Debt and Other Forms of Financing Ch.11 Test Bank Answers

Chapter 11 Questions

True/False

1. Only a handful of very large firms have access to funding sources such as asset-backed debt securitizations, A-l commercial paper ratings, and below-prime lending rates. (pg. 339)
2. Entrepreneurs requiring initial startup funding, generally seek capital from internal sources. (pg. 339)
3. Home equity lines of credit are the only way in which entrepreneurs provide funding for their businesses. (pg. 339)
4. The business operating cycle for a traditional manufacturer begins with the purchase of raw materials and ends with collections from the customer. (pg. 340)
5. The vast majority of organizations experience a gap between the time when they have to pay suppliers and when they receive payment from customers. This gap is known as the cost cycle. (pg. 341)
6. Companies with a negative cash conversion cycle will see their working capital requirements increase with growth. (pg. 341)
7. Corporate insolvency usually results when the firm fails to service its debt obligations on time. (pg. 342)
8. Net working capital is difficult to calculate; the method of taking the difference between current assets and current liabilities leaves the entrepreneur with ambiguous figures. (pg. 342)
9. From an ongoing perspective, the company’s new ratio might be more indicative of liquidity than either the current ratio or the quick ratio. (pg. 342)
10. Working capital requirements can fall short periodically as long as the company remains profitable. (pg. 342)
11. An entrepreneur may only cash in his accounts receivable by going to a finance company for a loan. (pgs. 342 - 343)
12. Accounts receivable represents liquid working capital that can be obtained prematurely without cost. (pg. 342)
13. Techniques for forecasting future sales are limited to methods that use external or economic information. (pg. 343)
14. From a microeconomic perspective, a company operating below its optimal output should always offer generous credit terms in order to stimulate demand. (pg. 344)
15. The credit terms of “10/15, net 30” mean that the payment is due within 15 days, but if paid within 10 days, there is a net 30% discount. (pg. 344)
16. The two major determinants of the credit decision are the character of the creditor firm and the capacity of the debtor company to repay the loan. (pg. 347)
17. Building up inventory typically reduces cash levels. (pg. 348)
18. When paying for working capital shortfalls, entrepreneurs look for short-term cash at the lowest possible rates. (pg. 348)
19. An entrepreneur only requires enough cash to cover needs under the most likely scenario he/she has forecasted. (pgs. 348 – 349)
20. One way for entrepreneurs to stretch their payables (to take longer to pay bills) is to take discounts. (pg. 349)
21. If an entrepreneur wants more credit and would like to stretch out her payables, she can negotiate with her suppliers for more generous credit terms. (pg. 349)
22. By paying bills more slowly, an entrepreneur will hurt his or her business. (pg. 349)
23. Some suppliers use generous terms on trade credit as a form of sales promotion. This is always less effective than an intensive advertising campaign or a high-pressure sales team. (pg. 350)
24. Pledging means using accounts payable as collateral for a loan from a finance company or bank. (pg. 351)
25. When a borrower instructs its customers to pay their invoices directly to the lender, the arrangement is called, “Pledging with notification.” (pg. 351)
26. A chattel mortgage is a loan secured by specific assets. (pg. 352)
27. When using a public warehousing arrangement for a bank loan, the entrepreneur surrenders access to his/her inventory. (pg. 352)
28. Factoring with recourse implies that if a company does not pay its bill, the factor must absorb the loss. (pg. 352)
29. The term, factoring, refers to selling accounts receivable at a discount to a finance company known as the factor. (pg. 352)
30. An entrepreneur's inventory is an asset that legally cannot serve as collateral for a loan. (pg. 352)

