Short-Term Financing & Liquidity - Corporate Finance

1. Company A has a cash conversion cycle of 60 days. Company B, a direct competitor of similar size and profitability, has a cash conversion cycle of 90 days. Assuming both companies face the same market conditions, which of the following statements is the most accurate assessment of their relative liquidity risk?
   Answer: Company B faces higher liquidity risk because its cash is tied up in working capital for a longer period, creating a greater need for external short-term financing. A longer cash conversion cycle (CCC) means a longer time lag between paying for inputs (cash out) and receiving cash from the sale of products (cash in). This longer period requires more financing to support working capital. A greater reliance on financing, particularly short-term financing, exposes the firm to higher liquidity risk. If financing becomes unavailable or too expensive, Company B would be in a more difficult position than Company A. Therefore, Company B faces higher liquidity risk. Distractor A incorrectly links a longer CCC to lower risk. Distractor B makes an assumption about payment terms that may not be true and incorrectly concludes A has higher risk. Distractor D is incorrect; the CCC is a key indicator of liquidity management and risk.
2. A company's financial policy is to fund a portion of its permanent current assets, as well as all of its temporary current assets, with short-term debt. This approach is best described as an 'aggressive' financing strategy. What is the primary risk inherent in this policy?
   Answer: High exposure to refinancing risk and interest rate risk, as short-term debt must be frequently rolled over at prevailing market rates. When you encounter questions about working capital financing strategies, focus on the fundamental trade-off between risk and return that defines conservative versus aggressive approaches. An aggressive financing strategy uses short-term debt to fund not only temporary current assets (which naturally fluctuate with business cycles) but also a portion of permanent current assets (the base level of inventory and receivables needed for ongoing operations). This creates a maturity mismatch where long-term assets are funded with short-term liabilities. The primary risk is captured in answer D: high exposure to refinancing and interest rate risk. Since short-term debt typically matures within one year, the company must continuously "roll over" this debt by obtaining new financing. Each time they refinance, they face two dangers: rates may have risen (interest rate risk), or credit may be unavailable entirely (refinancing risk). During credit crunches or economic downturns, this can create liquidity crises. A describes conservative financing, which maintains excess liquidity at the cost of lower returns. B is backwards—aggressive financing actually increases financial leverage and typically boosts ROE when successful. C confuses financing strategy with inventory management; aggressive financing doesn't inherently require holding more inventory, just funding existing inventory with short-term debt. Study tip: Remember the maturity matching principle—financing temporary needs with temporary funding is safe, but financing permanent needs with temporary funding creates rollover risk. Aggressive strategies sacrifice safety for potentially higher returns through cheaper short-term rates.
3. A large, publicly traded company with a very high credit rating needs to finance a seasonal increase in inventory for 90 days. Which of the following factors would most strongly favor the issuance of commercial paper over drawing on a bank line of credit?
   Answer: The ability to bypass financial intermediaries and access funds at a lower cost directly from the market. Commercial paper is a short-term unsecured promissory note issued by large corporations with high credit ratings directly to investors in the money market. A key advantage is that it allows the issuer to bypass banks (financial intermediaries) and borrow directly from investors, often resulting in a lower interest rate than a comparable bank loan. Distractor A is incorrect because bank lines of credit offer greater flexibility. Distractor B is incorrect because commercial paper is a transactional, market-based source of funds, not a relationship-based one. Distractor D is incorrect because access to the commercial paper market is restricted to firms with high creditworthiness.
4. A retail company is experiencing a sustained period of rapid sales growth. The company's CFO notes that accounts payable and accrued expenses are increasing proportionally with sales. Which of the following is the most likely financial challenge the company will face despite this increase in spontaneous financing?
   Answer: A financing deficit, because the growth in assets required to support sales will likely outpace the growth in spontaneous liabilities. Rapid growth requires a significant investment in working capital assets like inventory and accounts receivable. While spontaneous liabilities (accounts payable, accruals) will also increase with sales, they typically do not increase enough to fund the entire increase in required assets. This mismatch creates a financing deficit that must be covered by negotiated sources (like bank loans) or equity. Distractor A is incorrect; accruals are essentially interest-free loans. Distractor C is unlikely; growth almost always consumes cash. Distractor D is possible but less certain; the primary issue is the mathematical funding gap, not necessarily the perception of creditors.
