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IFT Notes for Level I CFA® Program

LM05 Working Capital & Liquidity

Part 1

1. Introduction

Working capital (also called net working capital) is defined as current assets minus current liabilities.

Working capital = Current assets – Current liabilities

Working capital includes both operating assets and liabilities (such as accounts receivable, accounts payable, inventory etc.) as well as financial assets and liabilities (such as short-term investments and short-term debt).

The goal of effective working capital management is to ensure that a company has adequate ready access to the funds necessary for day-to-day operating expenses, while avoiding excess reserves that can reduce a business’s profitability.

This reading covers:

  • Internal and external sources of working capital
  • Working capital approaches and their impact on the funding needs of a company
  • Primary and secondary sources of liquidity
  • Evaluating a company’s liquidity position
  • Evaluating the short-term financing choices available to a company

2. Financing Options

Exhibit 1 from the curriculum shows the main internal and external sources of capital for a company.

  Internal External
Financial Intermediaries Capital markets




·       After-tax operating cash flows

·       Accounts payable

·       Accounts receivable

·       Inventory

·       Marketable securities

·       Uncommitted lines of credit

·       Committed lines of credit

·       Revolving credit

·       Secured loans

·       Factoring

·       Commercial paper


Long-term ·       Long-term debt

·       Equity

We will discuss each of these sources in detail.

Internal Financing

Companies can generate internal financing from short-term operating activities in many ways such as:

  • Generating more after-tax operating cash flows.
  • Increasing working capital efficiency, e.g., by shortening its cash conversion cycle.
  • Converting liquid assets to cash, e.g., by selling inventories.

Some important terms related to internal financing are:

  • Operating cash flows: Calculated as ‘net income + depreciation – dividends.’ This is the cash available for investment after interest, tax, and dividend payments are made. Companies with high, relatively stable after-tax operating cash flows have a greater ability to use internal financing.
  • Accounts payable: Represents amounts due to suppliers of goods and services. They often have associated trade credit terms. For example, the terms ‘2/10 net 30’, mean that if the payment is made within 10 days, the company will get a 2 percent discount else the entire payment must be made within 30 days.
  • Accounts receivables: Represents amounts owed by customers. They can be thought of as being the opposite of accounts payables. The sooner the company can collect its accounts receivables, the lesser the need to use other sources to finance operations.
  • Inventory: Represents goods waiting to be sold. Since holding inventory costs money, efficient companies try to hold as little inventory as necessary and sell it as quickly as possible.
  • Marketable securities: Represents financial instruments such as stocks and bonds, that can be sold quickly and converted to cash. Companies invest in marketable securities to earn a higher rate of return as compared to simply holding cash.

Example: Internal Financing Decision

(This is based on Example 1 from the curriculum.)

A company is evaluating two options to fund its working capital needs:

  • Option1: Forgo the 2% discount offered by its supplier. The standard trade terms are 2/10 net 30.
  • Option 2: Borrow through its external line of credit. The effective annual rate for the line of credit is 7.7%.

Which option should the company prefer?


The effective annual rate on the forgone trade credit can be calculated as:

[(1+(2/98))^(365/20)] – 1 = 44.6%

This is significantly higher than the 7.7% rate on the external credit line. Therefore, the company should prefer the credit line.

External Financing: Financial Intermediaries

Financial intermediaries can include both bank or non-bank lenders. The main type of financing options available through these sources are:

  • Uncommitted lines of credit – They are the least reliable form of bank borrowing. The bank can refuse to honor the request to use the line. An uncommitted line is therefore not reliable.
  • Committed lines of credit – Also called regular lines of credit, they are more reliable than uncommitted lines. The bank makes a formal commitment to honor the line of credit. The interest rate charged is usually the bank’s prime rate or a money market rate plus a spread that depends on the borrower’s creditworthiness. These lines are usually in effect for 364 days. They are unsecured and prepayable without penalty. Unlike uncommitted lines, regular lines require compensation. Banks typically charge a commitment fee e.g., 0.50% of the full amount or the unused amount of the line.
  • Revolving credit agreements (Revolvers): They are the most reliable form of short-term bank borrowing. They involve formal agreements similar to those used for regular lines of credit. Revolvers differ from regular lines in two ways (1) they are in effect for multiple years and (2) they are often used for much larger amounts.
  • Secured (“asset-based”) loans: The options discussed above are unsecured loans. Secured loans are loans in which the lender requires the company to provide collateral in the form of assets. For example, a company can use its accounts receivables as a collateral to generate cash flows through the ‘assignment of accounts receivable’.

A company can also sell its accounts receivables to a lender (called a factor), typically at a substantial discount. This is called a factoring arrangement. In an assignment arrangement, the company retains the collection responsibilities, whereas in a factoring arrangement, the company shifts the collection responsibilities to the lender (factor).

Web-based lenders and non-bank lenders are recent innovations that operate primarily on the internet. They typically offer loans in relatively small amounts to small businesses in need of cash.

External Financing: Capital Markets

Short-Term Commercial Paper

It is a short-term, unsecured instrument typically issued by large, well-rated companies. It has maturities typically ranging from a few days to 270 days. Issuers of commercial paper are often required to have a backup line of credit. The short duration, high creditworthiness of the issuing company, and the backup line of credit generally makes commercial paper a low-risk investment for investors.