Multiple Choices

1. Which of these begins with the purchase of the raw materials, includes the work‐in‐process period, and ends with the sale of the finished goods? (pg. 341)
   1. The accounts receivable cycle
   2. The accounts payable cycle
   3. The cash conversion cycle
   4. The deferred income tax cycle
   5. The inventory cycle
2. During which of these operating cycles, the business generally receives some credit from suppliers? (pg. 341)
   1. The accounts receivable cycle
   2. The accounts payable cycle
   3. The cash conversion cycle
   4. The deferred income tax cycle
   5. The inventory cycle
3. Which of these begins with the purchase of the raw materials or finished goods, but it ends with the payment to the supplier? (pg. 341)
   1. The accounts receivable cycle
   2. The accounts payable cycle
   3. The cash conversion cycle
   4. The deferred income tax cycle
   5. The inventory cycle
4. Which of these describes a gap between the time when they have to pay suppliers and the time when they receive payment from customers? (pg. 341)
   1. The accounts receivable cycle
   2. The accounts payable cycle
   3. The cash conversion cycle
   4. The deferred income tax cycle
   5. The inventory cycle
5. The ______ of receivables collection and payment of accounts payable are key determinants in whether a firm is cash rich or cash poor. (pg. 342)
   1. quantity
   2. cost
   3. difference
   4. interest
   5. timing
6. The basis of all receivables and collections is actual net sales, which is equal to ______. (pg. 343)
   1. sales minus any returns.
   2. sales plus any returns.
   3. sales minus returns only if they are 90 days late.
   4. sales plus returns only if they are 90 days late.
   5. None of the above
7. Methods of forecasting environmental change fall into two broad groups. One group is primarily concerned with forecasting the future performance of the economy as a whole; the other group is more concerned with forecasting ______ for individual industries and products. (pg. 343)
   1. sales
   2. cost
   3. inventory
   4. weather patterns
   5. None of above
8. The relative proportions of cash sales and credit sales make an important difference to which of the following? (pg. 343)
   1. Expected sales.
   2. Expected cost.
   3. Expected inventory.
   4. Expected cash flows.
   5. Expected accounts receivable.
9. The magnitude of a company's accounts receivable obviously depends upon a number of factors, except _________. (pgs. 343-344)
   1. the level and the pattern of sales
   2. the breakdown between cash and credit sales
   3. the difference between current assets and current liabilities
   4. the nominal credit terms offered
   5. the enforcement of credit terms
10. What economic factor concerning the entrepreneur’s product is the most significant for the company’s credit policy? (pg. 344)
    1. Elasticity of demand
    2. Elasticity of supply
    3. Margin of profit
    4. Margin of utility
    5. None of above
11. Which of the following is a method of pursuing payment from a customer whom the entrepreneur believes able to pay? (pg. 346)
    1. Refusing any further supplies, or supplying only for cash
    2. Threatening legal action
    3. Actually undertaking legal proceedings, using a specialized collection agency
    4. All of the above
    5. None of the above
12. It’s safe to say that collection procedures are expensive and justifiable only when the expected results ______. (pg. 346)
    1. are lower than the cost.
    2. exceed the cost.
    3. are equal to the cost.
    4. are at least 40% lower than the cost.
    5. None of the above.
13. A method of reducing overdue accounts and limiting bad debts is setting limits to the credit allowed on______. (pg. 346)
    1. corporate buyers
    2. individual accounts
    3. high-cost goods
    4. low-cost goods
    5. none of the above
14. Which of the following is NOT one of the Five Cs of credit? (pg. 347)
    1. Character
    2. Capacity
    3. Capital
    4. Collateral
    5. Customers
15. Although the opportunity costs for accounts receivable may be quite large, the largest current asset balances are usually in______. (pg. 347)
    1. cash
    2. accounts receivable
    3. inventories
    4. property, plant, and equipment
    5. short-term investments
16. Which of the following assets represent the most important current asset of many manufacturing companies? (pg. 347)
    1. Cash
    2. Accounts receivable
    3. Inventories
    4. Property, plant, and equipment
    5. Short-term investments
17. What does a trade-credit effectively amount to? (pg. 349)
    1. Higher accounts payable.
    2. Higher trust among companies in the same industry.
    3. A loan to the entrepreneur’s working capital.
    4. Debt swaps.
    5. None of the above
18. Typically, a company can borrow what percent of its accounts receivable’s face value if it has a good credit rating and its customers have excellent credit ratings. (pg. 351)
    1. 15% to 25%
    2. 25% to 50%
    3. 50% to 75%
    4. 75% to 90%
    5. 90%to 100%
19. When factoring accounts receivables, a factor will charge the entrepreneur which of the following fee(s)? (pg. 352)
    1. An interest charge
    2. A collection fee
    3. A credit checking fee
    4. All of the above
    5. None of the above
20. Which of the following is NOT a way to use inventory as security for a loan?

(pg. 352)

• 1. A chattel mortgage
  2. A floating lien
  3. Field warehousing
  4. Public warehousing
  5. Outside project financing

1. Banks prefer 90-day maturities on short term loans in order to (pg. 354)
   1. Charge additional fees
   2. Gain more favor from the entrepreneur
   3. Hedge against changes in the LIBOR rate
   4. Have a chance to regularly check an entrepreneur’s financial statements
   5. None of the above
2. Which of the following is NOT a factor that influences the interest borrowers pay?

(pg. 355)

• 1. the dollar amount of the loan
  2. the length of time involved
  3. the nominal rate of interest
  4. the repayment location
  5. the method used to calculate the interest

1. The bank discount method is common in ______. (pg. 355)
   1. short-term business loans
   2. long-term business loans
   3. financing from customer prepayments
   4. collateral appraisal
   5. insurance
2. Bank term loans may include which of the following restrictive covenants? (pg. 356)
   1. General provisions
   2. Routine provisions
   3. Specific provisions
   4. All of the above
   5. None of the above

25) Which of the following requirements apply with an SBA loan (pg. 359)

• 1. The loan must purchase items made in the USA
  2. The venture’s debt to equity ratio must be less than or equal to 4:1 post loan
  3. The loan cannot be used for leasehold improvements
  4. All of the above
  5. None of the above.

