Practice: Working Capital and Liquidity

Corporate Issuers. 12 question(s) in this unit's pool (2 above the exam). Free up to ten a day; the coach picks which ones based on what you have already answered and when each is next due.

Corporate IssuersWorking Capital and Liquidity
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Today's practice

Pick an answer, say how sure you are, then reveal. Every wrong choice gets its own explanation. Questions you have already answered correctly and confidently stay out of the way until they are due for review again.

Question 1Exam level

A company reports the following annual data: Cost of Goods Sold = $480 million, Revenue = $600 million, Average Inventory = $80 million, Average Accounts Receivable = $50 million, Average Accounts Payable = $40 million. The company's Cash Conversion Cycle (CCC) is closest to:

How sure are you?

Correct: B. DIO = (80/480) x 365 = 60.8 days. DSO = (50/600) x 365 = 30.4 days. DPO = (40/480) x 365 = 30.4 days. CCC = 60.8 + 30.4 - 30.4 = 60.8 days.
A. Candidates who accidentally use Revenue as the DIO denominator get DIO = 80/600 x 365 = 48.7, then compute CCC = 48.7 + 30.4 - 30.4 = 48.7, which isn't one of the choices, so they might round and pick A. DIO must use COGS, not Revenue, because inventory is carried at cost.
C. Candidates who ADD DPO instead of subtracting it: 60.8 + 30.4 + 30.4 = 121.6... or who add all three without subtraction. DPO is subtracted because payables are financing provided by suppliers. Those days are not paid out of the company's own cash.

Unit: working-capital-and-liquidity

Question 2Exam level

A retail company's Days Inventory Outstanding (DIO) increased from 45 days to 62 days while Days Payable Outstanding (DPO) increased from 30 days to 38 days. The Days Sales Outstanding (DSO) remained constant at 25 days. Which of the following best describes the impact on the cash conversion cycle and the company's liquidity?

How sure are you?

Correct: A. Old CCC = 45 + 25 - 30 = 40 days. New CCC = 62 + 25 - 38 = 49 days. Change = +9 days. A longer CCC means more cash is tied up in operations for longer, so liquidity worsened.
B. Candidates who only look at DIO change (17 days) and ignore the DPO change offset. The DPO increase of 8 days partially offsets the DIO increase of 17 days. Net effect is 17 - 8 = 9 days.
C. Candidates who see DPO increased and think 'more days to pay = better liquidity'. While DPO increase is favorable on its own, the DIO increase was larger. The net CCC still increased, meaning liquidity worsened on balance.

Unit: working-capital-and-liquidity

Question 3Exam level

A company extends its payment terms to suppliers from 30 days to 60 days. All else equal, what is the most likely effect on the cash conversion cycle and the company's relationship with suppliers?

How sure are you?

Correct: A. Extending payment terms increases DPO. Since CCC = DIO + DSO - DPO, a higher DPO reduces CCC. This is favorable for the company's liquidity. However, suppliers may respond by tightening credit terms, requiring upfront payment, raising prices, or deprioritizing the company's orders. Especially if the company lacks sufficient bargaining power. The exam expects candidates to identify BOTH effects.
B. The mechanical formula effect is correct, but the exam always tests the second-order consequence. Supplier relationships are not 'unaffected'. The CFA curriculum explicitly notes that pushing DPO to extremes can damage supplier relationships.
C. You might confuse the direction: if you pay suppliers LATER, you might think you are paying more (higher cost), which sounds like a CCC increase. Higher DPO = lower CCC. DPO is subtracted in the formula. Paying later frees up your cash faster.

Unit: working-capital-and-liquidity

Question 4Exam level

A company has a $10 million revolving line of credit with a stated interest rate of 5% per annum. The bank requires a compensating balance of 10% of the total line. The company needs to borrow $8 million. The effective annual interest rate on the borrowed funds is closest to:

How sure are you?