Long-Term Debt

It has a maturity of at least one year. Due to their long maturities, bonds are riskier than shorter-term notes or money market instruments from an interest rate and credit risk perspective. Therefore, to reduce risk, bonds often contain covenants that are detailed contracts specifying the rights of the lender and restrictions on the borrower.

Public debt is negotiable (a negotiable instrument is a written document describing the promise to pay that is transferable and can be sold to another party) and more liquid as it trades on open markets. Private debt can also be negotiable, but it is less liquid and difficult to sell as it does not trade on open markets. Some private debt instruments, such as savings bond and certificates of deposit are not negotiable.

Common Equity

Common equity represents ownership in a company. It is considered a more permanent source of capital. Shareholders have a residual claim on the company’s profits after its obligations and other contractual claims are satisfied.

Example: External Financing Decision

(This is based on Example 2 from the curriculum.)

A company is planning its financing for a substantial investment of C$30 million next year. Specific details are as follows:

  • The total investment of C$30 million will be distributed as follows: C$5 million in receivables, C$5 million in inventory, and fixed capital investments of C$20 million, including C$5 million to replace depreciated equipment and C$15 million of net new investments.
  • Projections include a net income of C$10 million, depreciation charges of C$5 million, and dividend payments of C$4 million.
  • Short-term financing from accounts payable of C$3 million is expected. The company will use receivables as collateral for another C$3 million loan. The company will also issue a C$4 million short-term note to a commercial bank.
  • Any additional external financing needed can be raised from an increase in long-term bonds. If additional financing is not needed, any excess funds will be used to repurchase common shares.

How much, if any, does the company need to issue in long-term bonds?


Total amount receivable from different sources of capital for the company can be calculated as:

Source Amount
Operating cash flow (Net income + depreciation – dividends) 11
Accounts payable 3
Bank loan against receivables 3
Short-term note 4
Total 21

Since, the company requires C$30 million of financing and the planned sources total C$21 million, the company will need to issue C$9 million of new bonds.

3. Working Capital, Liquidity, and Short-Term Funding Needs

To determine their required working capital investment, companies first identify their optimal levels of inventory, receivables and payables as a function of sales. They then project these assumptions forward into the future.After determining its working capital requirements, a firm then identifies the optimal mix of short-and long-term financing necessary to fund these requirements. Companies may take different approaches to working capital management:

  • Conservative approach: In a conservative approach, the firm holds a larger position in current assets (cash, receivables, and inventories). This provides financial flexibility to respond to unforeseen events, but it results in a lower return on equity.

Instructor’s Note: Current assets can be divided into ‘permanent current assets’ and ‘variable current assets.’ Permanent current assets remain relatively constant throughout the year. Variable current assets vary based on the seasonality of the business, increasing during peak production periods.In a conservative approach, the firm finances a majority of its current assets (both permanent and variable) with long-term debt or equity financing.

  • Aggressive approach: In an aggressive approach, the firm holds a substantially smaller position in current assets. This reduces financial flexibility, but it results in a higher return on equity.

Also, the firm finances a majority of its current assets (both permanent and variable) with short-term debt or payables.

  • Moderate approach: In a moderate approach, the firm holds a position in current assets that is somewhere between the two approaches.

Also, the firm attempts to match the duration of the current assets with the liabilities. It would finance its permanent current assets with long-term debt and equity; and finance its variable current assets with short-term debt and payables.

Example 3 from the curriculum presents the pros and cons of each approach. Excerpts from this example are presented below:

Conservative approach

Pros Cons
Stable, more permanent financing that does not require regular refinancing; reduced rollover risk Higher debt financing cost with an upward-sloping yield curve
Financing costs are known upfront High cost of equity
Certainty of working capital needed to purchase the necessary inventory Permanent financing dismisses the opportunity to borrow only as needed (increasing ongoing financing costs)
Extended payment term reduces short-term cash needs for debt service A longer lead time is required to establish the financing position
Improved flexibility during times of stress, with excess liquidity in marketable securities Long-term debt may require more covenants that restrict business operations


Aggressive approach

Pros Cons
Short-term lines of credit provide the flexibility to access financing only when needed—particularly appropriate for seasonality—reducing overall interest expense Higher levels of short-term cash may be needed to meet short-term debt maturities
Short-term loans involve less rigorous credit analysis, as the lender has greater clarity as to the short-term operations of the firm Potential difficulty in rolling the short-term loans, thus increasing bankruptcy risk, particularly during times of stress
Flexibility to refinance if rates decline Greater reliance on trade credit (expensive financing) may be necessary if the business is unable to refinance at favorable terms
Tighter customer credit standards may be required, thereby reducing sales, if the business is unable to access the necessary financing to support credit terms to its customers

Moderate approach

Pros Cons
Lower cost of financing than conservative approach Access to short-term capital may be restricted when needed for inventory build
Flexibility to increase financing for seasonal spikes while maintaining a base level for ongoing needs Potential difficulty in rolling the short-term loans, thus increasing bankruptcy risk, particularly during times of stress
Diversifying sources of funding with a more disciplined approach to balance sheet management Greater reliance on trade credit (expensive financing) may be necessary if the business is unable to refinance at favorable terms
Tighter customer credit standards may be required, thereby reducing sales, if the business is unable to access the necessary financing to support credit terms to its customers

Exhibit 2 fromthe curriculum summarizes the relationship between financing requirements, costs, risks, and return on equity based on funding approach.

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