1. 21) SBA‐guaranteed loans can be used for which of the following purposes? (pg. 359)
   1. Expand or renovate facilities
   2. Purchase machinery, equipment, fixtures, and leasehold improvements
   3. Finance receivables and augment working capital
   4. Provide seasonal lines of credit
   5. All of the above

Open Ended

1. When choosing to use internal funds as means to support growth, discuss to what ends this growth must be ultimately focused on (in terms of financing considerations). (pgs. 339 – 340)
   • Entrepreneurs must constantly ensure a balance and alignment exist between their goals, their means to achieve said goals, and the ways in which theirs mean are applied to reach those goals. Misalignment between any parts of these three creates additional strategic risk. When entrepreneurs use internal funds they are pairing venture risk with at least some personal risk. Therefore the goal of using internal funds should be to obtain access to better sources of funds which entail less personal risk. Key metrics such as free cash flow and pre-tax undedicated cash flow vary in relative importance depending on whether the entrepreneurs’ goals include growth through debt financing or through acquisition, respectively. Unless the entrepreneur’s personal internal funds are vast, he/she should ensure his/her internal means are sufficient to realistically allow the venture to set the conditions to receive external funding in a reasonable period of time, with reserves built in for the unexpected crisis and opportunities. The absence of sufficient internal means necessitates the revision of the entrepreneurs’ goals, risk tolerance, or a combination of all the above.
2. What actions towards the ventures’ cash collection cycle, should an entrepreneur take before seeking ways to prematurely extract short term cash from his/her operating assets? (pgs. 340 – 351)
   • “An ounce of prevention is worth a pound of cure”- Before investing too much time in planning how to harvest short term cash from your operating assets, ensure you have done all that you can to optimize your CCC. Consider how variation on your value proposition, or value chain, can improve your CCC. Without misaligning priorities, strive to build the lowest possible requirements for working capital possible from the beginning, while retaining the ability to grow in the future. Removing 15% of your working capital requirements upfront will save time, worry, and money in the future as your venture grows, and could make or break your ability to set the conditions necessary to obtain future external funds. Attempting to mitigate the ill-effects of a bloated cash conversion system in the midst of growth would be far more difficult.
3. Discuss the importance of the cash conversion cycle. (pg. 341)
   • It is clear now that working capital requirements will increase when a venture with a positive cash conversion cycle (CCC) grows. This increased need requires additional funds and must be aligned with fund sources or else growth can lead to insolvency. Working capital is but one of many requirements to support growth.
   • The vast majority of organizations, particularly manufacturing operations, experience a gap between the time when they have to pay suppliers and the time when they receive payment from customers.
   • One of the primary causes of bankruptcy is the inability to finance operations, shutting down potentially successful ventures.
   • The industry’s typical cash conversion cycle is one of the most important things an entrepreneur should find out in regards to determining his or hers financing scheme.
4. Net working capital is often thought of as the balance of completely liquid assets and liabilities. However, this is not completely true. Please explain why parts of working capital can become stagnant and hurt cash levels, even if a firm is growing and profitable. (pg. 342)

• As a small firm grows, current operating assets will increase. Increased inventory requirements as company increases its number of stores is one example. Even as the actual products are being sold out of inventory, the number of products that must be held in inventory reserves remains the same. This obstructs liquidity and reduces the company’s available cash.
• If current operating liabilities do not increase at the same rate as the increase in current operating assets, then the entrepreneur will find that the firm's net liquid balance will decrease. More of the firm’s cash will become tied up in accounts receivable and inventory.
• If the increase in working capital requirements exceeds the increase in profits, then the firm will find its liquidity, and cash on hand, reducing.

1. Is it a mistake for a company to offer credit terms to its customers for early payment? (pgs. 344 – 345)

• This depends on whether giving a cash discount speeds up collections, and whether the opportunity cost of the funds that would otherwise have been locked up in receivables justifies the reduction in net sales revenues.

1. What factors should an entrepreneur consider when appraising the creditworthiness of new customers (also known as the 5Cs)? (pg. 347)
   • Character - the customer’s integrity and willingness to repay the financial obligation.
   • Capacity - addresses the borrower’s cash flow and ability to repay the debt from ongoing business operations.
   • Capital - the borrower’s financial net worth; consequently, a wealthy borrower may be a desirable customer even if his or her annual cash flows are relatively low
   • Collateral - refers to the resale value of the product in the event repossession becomes necessary.
   • Conditions - refer to national or international economic, industrial, and firm‐specific prospects during the time period of the credit.
2. Why do entrepreneurs usually want to keep inventory levels as low as possible? What are the challenges facing entrepreneurs who want to reduce their inventory levels? (pgs. 347- 348)

To reduce the inventory expenses such as storage costs and insurance. To ensure that as little capital as possible is tied up in inventory.

