CAF-7 · Chapter 12
Working Capital Management MCQs with Answers
15 multiple-choice questions on Working Capital Management for CAF-7 Business Insights and Analysis. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
What is the standard formula used to calculate a company's Cash Operating Cycle?
- A) Inventory Days + Trade Payable Days - Trade Receivable Days
- B) Inventory Days + Trade Receivable Days - Trade Payable Days
- C) Trade Receivable Days + Trade Payable Days - Inventory Days
- D) Current Assets - Current Liabilities
Show answer & explanation
Answer: B) Inventory Days + Trade Receivable Days - Trade Payable Days
The cash operating cycle measures the time between paying cash for inventory and receiving cash from customers. It is calculated by adding inventory holding days and receivable collection days, and then subtracting the payable deferral days.
Question 2
A rapidly expanding retail business is facing severe cash shortages. It is frequently delaying payments to its suppliers, relying heavily on its bank overdraft, and its current ratio has fallen to 0.8. This company is displaying classic symptoms of:
- A) Over-capitalization
- B) Overtrading (Under-capitalization)
- C) Efficient working capital management
- D) Debt securitization
Show answer & explanation
Answer: B) Overtrading (Under-capitalization)
Overtrading occurs when a business tries to support too large a volume of trade with too little long-term capital. Symptoms include a heavy reliance on overdrafts, deteriorating liquidity ratios, and an inability to pay suppliers on time.
Question 3
When assessing a company's short-term liquidity, why is the Quick Ratio (Acid Test Ratio) often considered a more severe and accurate test than the Current Ratio?
- A) Because it excludes trade payables from the calculation
- B) Because it assumes all short-term debt will be converted to long-term debt
- C) Because it excludes inventory, which is often the least liquid of the current assets
- D) Because it only includes cash balances and ignores trade receivables
Show answer & explanation
Answer: C) Because it excludes inventory, which is often the least liquid of the current assets
The Quick Ratio excludes inventory from current assets because inventory can take a significant amount of time to sell and convert into cash. Therefore, removing it provides a stricter test of the company's immediate ability to pay its debts.
Question 4
A company sells its outstanding trade receivables to a third-party financial institution. The agreement stipulates that if any of the customers default on their payments, the financial institution bears the loss and cannot demand the money back from the company. This arrangement is known as:
- A) Invoice discounting
- B) Recourse factoring
- C) Non-recourse factoring
- D) Securitization
Show answer & explanation
Answer: C) Non-recourse factoring
In non-recourse factoring, the factor (the financial institution) assumes the risk of bad debts. If a customer defaults, the factor bears the loss, providing the selling company with complete protection against credit risk.
Question 5
A company adopts an aggressive working capital financing policy. Which of the following best describes this policy?
- A) Financing all non-current assets and a large portion of fluctuating current assets with long-term debt and equity
- B) Financing all fluctuating current assets and a portion of permanent current assets with short-term finance
- C) Financing non-current assets with short-term overdrafts to minimize interest costs
- D) Holding massive cash reserves to protect against unexpected economic shocks
Show answer & explanation
Answer: B) Financing all fluctuating current assets and a portion of permanent current assets with short-term finance
An aggressive working capital policy relies heavily on cheaper (but riskier) short-term finance. Under this policy, short-term finance is used to fund all fluctuating current assets and a portion of the permanent current assets.
Question 6
According to economic theory, there are three primary motives for a business to hold cash. Which motive relates to holding cash to take advantage of sudden, unexpected investment opportunities or favourable market price drops?
- A) The transactions motive
- B) The precautionary motive
- C) The speculative motive
- D) The profitability motive
Show answer & explanation
Answer: C) The speculative motive
The speculative motive involves holding cash to be in a position to exploit unexpected opportunities, such as purchasing discounted raw materials or acquiring a struggling competitor at a bargain price.
Question 7
A business decides to drastically increase its trade payable days from 30 days to 75 days by delaying payments to its suppliers. While this will improve the company's cash flow in the short term, what is the most likely negative consequence?
- A) The cash operating cycle will significantly lengthen
- B) The company will lose the trust of its suppliers, potentially resulting in delayed deliveries or suppliers refusing to offer future credit
- C) The company's quick ratio will immediately increase
- D) Trade receivable days will automatically increase
Show answer & explanation
Answer: B) The company will lose the trust of its suppliers, potentially resulting in delayed deliveries or suppliers refusing to offer future credit
Artificially extending payable days effectively forces suppliers to act as a source of free finance. This severely damages supplier relationships, risking supply chain disruptions, loss of goodwill, and the withdrawal of future credit facilities.
Question 8
Which of the following factors is LEAST likely to influence the required level of working capital investment in a company?
