Working Capital Management

Contents
Introduction to Liquidity and Liquidity Ratios .................................................................................................2
Working Capital and Liquidity ....................................................................................................................2
Key liquidity ratios .....................................................................................................................................2
Working Capital Effectiveness ...................................................................................................................4
Managing Liquidity and Cash........................................................................................................................6
Daily cash position ....................................................................................................................................6
Short-term investments .............................................................................................................................6
Yield or return on short-term investments..................................................................................................7
Short term investment strategies ...............................................................................................................8
Tracking tools ...........................................................................................................................................8
Managing Components of Working Capital ...................................................................................................9
Short-Term Funding ...................................................................................................................................14
1. Bank options: ......................................................................................................................................14
2. Non-Bank options:...............................................................................................................................14
Cost of borrowing ....................................................................................................................................15
Factors to consider .................................................................................................................................15
INTRODUCTION TO LIQUIDITY AND LIQUIDITY RATIOS

Working Capital and Liquidity

Working capital is an organisations availability of cash and near cash assets (such as receivables and
inventory), and considers its ability to pay its immediate bills using those funds.

Liquidity is a simple idea, it’s all about having assets available, that can be quickly turned into cash, so that a
business is able to meet its immediate obligations.

Inability to maintain a certain level of liquidity means that a company risks NOT meeting these immediate needs,
and runs the risk of insolvency.

Sources of liquidity
There are two sources of liquidity: Primary and Secondary.

 Some primary sources of liquidity include:

o Company’s cash balances and immediately cashable securities,
o Ability to obtain short term funding (a line of credit), and
o Management of cash flows, including their influence over collections and payments.

 In terms of secondary sources of liquidity, a firm might consider:

o Renegotiating agreements on borrowed funds,
o Organise a bridge of interest only payments on a loan for a period,
o They might also consider looking at liquidation, the sale of assets at some discount to fair value
to get money immediately,
o After that, we have bankruptcy or insolvency, the last possible form of liquidity that a business
will turn to meet obligations.

Factors influencing liquidity

The most important driving force of a company’s liquidity position is the management of cash flows, getting cash
in faster, and allowing cash to flow outwards, more slowly.

 When cash is coming in too slowly, this is called a Drag on liquidity

o Receivables that take a long time to be collected
o Inventory that sits unsold until it becomes obsolete
o Economic conditions that lead to difficulty in obtaining credit

 When cash outflows are moving too quickly, this is referred to as a Pull on liquidity
o Paying out on obligations earlier than necessary
o Suppliers or financial partners pulling back on the credit they are offering to us

The net effect of a combination of these effects is that company’s end up with money going out faster than they
can get it in, requiring them to find sources of funding outside of collections from sales.

Key liquidity ratios

Ratios can help us measure and understand a company’s liquidity position, so that we can compare it to other
companies to help us understand how we are doing relative to them with managing our liquidity.

To compare a company’s liquidity with the liquidity of their peers, we will consider main liquidity ratios.

Current Ratio and Quick Ratio

These are two widely used measures that aim to gauge liquidity by comparing elements of the balance sheet.
  The current ratio simply balances current assets against current liabilities. It is probably the most basic
and widely used measure for assessing liquidity. A ratio of greater than one implies that you have
enough cash or near cash assets to be able to pay your immediate liabilities, so a lack of liquidity is
unlikely to be a concern. It’s worth noting that having a current ratio that too high is equally not ideal as it
could be the company is struggling to think of what to do with their liquid funds to generate a return, they
may have run out of ideas for investments.

Current ratio = Current assets / Current liabilities

 The quick ratio then is a slight tweak on the current ratio, just as widely used. Instead of considering
ALL current assets, we only include the most liquid ones: cash, marketable securities and receivables
would be commonly included. Again, the quick ratio is a widely used, easy to calculate measure of
liquidity. You will notice that the quick ratio doesn’t include inventory, this is on the assumption that
inventory often takes quite a long time to turn into cash, especially if we sell on credit, and so should not
be considered as part of the available funds for paying our immediate liabilities.

Quick ratio = (Current assets – Inventory) / Current liabilities

OR: Quick ratio = (Cash + Marketable securities + Receivables) / Current liabilities

Receivables Turnover and Number of Days of Receivables

1. Receivables turnover

Credit Sales
Receivables Turnover =
Average Receivables

2. Number of Days of Receivables

Receivables Turnover
365
OR:

Accounts Receivable
Average Day ′ s Sales on Credit
OR:

Accounts Receivable
× 365 days
Annual Sales

Inventory Turnover and Number of Days of Inventory

1. Inventory turnover

Cost of Goods Sold

Inventory Turnover =
Average Inventory
 2. Number of Days of Inventory

Inventory Turnover
365
OR:

Inventory
Average Day ′ s Cost of Goods Sold
OR:

Inventory
× 365 days
Cost of Goods Sold

Payables Turnover and Number of Days of Payables

1. Payables turnover

Credit Purchases
Payables Turnover =
Average Payables
2. The number of days of payables

Payables Turnover
365
OR:

Accounts Payables
Average Day ′ s Purchases
OR:

Accounts Payables
× 365 days
Credit Purchases

Working Capital Effectiveness

Working capital effectiveness describes how a company is managing its liquidity position. How well are they
converting stock into cash? are they paying their suppliers too quickly?

There are two major indicators we can use to assess this idea of working capital effectiveness:

1. The operating cycle

The operating cycle tells us:
 How long on average it takes raw materials to be converted into cash from sales?
 How long does inventory sit in the company?
 Then once it’s been sold, how long before we actually receive cash?
 This is calculated by combining together receivables days, and inventory days.

