Question 1

The effect of compensating balances is to decrease the effective interest rate of a loan.

Accepted Answer

Compensating balances increase the effective interest rate of a loan because they require the borrower to maintain a minimum balance in a non-interest-bearing account, effectively reducing the amount of the loan available for use while still paying interest on the full loan amount.

Question 2

When the accounts receivable turnover and payables deferral period are decreased, a firm's cash conversion cycle will be lengthened.

Accepted Answer

A shorter accounts receivable turnover and a longer payables deferral period both mean that the company takes longer to convert sales into cash. This is reflected in a lengthening of the cash conversion cycle.

Question 3

Under a public warehouse agreement, the inventory used as collateral for the loan is stored on the premises of a third party.

Accepted Answer

The inventory used as collateral for the loan is stored on the premises of a third-party under a public warehouse agreement.

Question 4

The inventory conversion period of the operating cycle terminates when the inventory is paid for with cash.

Accepted Answer

The inventory conversion period ends when the inventory is sold, not when it is paid for with cash.

Question 5

As a rule, managers should try to always use the free component of trade credit but should use the costly component only if the cost of this credit is lower than the costs of credit from other sources.

Accepted Answer

It is generally recommended that managers should use the free component of trade credit before using the costly component, unless the cost of the costly component is lower than other available sources of credit.

Question 6

Due to the complexity of factoring procedures, factoring is rarely used as a source of short-term financing in Canada today.

Accepted Answer

Factoring is actually a commonly used method of short-term financing in Canada and many other countries, as it allows businesses to quickly convert their accounts receivable into cash, thereby improving their liquidity and cash flow.

Question 7

Stretching accounts payable is a widely accepted and costless financing technique.

Accepted Answer

The answer of Stretching accounts payable is a widely accepted...

Question 8

The maturity matching, or "self-liquidating," approach involves the financing of permanent net operating working capital with combinations of long-term capital and short-term capital that vary depending on the level of interest rates. When short-term rates are relatively high, short-term assets will be financed with long-term debt to reduce costs and risk.

Accepted Answer

The maturity matching or "self-liquidating" approach involves financing assets with a similar maturity. Permanent net operating working capital would typically be financed with long-term capital, not a combination that varies with interest rates. The approach described mixes strategies and misinterprets the concept of maturity matching.

Question 9

The trade credit that a firm receives during the discount period is referred to as free trade credit.

Accepted Answer

Free trade credit refers to the trade credit received during the discount period, which is essentially an interest-free loan from the supplier to the buyer.

Question 10

While the maturity of most bank loans is short term, they are frequently repaid on demand rather than on a specific maturity date.

Accepted Answer

Most bank loans have a short-term maturity of 1-5 years, but they are often repaid on demand, meaning the lender can request repayment at any time rather than waiting for a specific maturity date. This is commonly seen in lines of credit or revolving credit facilities.

Question 11

Accruals are spontaneous, but, unfortunately, due to law and economic forces, firms have little control over the level of these accounts.

Accepted Answer

Accruals, such as accounts payable and accounts receivable, are generated as a result of normal business operations and are not under a firm's direct control. Laws and economic factors also play a role in their levels.

Question 12

One of the effects of not taking trade credit discounts when offered is that the firm's use of accounts payable rises.

Accepted Answer

If a firm does not take trade credit discounts when offered, they are essentially extending their accounts payable period. This means they will owe more money to their suppliers and therefore their use of accounts payable will increase.

Question 13

A line of credit can be either a formal or an informal agreement between a borrower and a bank regarding the maximum amount of credit the bank will extend to the borrower subject to certain conditions, including the borrower's maintaining its financial strength.

Accepted Answer

A line of credit is a formal or informal agreement between a borrower and a bank regarding the maximum amount of credit the bank will extend to the borrower subject to certain conditions, including the borrower's maintaining its financial strength.

Question 14

Pledging of receivables involves the sale of accounts receivable.

Accepted Answer

Pledging of receivables involves using accounts receivable as collateral for a loan, but they are not sold. Factoring, on the other hand, involves the sale of accounts receivable.

Question 15

Generally, the longer the normal inventory holding period of customers, the longer the credit period. One effect of lengthening the credit period to match the customer's merchandise holding period is to increase the payables deferral period, which shortens the customer's cash conversion cycle.

Accepted Answer

When the credit period is lengthened to match the customer's merchandise holding period, it allows customers to hold onto the inventory for longer before paying for it, which increases the payables deferral period. This shortens the customer's cash conversion cycle as they are able to hold onto their cash for longer before making payments.

Question 16

Interest rates charged on loans vary depending on the risk of borrower, and the size of the loan, but not the economic conditions.

Accepted Answer

Economic conditions can significantly affect interest rates. During periods of economic growth, interest rates may be lower due to increased competition among lenders. During recessions, interest rates may be higher due to increased risk and reduced availability of credit.

Question 17

An informal line of credit and a revolving credit agreement are similar except that a line of credit creates a legal obligation for the bank.

Accepted Answer

An informal line of credit and a revolving credit agreement are similar in that they both allow the borrower to borrow funds up to a certain limit and repay the borrowed amount along with interest. However, a revolving credit agreement creates a legal obligation for the borrower to repay the borrowed amount, whereas an informal line of credit does not have a formal agreement outlining the terms of borrowing and repayment, and therefore does not create a legal obligation.

Question 18

Under a revolving credit agreement, the risk to the firm of being unable to obtain funds when needed is lower than with an informal line of credit.

Accepted Answer

Under a revolving credit agreement, the firm has a pre-approved credit limit which can be drawn upon as needed, providing greater certainty of access to funds compared to an informal line of credit.

Question 19

Accruals are "free" capital in the sense that no explicit interest must be paid on accruals.

Accepted Answer

This statement is true. Accruals are funds that are owed but have not yet been paid and do not require explicit interest payments.

Question 20

Uncertainty about the exact lives of assets prevents precise maturity matching in an ex post (i.e., after the fact) sense even though it is possible to match maturities on an expected basis.

Accepted Answer

This statement is true. While it is possible to match maturities based on expectations, uncertainties about the actual lives of assets make it difficult to do so in a precise manner after the fact.

Quiz 17: Working Capital Management and Short-Term Financing