5. ServiceCorp's bank requires maintenance of a 1.25× minimum current ratio and 0.90× minimum quick ratio as loan covenants. Current position: Current assets $2.8M (including inventory $900K), Current liabilities $2.1M. The company plans to purchase $400K additional inventory using a combination of trade credit ($150K, 45-day terms) and short-term borrowing ($250K). Will this transaction violate covenants, and what is the maximum additional short-term debt ServiceCorp can assume while maintaining covenant compliance?
   Answer: Transaction violates quick ratio covenant; maximum additional short-term debt capacity is $180K under current structure Current ratios: Current ratio = $2.8M ÷ $2.1M = 1.33 (above 1.25 minimum). Quick ratio = ($2.8M - $900K) ÷ $2.1M = 0.905 (above 0.90 minimum). After transaction: Current assets = $2.8M + $400K = $3.2M. Current liabilities = $2.1M + $150K trade credit + $250K borrowing = $2.5M. New current ratio = $3.2M ÷ $2.5M = 1.28 (compliant). New quick ratio = ($3.2M - $1.3M inventory) ÷ $2.5M = 0.76 (violates 0.90 minimum). Maximum debt while maintaining 0.90 quick ratio: ($1.9M quick assets) ÷ 0.90 = $2.11M max current liabilities. Current capacity = $2.11M - $2.1M = $10K, but with planned trade credit, capacity ≈ $180K total. Choice B ignores quick ratio violation. Choice C overstates violation severity. Choice D miscalculates constraint binding.
6. A company is comparing two short-term borrowing options. Option 1 is a $100,000 discount loan with a 6% nominal annual rate for one year. Option 2 is a $100,000 loan with a 6.2% stated annual rate and a 15% compensating balance requirement. The company maintains no normal cash balance with the lending bank. Which option has a lower effective annual rate (EAR)?
   Answer: Option 1 has a lower EAR of 6.38%. This requires calculating the EAR for both options. For Option 1 (discount loan), the interest of $100,000 6% = $6,000 is deducted upfront. The firm receives only $94,000. EAR = $6,000 / $94,000 = 6.38%. For Option 2, the interest paid is $100,000 6.2% = $6,200. The compensating balance is $100,000 * 15% = $15,000, so the usable funds are $100,000 - $15,000 = $85,000. EAR = $6,200 / $85,000 = 7.29%. Comparing the two, Option 1's EAR of 6.38% is lower than Option 2's EAR of 7.29%.
7. A financial manager is establishing a short-term credit facility for a firm operating in a sector known for high demand volatility. The manager is concerned about a potential economic downturn in the next 12 months, which could tighten credit markets and cause lenders to become more risk-averse. Which of the following financing sources and rationales best addresses this specific concern?
   Answer: A committed revolving credit facility, because it contractually obligates the lender to provide funds up to the credit limit, regardless of market conditions. The manager's primary concern is the availability of credit during a potential downturn. A committed revolving credit facility is a formal, contractual agreement that obligates the bank to lend up to a specified maximum amount during a specified period. This feature provides the most reliable access to funds, which is critical when credit markets are tight. The other options are less reliable in such a scenario. An uncommitted line can be canceled by the bank at any time. The commercial paper market can become illiquid or inaccessible for all but the highest-quality issuers during a credit crunch. Trade credit may be tightened by suppliers facing their own financial pressures.
8. A newly formed technology company with significant intellectual property but few tangible assets and only one year of operating history is seeking a $500,000 line of credit to manage its cash flow. What is the greatest obstacle this company will likely face in securing unsecured short-term financing from a commercial bank?
   Answer: The lack of a sufficient operating history and established creditworthiness. When evaluating creditworthiness for unsecured short-term financing, banks primarily assess a borrower's ability to repay based on their financial track record and stability. Since there's no collateral backing the loan, the bank relies entirely on the company's creditworthiness and cash flow predictability. The correct answer is D because this technology company presents multiple red flags for lenders: only one year of operating history provides insufficient data to assess financial stability, cash flow patterns, or management competency. Without an established credit history or proven ability to generate consistent revenue, the bank cannot reliably predict the company's capacity to service debt. Even though the company has intellectual property, banks struggle to evaluate intangible assets for credit decisions, especially without a proven monetization track record. Let's examine why the other options are less significant obstacles: A is incorrect because while high interest rates affect borrowing costs, they don't prevent creditworthy borrowers from accessing credit—banks simply price the risk accordingly. B is wrong because banks typically accept reviewed or compiled financial statements from small businesses, especially newer companies where audited statements may be cost-prohibitive. C misses the mark because the question doesn't indicate problems with receivables quality or liquidity—the issue is the overall lack of operating history, not specific asset quality. Remember that for unsecured lending, banks prioritize the "5 C's of Credit," with character and capacity being paramount. A short operating history directly undermines both factors, making it the primary barrier to obtaining unsecured financing regardless of other business strengths.
