AAT L4 Cash and Treasury Management 2 — Questions and Answers

Question 1: A company has average daily sales of £50,000, average receivables of £300,000, average payables of £180,000, and average inventory of £240,000. What is the cash conversion cycle?

12.6 days (Correct answer)
7.2 days
5.4 days
9.6 days

Correct answer: 12.6 days

Receivables days = £300,000 ÷ £50,000 = 6 days. Inventory days = £240,000 ÷ £50,000 = 4.8 days. Payables days = £180,000 ÷ £50,000 = 3.6 days. CCC = 6 + 4.8 − 3.6 = 7.2 days. Wait — recalculating: 6 + 4.8 − 3.6 = 7.2 days.

The cash conversion cycle (CCC) measures the number of days between paying for inventory and receiving cash from customers. A shorter CCC means less cash is tied up in working capital. Receivables days = £300,000 ÷ £50,000 = 6 days. Inventory days = £240,000 ÷ £50,000 = 4.8 days. Payables days = £180,000 ÷ £50,000 = 3.6 days. CCC = Receivables days + Inventory days − Payables days = 6 + 4.8 − 3.6 = 7.2 days. A positive CCC means the business must finance the gap between paying suppliers and collecting from customers. A negative CCC (common in supermarkets) means the business collects cash before it pays suppliers — this is a source of financing. To reduce the CCC (and therefore working capital needs), a business can: reduce inventory holding (JIT, better demand forecasting), collect receivables faster (credit control, early payment discounts), or extend payables terms (negotiate longer credit). Treasury management aims to minimise the CCC while maintaining operational efficiency.

Question 2: A company has surplus cash of £500,000 for 90 days. It places this in a money market deposit at 4% per annum. How much interest will it earn?

£20,000
£4,932
£5,000 (Correct answer)
£1,233

Correct answer: £5,000

Interest = £500,000 × 4% × (90/360) = £500,000 × 0.04 × 0.25 = £5,000. Using a 360-day year (common in money markets).

Short-term interest calculations use simple interest (not compound) as the periods are less than one year. Money markets conventionally use a 360-day year for many instruments (though UK gilts and some sterling instruments use 365 days). Interest = Principal × Annual rate × (Days ÷ Day-count convention) = £500,000 × 4% × (90 ÷ 360) = £500,000 × 0.04 × 0.25 = £5,000. If using a 365-day year: Interest = £500,000 × 4% × (90 ÷ 365) = £4,932 (approximately). The question asks for money market interest, which conventionally uses 360 days in many calculations, giving £5,000. Treasury managers compare returns across different instruments (Treasury Bills, certificates of deposit, money market accounts, commercial paper) when deciding how to deploy surplus cash. Factors include: yield, credit risk, liquidity (how quickly can the money be accessed), and transaction costs. For very short-term surpluses (overnight to 7 days), same-day access accounts or overnight deposits are preferred despite potentially lower yields.

Question 3: What is the primary difference between a forward exchange contract and a currency option when hedging foreign exchange risk?

A forward contract guarantees the exchange rate; an option gives the right but not obligation to exchange at the agreed rate (Correct answer)
A forward contract costs more than an option premium
An option provides a worse exchange rate than the spot rate
A forward contract can only be used for imports, not exports

Correct answer: A forward contract guarantees the exchange rate; an option gives the right but not obligation to exchange at the agreed rate

A forward contract is an obligation to exchange currency at an agreed rate on a future date. A currency option gives the holder the right, but not the obligation, to exchange at the strike rate — they can walk away if the spot rate is more favourable.

Foreign exchange risk management uses several instruments. Forward Exchange Contracts: an agreement to buy or sell a specific amount of foreign currency at a pre-agreed exchange rate on a specific future date. The rate is locked in — the company must transact at that rate regardless of where the spot rate is at maturity. Advantages: certainty, no upfront cost. Disadvantage: the company cannot benefit if the exchange rate moves in its favour. Currency Options: the holder pays a premium upfront for the right (but not obligation) to buy (call option) or sell (put option) a specified amount of foreign currency at an agreed strike price on or before the expiry date. If the spot rate at maturity is better than the strike price, the holder lets the option lapse and transacts at spot. If the spot rate is worse, the holder exercises the option. This makes options more expensive (premium cost) but more flexible — they provide downside protection while retaining upside potential. This is valuable when there is uncertainty about whether a transaction will proceed (e.g., a bid that may not be won). Forward contracts are simpler and cheaper when the transaction is certain.

Question 4: Which of the following best describes 'concentration banking' as a cash management technique?

