Banks sometimes require borrowers to maintain compensating balances,which
are deposit requirements set at between 10 and 20 percent of the loan amount.
Compensating balances raise the effective interest rate on bank loans.
Aline of creditis an informal agreement between the bank and the borrower in-
dicating the maximum amount of credit the bank will extend to the borrower.
A revolving credit agreementis a formal line of credit often used by large firms;
it involves a commitment fee.
Commercial paperis unsecured short-term debt issued by large, financially
strong corporations. Although the cost of commercial paper is lower than the cost
of bank loans, it can be used only by large firms with exceptionally strong credit
ratings.
Sometimes a borrower will find that it is necessary to borrow on a secured basis,
in which case the borrower pledges assets such as real estate, securities, equipment,
inventories, or accounts receivable as collateral for the loan.
Questions
Define each of the following terms:
a.Working capital; net working capital; net operating working capital
b.Inventory conversion period; receivables collection period; payables deferral period; cash
conversion cycle
c.Relaxed NOWC policy; restricted NOWC policy; moderate NOWC policy
d.Transactions balance; compensating balance; precautionary balance
e.Cash budget; target cash balance
f.Trade discounts
g.Account receivable; days sales outstanding; aging schedule
h.Credit policy; credit period; credit standards; collection policy; cash discounts
i.Permanent NOWC; temporary NOWC
j.Moderate short-term financing policy; aggressive short-term financing policy; conservative
short-term financing policy
k.Maturity matching, or “self-liquidating,” approach
l.Accruals
m. Trade credit; stretching accounts payable; free trade credit; costly trade credit
n.Promissory note; line of credit; revolving credit agreement
o.Commercial paper; secured loan
What are the two principal reasons for holding cash? Can a firm estimate its target cash balance
by summing the cash held to satisfy each of the two reasons?
Is it true that when one firm sells to another on credit, the seller records the transaction as an
account receivable while the buyer records it as an account payable and that, disregarding dis-
counts, the receivable typically exceeds the payable by the amount of profit on the sale?
What are the four elements of a firm’s credit policy? To what extent can firms set their own
credit policies as opposed to having to accept policies that are dictated by “the competition”?
What are the advantages of matching the maturities of assets and liabilities? What are the
disadvantages?
From the standpoint of the borrower, is long-term or short-term credit riskier? Explain. Would it
ever make sense to borrow on a short-term basis if short-term rates were above long-term rates?
“Firms can control their accruals within fairly wide limits.” Discuss.
Is it true that most firms are able to obtain some free trade credit and that additional trade credit
is often available, but at a cost? Explain.
16–9 What kinds of firms use commercial paper?
16–8
16–7
16–6
16–5
16–4
16–3
16–2
16–1
Questions 613
608 Working Capital Management