Correct: B. The compensating balance requirement means 10% of $10 million = $1 million must remain on deposit and cannot be used. The company borrows $8 million but must maintain $1 million as a compensating balance, leaving $7 million freely available... Actually the standard exam approach: compensating balance is 10% of borrowed amount or 10% of credit line. If 10% of line = $1M must stay on deposit. The company needs $8M usable. It must borrow $8M / (1 - 0.10) = $8.89M to have $8M available after setting aside the 10% compensating balance. Interest cost = $8.89M x 5% = $0.444M. Effective rate on $8M = $0.444M / $8M = 5.56%.
A. You might ignore the compensating balance and use the stated rate directly. The compensating balance reduces the usable funds, so the effective cost is always higher than the stated rate.
C. Candidates who compute effective rate as stated rate / (1 - compensating balance %) = 5% / 0.80 = 6.25% because they use the wrong compensating balance percentage or apply it incorrectly. The compensating balance here is 10% (not 20%), so the denominator is 0.90, not 0.80.

Unit: working-capital-and-liquidity

Question 5Exam level

Which of the following short-term financing sources is most likely available only to large, creditworthy corporations?

How sure are you?

Correct: B. Commercial paper is an unsecured short-term promissory note issued directly in the money market. Because it is unsecured and sold to sophisticated investors without individual credit assessment at each issuance, it is only available to companies with the highest credit ratings. Small or medium-sized companies cannot issue commercial paper. Bank lines of credit are available to companies of all sizes. Factoring is available to any company with receivables, often used by smaller firms.
A. Bank lines of credit sound more 'institutional' and formal. Banks extend lines of credit to companies of all sizes, including small businesses. They are not restricted to large corporations.
C. Factoring sounds sophisticated and financial. Factoring (selling receivables to a third party) is actually most commonly used by smaller companies that lack access to other forms of short-term financing. Large companies rarely factor because they have cheaper alternatives.

Unit: working-capital-and-liquidity

Question 6Exam level

A company sells $5 million in accounts receivable to a factor at a 3% discount with recourse. Which of the following statements is most accurate?

How sure are you?

Correct: A. With a 3% discount, the company receives 97% x $5 million = $4.85 million. 'With recourse' means if the receivables are not collected, the factor can seek repayment from the company. The company retains the credit risk. Non-recourse factoring would transfer the credit risk to the factor (at a higher discount rate).
B. You might confuse recourse and non-recourse. 'With recourse' sounds like the factor is giving something back (recourse to the factor). 'With recourse' means the factor has recourse against the SELLER (the company) if receivables go bad. Credit risk stays with the company.
C. You might think the face value is received and the discount is paid later. In factoring, the discount is taken upfront. The company receives less than face value immediately.

Unit: working-capital-and-liquidity

Question 7Exam level

A company's management wants to reduce its cash conversion cycle by 15 days without affecting sales or cost of goods sold. Which of the following actions would most directly achieve this goal?

How sure are you?

Correct: A. Negotiating longer payment terms increases DPO, which directly reduces CCC (CCC = DIO + DSO - DPO). Offering early payment discounts to customers would reduce DSO (customers pay faster), which also reduces CCC. But the cost is the discount given, which may affect margins. Increasing safety stock increases DIO, which increases CCC. The most direct and cost-free approach to reduce CCC is extending DPO via supplier negotiation.
B. Early payment discounts do reduce DSO and therefore CCC. This is a valid strategy. While B reduces CCC, the question asks for the action that 'most directly' achieves it without other side effects. B requires offering a financial incentive (a cost), and the question says 'without affecting sales or COGS.' A has no cost if the company has negotiating leverage.
C. Safety stock sounds like prudent management. Higher safety stock = more inventory = higher DIO = higher CCC. This is the opposite of the goal.

Unit: working-capital-and-liquidity

Question 8Exam level

Which of the following best describes a 'drag on liquidity' in the context of working capital management?

How sure are you?

Correct: B. A drag on liquidity occurs when short-term assets are slow to convert to cash. For example, uncollected receivables beyond their due date or excess inventory that is not selling. These assets are on the balance sheet but cannot be used to meet obligations. This directly maps to high DIO and high DSO in the CCC framework.
A. Short-term borrowing sounds like it 'drags' on the company. Short-term borrowing that creates immediate repayment pressure is a 'pull on liquidity'. Not a drag. A pull increases cash outflows. A drag reduces cash inflows.
C. Extended payables might sound like 'dragging' out payment. Extended payables are a 'pull on liquidity' if the creditor demands payment, or they may be a favorable financing source. They are not a drag.

Unit: working-capital-and-liquidity

Question 9Exam level

Company X has the following data: DIO = 45 days, DSO = 30 days, DPO = 20 days. Company Y has: DIO = 35 days, DSO = 25 days, DPO = 35 days. Which company most likely has the more efficient working capital management, and why?