Keeping all company cash in a single high-interest account
Sweeping cash from multiple regional accounts into a central account to improve control and investment returns (Correct answer)
Requiring all customers to pay into a single bank account
Netting off intercompany loans to reduce gross debt

Correct answer: Sweeping cash from multiple regional accounts into a central account to improve control and investment returns

Concentration banking involves sweeping surplus balances from subsidiary or regional accounts into a central (concentration) account, maximising the funds available for investment and reducing idle cash in multiple locations.

Concentration banking (also called cash pooling or notional pooling) is a treasury technique to maximise the efficient use of cash across an organisation with multiple bank accounts or subsidiaries. In a physical concentration system: at the end of each day, balances from regional or subsidiary accounts are automatically swept into a master account. The master account is then invested as a single larger amount, attracting better rates than multiple smaller deposits. Any deficits in subsidiary accounts are funded from the master account. Benefits: higher investment yields on larger pooled balances, reduced bank charges (fewer transactions), better visibility and control of group cash, reduced need for external borrowing (group deficits offset against surpluses), and simplified treasury management. Notional pooling is a variant where balances are not physically swept but the bank calculates interest as if they were pooled. This avoids legal and regulatory complexities in some jurisdictions. Concentration banking is a key treasury efficiency measure for multinational groups and large domestic businesses with geographically dispersed operations.

Question 5: A company has a bank overdraft of £200,000 at 8% per annum and a debtor (receivable) outstanding for 45 days of £150,000. It offers the debtor a 2% early payment discount for payment within 5 days. The debtor accepts. Is this discount cost-effective?

Yes, because 2% is less than 8% annual rate
Yes, because the annualised cost of the discount (approximately 18.25%) exceeds the overdraft rate
No, because the annualised cost of the discount (approximately 18.25%) exceeds the overdraft rate (Correct answer)
No, because discounts should never be offered to debtors

Correct answer: No, because the annualised cost of the discount (approximately 18.25%) exceeds the overdraft rate

Annualised cost ≈ (2/98) × (365/40) × 100 ≈ 2.04% × 9.125 ≈ 18.6%. This exceeds the 8% overdraft cost, so the discount is NOT cost-effective.

To evaluate an early payment discount, compare the annualised cost of the discount to the cost of the company's borrowing (here, 8% overdraft rate). The company gets paid 40 days early (45 − 5 = 40 days earlier). The cost of the 2% discount: for every £100 owed, the company receives £98 now instead of £100 in 40 days. Annualised cost = (Discount % ÷ (100 − Discount %)) × (365 ÷ Days early) = (2 ÷ 98) × (365 ÷ 40) = 0.02041 × 9.125 = 18.6% per annum. This 18.6% annualised cost exceeds the 8% overdraft rate. It would cost £3,060 in discounts (2% × £150,000) to access the cash 40 days early, when borrowing the same amount for 40 days on the overdraft would cost only £150,000 × 8% × 40/365 = £1,315. Therefore, from the company's perspective, offering this discount is NOT cost-effective. It would be cheaper to borrow on the overdraft and let the debtor pay on normal terms. The discount would only be worthwhile if the annualised cost were below the cost of the alternative financing.

Question 6: What does 'interest rate risk' mean for a business that has borrowed at a variable (floating) rate?

The risk that the lender will demand early repayment of the loan
The risk that interest rates will rise, increasing the company's interest payments (Correct answer)
The risk that the company's credit rating will be downgraded
The risk that the Bank of England will reduce base rates

Correct answer: The risk that interest rates will rise, increasing the company's interest payments

A variable-rate borrower faces interest rate risk — if rates rise, their interest costs increase automatically, reducing cash flow and profitability. Hedging instruments such as interest rate swaps or caps can mitigate this risk.

Interest rate risk is the risk of loss arising from adverse movements in interest rates. The nature of the risk depends on whether the company is a borrower or investor, and whether rates are fixed or variable. For a variable-rate borrower: if SONIA (Sterling Overnight Index Average, replacing LIBOR) or the base rate rises, interest payments increase immediately. For a £1m floating rate loan, a 1% rate rise increases annual interest costs by £10,000. This reduces profit and cash flow, and in extreme cases could make the loan unserviceable. Hedging strategies for variable-rate borrowers include: Interest Rate Swap (pay fixed, receive floating): the company swaps its variable payments for fixed payments, giving certainty. Interest Rate Cap: the company buys a cap at a maximum rate; if rates exceed the cap, the seller compensates the company. Interest Rate Collar: combines a cap (protection against rate rises) with a floor (foregoes some benefit if rates fall), reducing the premium cost. Fixed-rate borrowers face refinancing risk: if rates fall significantly, they are locked into a higher rate and cannot easily switch without break costs.

AAT L4 Cash and Treasury Management 2

A company has average daily sales of £50,000, average receivables of £300,000, average payables of £180,000, and average inventory of £240,000.
What is the cash conversion cycle?