9. TechStart's working capital financing includes: $800K accounts receivable (45-day collection period), $1.2M inventory (60-day turnover), $600K accounts payable (30-day payment period). The company is considering asset-based lending with 80% advance on receivables and 50% on inventory, at prime + 3% (currently 8.5% total). Alternatively, they could factor receivables at 85% advance with 2.8% monthly fee. Which option provides better liquidity management if the company needs $1.1M immediately?
   Answer: Asset-based lending provides $1.24M capacity at 8.5% annual cost, offering better liquidity and lower cost than factoring Asset-based lending capacity = (80% × $800K) + (50% × $1.2M) = $640K + $600K = $1.24M, exceeding the $1.1M need at 8.5% annual cost. Factoring provides only $680K (85% × $800K), insufficient for the $1.1M requirement. Even with factoring's operational benefits (credit risk transfer, collection services), the company would need additional financing for the $420K shortfall, likely at higher rates. The asset-based lending clearly provides better liquidity coverage at reasonable cost. Choice B correctly identifies factoring's limitations but understates the significance. Choice C overvalues factoring's operational benefits given the liquidity shortfall. Choice D is unnecessary since asset-based lending alone meets the requirement.
10. A manufacturing firm is experiencing tight liquidity and decides to factor its accounts receivable to generate cash. The agreement is 'with recourse.' Which of the following statements best describes a key implication of this arrangement?
    Answer: The factor has the right to collect directly from the firm's customers, but the firm must buy back any receivables that prove to be uncollectible. Factoring 'with recourse' means that the firm selling the receivables retains the risk of any bad debts. If a customer fails to pay, the firm must buy back that receivable from the factor. This arrangement creates a contingent liability for the firm. In contrast, 'without recourse' transfers the credit risk to the factor. Distractor A describes a 'without recourse' arrangement. Distractor C is incorrect; the firm is not protected from defaults. Distractor D confuses the 'recourse' feature with the 'notification' feature; notification is a separate aspect of the agreement.
11. A large retailer of consumer electronics needs to finance its inventory, which consists of thousands of individually packaged, high-value items like laptops and televisions, each with a unique serial number. Which form of inventory financing would a lender most likely require for this type of collateral?
    Answer: A trust receipt loan, as it allows for the tracking and release of specific, identifiable items of collateral as they are sold. A trust receipt loan is ideal for financing high-value, serialized inventory (e.g., automobiles, large appliances, electronics). The borrower holds the goods 'in trust' for the lender. As each specific item is sold, the borrower repays the corresponding portion of the loan, and the lender releases its lien on that specific item. A blanket lien (A) is too general for such easily identifiable collateral. Warehouse receipts (C and D) involve a third-party warehouse arrangement, which is less practical for inventory that needs to be on a retail sales floor.
12. An American company is importing goods from a supplier in Vietnam. The two companies have no prior business relationship, and the Vietnamese supplier is concerned about the credit risk of the American buyer. Which short-term financing instrument is specifically designed to mitigate this risk by substituting a bank's creditworthiness for the buyer's?
    Answer: A banker's acceptance When you encounter questions about international trade financing, focus on which instruments specifically address credit risk between parties who don't know each other well. This scenario involves cross-border trade where the supplier needs assurance of payment. A banker's acceptance (D) is the correct answer because it's specifically designed for this situation. When a Vietnamese supplier is worried about an American buyer's creditworthiness, a banker's acceptance allows a reputable bank to guarantee payment. The buyer arranges for their bank to "accept" responsibility for the payment, essentially substituting the bank's strong credit rating for the buyer's unknown or weaker credit profile. This gives the supplier confidence they'll be paid, even if they don't trust the buyer directly. Commercial paper (A) is unsecured short-term debt issued by corporations to raise funds, but it doesn't involve banks guaranteeing payments between trading partners. A revolving credit agreement (B) is a loan facility that provides ongoing access to funds, but it doesn't address the supplier's concern about getting paid by the buyer. Factoring of accounts receivable (C) involves selling receivables to a third party for immediate cash, but this happens after the sale is made and doesn't help the supplier manage credit risk upfront. Remember this pattern: banker's acceptances are the go-to solution when international trading partners need a bank's creditworthiness to bridge trust gaps. Look for keywords like "substitute bank's credit," "international trade," and "credit risk between unfamiliar parties" to identify these questions quickly.
