long as the company is not giving up worthwhile early-settlement discounts, carries little or no explicit cost — making it one of the cheapest forms of short-term finance. The risk is that stretching it too far can cost supplier goodwill, discounts or continued supply. Options A, C and D are incorrect: trade credit normally bears no explicit interest, is not repayable on receipt of goods, and is unsecured.

Answer: C. The three classic motives for holding cash are the transactions motive (to meet routine day-to-day payments), the precautionary motive (a buffer against unexpected cash needs) and the speculative motive (to be able to exploit opportunities such as bargain purchases or attractive short-term investments). The other options list unrelated business concepts. Understanding why cash is held underpins the cash-management models, such as Baumol and Miller-Orr, used to set optimal balances.

Answer: D. A cash flow forecast projects future receipts and payments so that managers can see, ahead of time, when the business will have surplus cash to invest and when it will face a shortfall for which finance (such as an overdraft) must be arranged. This supports proactive cash management. Option A is a tax computation, option B is a valuation exercise, and option C is wrong — the cash forecast complements, rather than replaces, the accruals-based profit statement.

Answer: A. The Baumol model applies the EOQ logic to cash: optimal transfer = √(2 × annual cash required × cost per transaction ÷ interest rate) = √((2 × 500,000 × 125) ÷ 0.05) = √2,500,000,000 = £50,000. Option B (£11,180) omits the division by the interest rate (√125,000,000). Option C halves the result. Option D multiplies by the interest rate instead of dividing by it. The model assumes cash is used at a steady, predictable rate, which is its principal limitation.

Answer: B. The Miller-Orr model sets an upper limit and a lower limit around a calculated return point. When cash reaches the upper limit, the company invests the surplus by buying short-term securities, bringing the balance down to the return point; when cash falls to the lower limit, it sells securities to restore the balance up to the return point. The model suits firms with uncertain, fluctuating cash flows. Option A ignores the rule, option C reverses it, and option D is unrelated to cash management.

Answer: D. The matching policy funds long-lived (permanent) assets — non-current assets plus the permanent core of current assets — with long-term finance, and funds the fluctuating element of current assets with short-term finance, so the life of each asset is matched to the life of its funding. An aggressive policy relies more on cheaper but riskier short-term finance, while a conservative policy uses more expensive but safer long-term finance. Option A is highly aggressive and risky, option B ignores the asset mix, and option C is excessively conservative.