- A) The length of the working capital cycle
- B) The company's risk management strategy and desired inventory buffers
- C) The industry's standard credit terms and payment practices
- D) The depreciation method used for valuing the company's factory machinery
Show answer & explanation
Answer: D) The depreciation method used for valuing the company's factory machinery
Depreciation is a non-cash expense related to long-term non-current assets. It has absolutely no direct impact on the day-to-day cash flows or the short-term working capital cycle (inventory, receivables, payables) of the business.
Question 9
A firm has an average inventory of Rs. 400,000, average trade receivables of Rs. 300,000, and average trade payables of Rs. 200,000. If its annual Cost of Sales is Rs. 2,000,000, what is its Inventory Turnover Period (assuming a 365-day year)?
- A) 73 days
- B) 55 days
- C) 37 days
- D) 91 days
Show answer & explanation
Answer: A) 73 days
Inventory Turnover Period (Inventory Days) = (Average Inventory / Cost of Sales) * 365. Calculation: (400,000 / 2,000,000) * 365 = 73 days.
Question 10
A company holds massive amounts of inventory 'just in case', has extremely relaxed credit terms allowing customers 90 days to pay, and keeps millions in idle cash in a zero-interest bank account. This company is most likely suffering from:
- A) Overtrading
- B) Over-capitalization
- C) Capital rationing
- D) Securitization
Show answer & explanation
Answer: B) Over-capitalization
Over-capitalization occurs when a company has too much working capital tied up in idle cash, excessive inventory, and slow-paying receivables. While it means low risk of insolvency, it results in extremely poor returns on investment and lost profitability.
Question 11
If a company successfully implements a 'Just-In-Time' (JIT) inventory management system, what will be the most immediate and direct impact on its working capital metrics?
- A) Trade payable days will significantly increase
- B) Inventory holding days will dramatically decrease
- C) Trade receivable days will drop to zero
- D) The quick ratio will fall below 0.5
Show answer & explanation
Answer: B) Inventory holding days will dramatically decrease
JIT involves purchasing raw materials exactly when they are needed for production and producing goods exactly when they are needed for sale. This virtually eliminates the need for holding stock, drastically reducing inventory holding days.
Question 12
When a company calculates its Work-in-Process (WIP) inventory valuation for working capital purposes, how should non-cash items like factory depreciation be treated?
- A) They must be added to the raw material cost at 100% completion
- B) They must be completely excluded from the calculation
- C) They must be included in conversion costs at a 50% completion rate
- D) They must be discounted back to their present value
Show answer & explanation
Answer: B) They must be completely excluded from the calculation
Working capital calculations dictate the actual cash required to finance operations. Depreciation is a non-cash expense and does not represent funds tied up in the daily operating cycle, so it must be stripped out of overheads before valuing WIP.
Question 13
A supplier offers terms of '2/10, net 30'. What does this mean for the purchasing company?
- A) The company must pay a 2% penalty if it pays after 10 days, with the final limit being 30 days
- B) The company can take a 2% cash discount if it pays within 10 days; otherwise, the full net amount is due within 30 days
- C) The company will receive a 10% discount if it pays within 2 days
- D) The company is required to pay 2/10ths of the invoice within 30 days
Show answer & explanation
Answer: B) The company can take a 2% cash discount if it pays within 10 days; otherwise, the full net amount is due within 30 days
This is standard credit term terminology. '2/10, net 30' means the buyer can deduct 2% from the invoice amount if payment is made within 10 days. If the discount is not taken, the full (net) invoice amount is due within 30 days.
Question 14
Which of the following is a primary disadvantage of financing working capital entirely through short-term debt (such as an overdraft) rather than long-term debt?
- A) Short-term debt is generally more expensive than long-term debt
- B) Short-term debt requires shareholders to surrender voting rights
- C) Short-term debt carries high renewal risk and subjects the company to fluctuating, volatile interest rates
- D) Short-term debt cannot be used to pay for raw materials
Show answer & explanation
Answer: C) Short-term debt carries high renewal risk and subjects the company to fluctuating, volatile interest rates
Short-term debt (like overdrafts) can be withdrawn by the bank at any time (renewal risk) and is subject to variable interest rates, exposing the company to significant liquidity and market risks if economic conditions tighten.
Question 15
In working capital management, the 'Matching Principle' (or Hedging Principle) suggests that a firm should finance:
- A) All assets exclusively with short-term bank overdrafts
- B) Short-term fluctuating assets with short-term finance, and permanent current assets and non-current assets with long-term finance
- C) All current assets solely with equity finance
- D) Its inventory entirely through early settlement discounts
Show answer & explanation
Answer: B) Short-term fluctuating assets with short-term finance, and permanent current assets and non-current assets with long-term finance
The matching principle is a moderate approach to working capital financing. It states that the maturity of the funding should match the life of the asset being funded. Short-term needs get short-term debt; long-term and permanent assets get long-term debt/equity.