1. What is the difference between working capital and net working capital?

What is the
cash cycle?
- Working capital showns as the current assets
- Net working capital is the difference between current assets and current liabilities
- The cash cycle refers to the continual flow of resource through various working capital
accounts such as cash, account receivables, inventory, payables and accruals that working capital
management focus.
2. Define the disadvantages and advantages of working capital investment policies?
Disadvantages:
- Policy A results in a lower expected profitability.
- Policy C yields a higher risk.
- Policy B yields balanced risk and profitablity .
Advantages:
- Policy A results in a lower risk.
- Policy C yields a higher expected profitability.
- Policy B reduced profitability.
3. How does the firm finance the working capital?
There are three approaches to finance the working capital :
- Matching approach: A firm uses long-term debt and equity capital to finance fixed assets and
permanent current assets
- Conservative Approach: Firms use long-term debt plus equity capital to finance fixed assets
and permanent current assets (frequent needs of working capital) and a part of fluctuating current
assets.That means firms use more long-term sources of financing and uses short-term debt to
finance fluctuating current assets.
- Aggressive approach: Firms use short-term debt to finance fluctuating current assets
(temporary needs of working capital) and a part of frequent needs of working capital. That
means firms use more short-term sources of financing.
4. Why does the firm hold the cash? How does it manage the cash?
Reasons of holding cash:
- Transactions motive: to meet payments, such as purchases, wages, taxes, and dividends, arising
in the ordinary course of business.
- Speculative motive: to take advantage of temporary opportunities, such as a sudden decline in
the price of a raw material.
- Precautionary motive: to maintain a safety cushion or buffer to meet unexpected cash needs.
The more predictable the inflows and outflows of cash for a firm, the less cash that needs to be
held for precautionary needs. Ready borrowing power to meet emergency cash drains also
reduces the need for this type of cash balance.
Manage the cash: The finanacial managers examines various ways to speed up the collection
process to have more usable funds:
Managing cash inflow:
- Earlier Billing: speed up the collection of receivables is to get invoices to customers earlier.
- Lockbox System: A company rents a local post office box and authorizes its bank to pick up
remittances in the box. Customers are billed with instructions to mail their remittances to the
lockbox. The bank picks up the mail several times a day and deposits the checks directly into the
company’s account. The checks are recorded and cleared for collection. The company receives a
deposit slip and a list of payments, together with any material in the envelopes.
Managing cash outflow:
- Payable-Through Drafts (PTDs) : Allows the firm to examine checks written by the firm’s
regional units. Checks are passed on to the firm, which can stop payment if necessary.
- Zero Balance Accounts (ZBAs): Different divisions of a firm may write checks from their own
ZBA. Division accounts then have negative balances. Cash is transferred daily from the firm’s
master account to restore the zero balance. Allows more control over cash outflows.
- Payroll and Dividend Disbursements: Many companies maintain a separate account for payroll
disbursements.
5. What is credit policy? Which is the most important component of credit policy?
When the company have account receivable, it establishes the credit policy. Credit poicy
includes these following components:
- Credit standards: minimally acceptable creditworthy customer defines the selling business’s
credit standards. Based on financial analysis and nonfinancial data, the credit analyst determines
whether each credit applicant exceeds the credit standard and thus qualifies for credit.
- Credit terms: Credit terms specify the length of time over which credit is extended to a
customer (credit period) and the discount (cash discount), if any, given for early payment.
- Collection policy and procedures: The firm determines its overall collection policy by the
combination of collection procedures it undertakes. These procedures include such things as
letters, faxes, phone calls, personal visits, and legal action. One of the principal policy variables
is the amount of money spent on collection procedures. Within a range, the greater the relative
amount expended, the lower the proportion of bad-debt losses, and the shorter the average
collection period, all other things being the same.
The most important component of credit policy is Credit Standards. Because they set the criteria
for evaluating the creditworthiness of potential customers, helping businesses minimize the risk
of default and bad debt. By analyzing financial data and other relevant information, companies
determine who is eligible for credit. Without proper credit standards, extending credit to
customers who can't repay may lead to financial losses.
6. Should the firm use the trade credit to finance working capital? Explain your answer?
The firm should use the trade credit to finance working capital. Because we have seen that trade
credit is a source of funds to the buyer because the buyer does not have to pay for goods until
after they are delivered. If the firm automatically pays its bills a certain number of days after the
invoice date, trade credit becomes a spontaneous (or built-in) source of financing that varies with
the production cycle. As the firm increases its production and corresponding purchases, accounts
payable increase and provide part of the funding needed to finance the increase in production.
7. Discuss with your good friend in the group about above questions