The challenges to keeping inventory levels low include:

The costs of frequent reordering.

Loss of quantity discounts.

Loss of customer goodwill or plant efficiency due to items being unavailable when needed.

1. Discuss the importance of forecasting cash flow requirements as it pertains to working capital. (pg. 348)
   • It is commonly heard that many entrepreneurs find themselves up late at night sweating over their cash flow statements, trying to sort out if they can make payroll at the end of the week. This is a problem of being short on cash, but one which often comes prior to running so short that suppliers cannot be paid such that they continue to do business with you. Forecasting cash flow is critical because, like oxygen, it will utterly consume the entrepreneurs’ full attention the moment it becomes scarce. Multiple factors can impact a venture need for cash, including the seasonality of demand, weather, stories in the press, or the occurrence of major cultural events. To the greatest practical extent possible, the entrepreneur must seek to forecast and source these needs for funds. That said, entrepreneurs must judiciously know when to stop allocating additional managerial time to further calculations, and adjust their forecasts to deal with the remaining uncertainties, and worst case contingencies, so that they can focus on execution successfully.
2. What are the advantages of trade credit over other sources of financing? (pg. 349)

• The first advantage is convenience: trade credit is not negotiated; it requires no great expenditure of executive time, and no legal expenses.
• The second advantage is that the credit available from this source automatically grows as the company grows. Accounts payable are known as a spontaneous source of financing. As sales expand, production schedules increase, which in turn means that larger quantities of materials and supplies must be bought. In the absence of limits on credit, the additional credit becomes available automatically simply because the firm has placed orders for the extra material. Of course, if the manufacturing process is long and the company reaches the supplier's payment before selling the goods, it may need some additional source of credit. But the amount will be much less than if no trade credit had been available.

1. Short of demanding payments, what sales terms could an entrepreneur choose in order to collect cash more quickly? (pgs. 350 – 351)

• Introduce, increase, or eliminate discounts. A company can initiate a discount for prompt payment (for example, a 2% discount for payment within ten days). Similarly, a company with an existing discount may increase the discount (for example, increase discount from 1% to 2%). Finally, a company can eliminate the discount altogether and simply demand cash immediately or upon delivery (COD). Companies will have difficulty instituting these measures if competitors offer significantly more, lenient credit terms.
• Emphasize cash sales. Some entrepreneurs, particularly those selling directly to consumers, may be able to increase their percentage of cash sales.
• Accept credit cards. Sales made on bank credit cards or on travel or entertainment cards are convertible into cash within a couple of days. The credit card companies charge 3% to 7% of the amount of the sale for this service.

1. What kind of information will the loan officer be interested in, when entrepreneurs are looking for a bank loan? (pg. 356)

• How much money the company needs.
• How the company will use this money.
• How the company will repay the bank, including financial statements from the company.
• When the company will repay the bank.

1. What are the three categories of restrictive covenants mentioned in the chapter, in relation to loan agreements? (pg. 356)

• General provisions, which force the borrower to preserve liquidity and limit cash outflows.
• Routine provisions, which are common and non-variable restrictions.
• Specific provisions, which vary according to the situation.

1. List two examples of Routine Provisions. (pgs. 357-358)

• The borrower must furnish the bank with periodic financial statements and maintain adequate property insurance.
• The borrower agrees not to sell a significant portion of its assets. A provision forbidding the pledging of the borrower's assets is also included in most loan agreements. This provision is often termed a negative pledge clause.
• The borrower is restricted from entering into any new leasing agreements that might endanger the ability to pay the loan.
• The borrower is restricted from acquiring other firms unless prior approval has been obtained from the lender.

1. Give an example of a Specific Provision that an entrepreneur might encounter in a loan agreement. (pg. 358)

• Key executives may be required to sign employment contracts or take out substantial life insurance.
• The bank may require the right to be consulted before any changes are made in the company's top management.
• Some covenants prevent increases in top management salaries or other compensation.

1. To qualify for assistance from the Small Business Administration, the proceeds of an SBA-guaranteed loan must be used for what purpose? (pg. 359)

• Expand or renovate facilities
• Purchase machinery, equipment, fixtures and leasehold improvements
• Finance receivables and augment working capital
• Refinance existing debt (for compelling credit reasons of benefit to the borrower)
• Provide seasonal lines of credit
• Construct commercial buildings
• Purchase land or buildings.