How sure are you?

Correct: B. Company X CCC = 45 + 30 - 20 = 55 days. Company Y CCC = 35 + 25 - 35 = 25 days. Company Y has a CCC of 25 days vs. Company X's 55 days. A lower CCC means less cash is tied up in the operating cycle, indicating more efficient working capital management. Company Y achieves this through lower DIO (faster inventory turnover), lower DSO (faster collections), and higher DPO (longer to pay suppliers).
A. Company X does not have a longer DPO. Company X's DPO is 20 days and Company Y's is 35 days, so Company X's is the shorter one, not the longer one. This answer gets the comparison backwards.
C. Candidates who focus on DIO + DSO as a gross measure without accounting for DPO. CCC = DIO + DSO - DPO. You cannot assess efficiency without including the DPO offset.

Unit: working-capital-and-liquidity

Question 10Exam level

A company's aggressive short-term financing strategy most likely involves which of the following?

How sure are you?

Correct: C. An aggressive financing strategy uses short-term debt to finance not only temporary working capital but also a portion of the permanent working capital (the baseline level of current assets always on the books). This maximizes the cost advantage of short-term rates but increases rollover risk and refinancing risk. A conservative strategy uses long-term debt for all permanent assets plus some temporary working capital. A matching (hedging) strategy aligns the maturity of financing with the duration of the asset.
A. Using long-term debt for permanent working capital sounds 'aggressive' because it uses debt. Financing permanent capital with long-term debt is actually the conservative or matching strategy. The maturities are aligned.
B. This matches the textbook definition of the matching (hedging) strategy perfectly. This is the moderate/matching strategy, not the aggressive strategy. The aggressive strategy goes further by financing permanent assets with short-term debt.

Unit: working-capital-and-liquidity

Question 11Above the exam

A company has Days Inventory Outstanding (DIO) of 50 days, Days Sales Outstanding (DSO) of 35 days, and Days Payable Outstanding (DPO) of 40 days. Management is considering a supplier negotiation that would extend DPO to 55 days with no other changes. Combining the cash conversion cycle formula with this proposed change, the new cash conversion cycle would be closest to:

How sure are you?

Correct: B. Cash conversion cycle = DIO + DSO - DPO. Currently: 50 + 35 - 40 = 45 days. With DPO extended to 55 days: 50 + 35 - 55 = 30 days. Extending how long the company takes to pay its own suppliers (DPO) SHORTENS the cash conversion cycle, since the company holds onto its own cash longer before paying it out, financing more of its operations with supplier credit instead of its own working capital.
A. 65 days would result from adding DPO instead of subtracting it (50 + 35 + ... using a wrong sign somewhere), reversing the direction of DPO's effect; a longer payment period to suppliers reduces, not increases, the cash conversion cycle.
C. 125 days sums all three figures (50 + 35 + 40) as though DPO were an ADDITIONAL period the company waits, rather than a period that OFFSETS (reduces) the time cash is tied up; DPO is subtracted in the cash conversion cycle formula precisely because it represents financing supplied by others, not a further delay in the company's own cash cycle.

Unit: working-capital-and-liquidity

Question 12Above the exam

A company with strong, stable operating cash flow chooses to maintain a very large cash and marketable securities balance, well beyond its near-term operating needs, rather than return the cash to shareholders or invest it in the business. Combining the trade-off between liquidity and profitability with the opportunity cost of holding idle cash, this policy most likely:

How sure are you?

Correct: B. Working capital and liquidity management involves a direct trade-off: more liquidity (higher cash balances) reduces financial risk but typically also reduces returns, since cash and low-risk marketable securities generally earn less than the firm's cost of capital or its return on operating investments. Holding cash well beyond genuine operating needs, with no plan to deploy or return it, sacrifices the higher returns available elsewhere, which can reduce shareholder value even though it strengthens the balance sheet's liquidity position.
A. More liquidity is not unconditionally better; beyond a reasonable operating and precautionary buffer, excess cash sitting idle earns a low return and represents an opportunity cost, which is exactly the trade-off this LOS asks candidates to weigh, not a one-directional 'more is always better' rule.
C. Cash and marketable securities typically earn LESS than a firm's cost of capital (that is the whole basis of the opportunity-cost argument against holding excess cash); assuming they earn an equal return eliminates the very trade-off the question is built around.

Unit: working-capital-and-liquidity