13. MedDevice Corp maintains a target cash balance of $200,000 using a Miller-Orr model with $50,000 lower limit and $350,000 upper limit. The company's daily cash flow volatility (standard deviation) is $25,000, and short-term interest rates are 6% annually. If the company's cash balance reaches $380,000 on Monday, what should management do, and what will be the likely cash position by Wednesday assuming normal volatility?
    Answer: Invest $180,000 immediately; Wednesday balance will likely be near $200,000 target with normal fluctuation In the Miller-Orr model, when cash exceeds the upper limit ($350K), management should immediately invest the excess to return to the target return point ($200K). The investment amount = $380K - $200K = $180K. After returning to target, normal volatility will cause fluctuations around $200K, but the model is designed to keep cash between the bands with high probability. Wednesday's balance will likely be near $200K ± normal daily variation. Choice B uses wrong return point calculation. Choice C violates the model's immediate action rule when limits are breached. Choice D miscalculates the investment amount and misunderstands volatility effects.
14. A firm factors $500,000 of its accounts receivable without recourse. The factor charges a 3% fee on the face value of the receivables and holds back a 10% reserve against returns and allowances. What is the immediate impact of this transaction on the firm's balance sheet?
    Answer: Cash increases by $435,000, and Accounts Receivable decreases by $500,000. When you encounter factoring problems, focus on three key components: the cash received, the fees charged, and whether the factoring is with or without recourse. "Without recourse" means the factor assumes all credit risk, so the firm has no future liability. Let's calculate what the firm actually receives. The factor purchases $500,000 in receivables but immediately deducts two amounts: a 3% fee ($500,000 × 0.03 = $15,000) and a 10% reserve ($500,000 × 0.10 = $50,000). The firm receives $500,000 - $15,000 - $50,000 = $435,000 in cash immediately. Since this is factoring without recourse, the firm completely transfers ownership of the receivables. Therefore, the full $500,000 in accounts receivable must be removed from the balance sheet, regardless of how much cash was received. Answer A incorrectly assumes the firm receives the full face value, ignoring both the fee and reserve. Answer B treats this like factoring with recourse by creating a liability, but "without recourse" means no future obligation exists. Answer C makes the common error of reducing accounts receivable by only the net amount received ($450,000), but this ignores the reserve amount that will eventually be settled by the factor. Answer D correctly shows cash increasing by $435,000 (the net amount received) and accounts receivable decreasing by the full $500,000 (complete transfer of ownership). Study tip: In factoring problems, always distinguish between "with recourse" (creates a liability) and "without recourse" (clean sale). Calculate net cash as face value minus all fees and reserves.
15. A company has a $10 million committed revolving credit agreement with its bank. The agreement contains a standard 'material adverse change' (MAC) clause. From the company's perspective, what is the most significant risk associated with this clause?
    Answer: The bank may be able to refuse a request for funds if the company's financial condition deteriorates, undermining the 'committed' nature of the line. When you encounter questions about committed credit facilities, focus on understanding how contractual clauses can undermine the apparent certainty of "committed" financing. Material adverse change (MAC) clauses are among the most important protective mechanisms banks build into lending agreements. A MAC clause gives the bank discretionary power to refuse funding requests if it determines the borrower's financial condition has deteriorated significantly since the agreement was signed. This creates a fundamental tension: while the credit line appears "committed," the MAC clause provides the bank with a potential exit strategy. For the company, this means that precisely when they most need access to funds—during financial distress—the bank may legally deny their requests, effectively converting a committed facility into an uncommitted one. Option A correctly identifies this core risk. The MAC clause can render the "committed" nature of the facility meaningless when the company needs it most. Option B is incorrect because MAC clauses don't typically trigger fee increases for improved performance—banks generally welcome borrower improvements. Option C mischaracterizes MAC clauses, which don't restrict the company's ability to seek other financing sources. Option D confuses MAC clauses with credit rating triggers or floating rate provisions, which are separate contractual mechanisms. Study tip: Remember that in corporate finance, "committed" facilities often contain hidden escape hatches for lenders. Always look for clauses that could give banks discretionary power to refuse funding, especially MAC clauses, which are the most common and powerful tool banks use to protect themselves from borrower deterioration.
