IFT Notes for Level I CFA® Program
IFT Notes for Level I CFA® Program

R35 Working Capital Management

Part 1


1.  Introduction

Working capital management is a measure of the operational liquidity of a business. It involves managing the relationship between a firm’s short-term assets and its short-term liabilities. 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.

There are several factors that impact working capital needs:

Internal Factors:

  • Company size and growth rate: Large and fast-growing companies have high working capital needs.
  • Organizational structure: Decentralized companies have high working capital needs as liquidity is managed by each business unit.
  • Sophistication of working capital management: Sophisticated companies will do a better job at keeping the working capital low and still meet the short-term obligations.
  • Borrowing and investing positions, activities, and capacities: Companies that can borrow easily will have low working capital needs.

External Factors:

  • Banking services: Economies with developed banking systems will have low working capital needs as borrowing is easy.
  • Interest rates: High interest rates lead to high working capital.
  • New technologies and new products: New technologies that make it easier to manage working capital will lead to low working capital needs.
  • The economy: Depends on the industry and the state of the economy. In a downturn, companies maintain low inventory and are high on cash as it becomes difficult to borrow money.
  • Competitors: In a highly competitive industry, working capital requirements will be relatively high.

2.  Managing and Measuring Liquidity

Liquidity is the extent to which a company is able to meet its short-term obligations using assets that can be readily converted into cash (by selling or financing).

2.1.     Defining Liquidity Management

Liquidity management refers to the ability of an organization to generate cash when and where needed.

Two sources of liquidity for a company are:

  1. Primary sources:
  • Cash sources used in day-to-day operations.
  • For example, cash balances, trade credit, lines of credit from banks, etc.
  1. Secondary sources:
  • For example, liquidating assets, filing for bankruptcy, negotiating debt agreements, etc.
  • The main difference between the two is that using primary sources has no effect on the operations of a company while using secondary sources may negatively impact a company’s financial position.

A company’s liquidity position is affected by cash receipts and the amount of cash it has to pay.

Drags on liquidity reduce cash inflows. For example, bad debts, obsolete inventory, uncollected receivables, etc.

Pulls on liquidity accelerate cash outflows. For example, earlier payment of vendor dues, etc.

2.2.     Measuring Liquidity

Liquidity contributes to a company’s credit-worthiness. Credit-worthiness is the perceived ability of the borrower to pay what is owed in a timely manner despite adverse conditions. A high credit-worthy company is one that has the ability to make interest payments on a loan as they come due.

High credit-worthiness allows a company to:

  • Obtain lower borrowing costs.
  • Obtain better terms for trade credit.
  • Have greater flexibility.
  • Exploit profitable opportunities, as the company can raise money relatively quickly to invest in profitable projects.

Liquidity ratios

Liquidity ratios measure a company’s ability to meet short-term obligations. In the reading on financial ratios, we discussed all the ratios listed here.

In financial reporting and analysis, the turnover ratios were classified as activity ratios. But, here we consider them as a measure of liquidity as well because of the effect (drag/pull) they have on the liquidity of a company.

Liquidity ratios
Ratio Formula
Current ratio Current assets ÷ Current liabilities
Quick ratio (Cash + Marketable securities + Receivables) ÷ Current liabilities
Receivable turnover Credit Sales ÷  Average receivables
Number of days of receivables 365 or days in period ÷ Receivable turnover
Inventory turnover Cost of goods sold ÷ Average inventory
Number of days of inventory 365 or days in the period ÷ Inventory turnover
Payables turnover Average day’s purchases ÷ Average trade payables
Number of days of payables 365 or days in the period ÷ Payables turnover

Net Operating Cycle

Operating cycle is the time needed to convert raw materials into cash from a sale. It does not consider payments to suppliers.

Operating cycle = Number of days of inventory + Number of days of receivables

Net operating cycle is a more accurate measure which measures the time from paying suppliers for raw materials to collecting cash from customers. The shorter the cycle, the better is the cash-generating ability of a company.

Net operating cycle = Number of days of receivables + Number of days of inventory                       – Number of days of payables

3.  Managing the Cash Position

The purpose of managing a firm’s daily cash position is to make sure there is sufficient cash (target balance). A company does not want low or negative balances because it is expensive to borrow cash on short notice. However, it does not want an unnecessarily high cash balance either because interest income is forgone by not investing the cash.

Companies should recognize the major sources of cash inflows and outflows in order to precisely forecast cash flows and maintain a minimum cash balance. Some common sources of cash inflows and outflows are listed below:

Examples of Cash Inflows and Outflows
Inflows Outflows
Receipts from operations Payments to employees
Fund transfer from subsidiaries Payments to suppliers
Maturing investments Other expenses
Other income Investments
Tax refunds Debt payments
Money from loans Taxes

Corporate Finance Working Capital Management Part 1