16. A firm is arranging a $2 million, one-year revolving credit line. The terms include a 7% interest rate on borrowed funds, a 0.5% commitment fee on the unused portion of the line, and a 10% compensating balance requirement on the total amount of the line. If the firm expects to borrow an average of $1.2 million for the year, what is the effective annual rate (EAR) of this arrangement?
    Answer: 8.80% This is a multi-step calculation. Step 1: Calculate total costs. Interest paid = $1,200,000 7% = $84,000. Unused portion = $2,000,000 - $1,200,000 = $800,000. Commitment fee = $800,000 0.5% = $4,000. Total cost = $84,000 + $4,000 = $88,000. Step 2: Calculate net usable funds. The firm borrows $1,200,000. The compensating balance is 10% of the entire line ($2,000,000), which is $200,000. Net usable funds = $1,200,000 (borrowed) - $200,000 (compensating balance) = $1,000,000. Step 3: Calculate EAR. EAR = Total Cost / Net Usable Funds = $88,000 / $1,000,000 = 8.80%.
17. A company is evaluating secured short-term financing options using its accounts receivable. A financial analyst must distinguish between pledging receivables and factoring receivables. Which of the following correctly identifies a primary difference between these two methods?
    Answer: In pledging, the firm retains title to the receivables and continues to service them; in factoring, the receivables are typically sold to the lender who takes over collection. The core distinction lies in ownership and servicing. When receivables are pledged, they are used as collateral for a loan, but the firm still owns them and is responsible for collecting from customers. In a typical factoring arrangement, the receivables are sold outright to the factor, who then owns them and handles collection. Distractor B is incorrect; lenders will scrutinize the quality of receivables in both cases. Distractor C is not always true; the effective cost depends on many factors. Distractor D is incorrect as both can be arranged on an ongoing basis.
18. A company's accounts receivable turnover decreased from 8.2x to 6.1x while sales increased 15% year-over-year. Simultaneously, the company's quick ratio improved from 1.1 to 1.3. Which of the following best explains this liquidity paradox?
    Answer: The company reduced inventory levels significantly while extending payment terms to boost sales revenue The decreased A/R turnover (8.2x to 6.1x) with 15% sales growth indicates receivables increased disproportionately, likely from extended payment terms. However, the improved quick ratio (1.1 to 1.3) suggests the numerator (cash + marketable securities + A/R) increased relative to current liabilities. Since A/R management worsened, the improvement must come from reduced inventory (excluded from quick ratio) or increased cash/securities. Choice A correctly identifies this trade-off. Choice B incorrectly suggests improved collections. Choice C doesn't explain the A/R turnover decline. Choice D oversimplifies with seasonal effects without addressing the fundamental contradiction.
19. A corporation secures a $5 million loan for one year at a stated annual interest rate of 6%. The loan agreement requires a compensating balance of 10% of the loan amount. The corporation normally maintains a transaction balance of $200,000 in its account with the lending bank. What is the effective annual interest rate (EAR) on this loan?
    Answer: 6.38% This is a multi-step calculation. First, calculate the total interest paid: $5,000,000 6% = $300,000. Second, calculate the required compensating balance: $5,000,000 10% = $500,000. Third, determine the additional funds the firm must leave in the account. Since they already keep $200,000, the incremental deposit is $500,000 - $200,000 = $300,000. Fourth, calculate the usable loan proceeds: $5,000,000 - $300,000 = $4,700,000. Finally, the effective annual rate is the total interest divided by the usable proceeds: $300,000 / $4,700,000 ≈ 6.38%.
20. A firm's treasurer, concerned about potential supply chain disruptions, decides to significantly increase the company's holdings of cash and marketable securities relative to other assets. Which of the following describes the most likely combined effect on the firm's liquidity and profitability?
    Answer: Liquidity risk decreases and the rate of return on assets decreases. This question addresses the classic liquidity-profitability tradeoff. Holding more cash and marketable securities (highly liquid assets) makes it easier for the firm to meet its short-term obligations, thus decreasing liquidity risk. However, these liquid assets typically generate very low returns compared to operating assets like inventory and fixed assets. By increasing the proportion of low-return assets, the firm's overall rate of return on total assets (a measure of profitability) will decrease. Therefore, liquidity risk decreases and profitability decreases.

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