2. The cash conversion cycle

The cash conversion cycle then adds the fact that our cash balances are supported by the amount of time
we delay on paying suppliers. How much are we offsetting the delay on the cash inflow side, by the time we
delay on the cash outflow side?

This is calculated by deducting payables days from the operating cycle.

This tells us the time delay between cash out and cash in, and so is the length of time cash is tied up for in
working capital.

When it comes to comparing these with our peer companies, remember that a higher cash conversion cycle is
undesirable. Overall, we want raw materials to turn into cash as quickly as possible. When the operating cycle is
unavoidably long, we expect the management to maintain liquidity by using payables. A longer cash conversion
cycle means that the company is excessively invested in working capital.
MANAGING LIQUIDITY AND CASH

Daily cash position

The daily cash position is a term used to describe the amount of cash a company has available for the
immediate purchase of goods, or for meeting immediate obligations. The central goal of any working capital
management plan is to ensure that this cash position stays positive.

This uninvested cash, sitting available for immediate use may seem like a waste of possible interest income, but
it will be up to the management team to decide what level of uninvested cash represents an efficient safety net,
and at what point the opportunity cost of not investing that cash in long term investments comes into play.

In practice, they will target a minimum cash balance as their ideal expected level, rather than targeting a zero
balance with perfectly offsetting inflows and outflows.

On a daily basis, the team will have to balance inflows and outflows.

Cash inflows:
 Cash from sales
 Collections from receivables
 Cash from subsidiaries

Cash outflows:
 Payments to employees
 Payments to vendors
 Cash going out to subsidiaries

Using available reporting, and statistical analysis, a company will draw up short-term, medium-term and long-
term forecasts of their cash flow to most effectively maintain the necessary available funds, while achieving the
best possible return on their cash before it leaves.

For a real world example of a company that operates directly in this area, you can visit cashanalytics.com. There
you will get an insight for how important cash flow forecasting and intelligent working capital management are in
modern business.

Short-term investments
Here we consider the use of spare cash funds to generate a return, without taking undue risks, and maintaining
a position where the investments could be liquidated if needs be.

There are various potential investments that may be suitable, including:

1. US treasury bills, or T-bills – which is essentially lending to the US government, hence virtually no risk,
but commensurately low returns.

2. Bank certificates of deposit, or CDs – these are effectively tradable savings deposits. The investor
makes a long-term deposit in return for a certificate of deposit. This certificate can be sold on to others if
the original investor wants to liquidate the deposit.

3. Repurchase agreements, or Repos – purchase of securities from a financial institution with an

agreement to be able to sell them back at a certain date in the future for a profit. The repo may simply be
held for a low return, or the securities used for speculation. This latter is usually not considered
appropriate for short-term liquidity management due to the risk of losses.

4. Commercial paper – this is short term company borrowing, that can be sold on a secondary market to
liquidate them.
There are many, many other examples as you might imagine!

Yield or return on short-term investments

Let us have a look at how we compute the yield, or return generated, on short term investments.

There are three major yield measures:

1. Discount Yield (also called Discount Basis Yield)

A discount instrument is one where interest is not paid, but the instrument is issued below face value, and
repays face value. The difference between the issue price and the face value is effectively the return.

Discount Yield is used for discount instruments, and is calculated by this formula:

(Face Value − Price) 360

×
Face Value No. of days in the term

For example, a $1,000,000 security may be issued for (or currently quoted at) $980,000 to be repaid in 3
months.

The yield would be [(1,000,000 – 980,000) / 1,000,000] x (12 / 3) = 8% per annum.

We have simply taken the 3-month yield here and multiplied by 4 to give us a simple annualised yield. The
exact approach will depend on convention as to exactly how the yield is annualised.

2. Money Market Yield

Here the concept is same, the only difference is that we divide the difference in the face value and price with
the price (instead of the face value):

(Face Value − Price) 360

×
Price No. of days in the term
So, for the same example, the money market yield will be:

[(1,000,000 – 980,000) / 980,000] x (360 / 90) = 8.2%

We assume 30 days in a month and 360 days in a year.

3. Bond Equivalent Yield

This measure assumes 365 days in the year, instead of 360, the rest is same as the Money Market Yield:

(Face Value − Price) 365

×
Price No. of days to maturity

So in our example, for interest payable in April, May and June:

[(1,000,000 – 980,000) / 980,000] x (365 / (30+31+30)) = 8.19%

When we look at the performance of a company’s short term investments, it’s important to remember that the
goal of an effective cash management policy is to earn a market return, without taking on unnecessary liquidity,
rate of return, default or foreign exchange risk and the policy should be evaluated based on its ability to achieve
that goal.
Short term investment strategies
Short term investment strategies can be either passive in nature, or active.

 A passive policy is characterised by one or two decision rules for making daily investments and are
generally less aggressive than active ones – in other words, they prioritise safety and liquidity.

 An active strategies require proactive daily involvement, and shopping around for the best possible
deals on a regular basis.

o A matching strategy is designed to match cash outflows with investment maturities.

o A mismatching strategy on the other hand doesn’t seek to try and match cash outflows with
investment maturities, but seeks the best return irrespective of the timing. This generally requires
the investment in very liquid securities, such as T-bills to be able to cope if adverse market
conditions arise.

o A laddering strategy plan is to ensure maturity is on a systematic basis – in other words at

regular intervals.

A company should state their short-term investment policy explicitly, including the following areas for
consideration:

 Purpose – for example emphasising safety and liquidity first, returns second

 Authority – for example the treasurer with approval from the CFO

 Maximum maturity

 Types and size of investment allowed

 Where investment documentation must be physically held

 Other limitations and restrictions

Tracking tools
Tracking tools such as spreadsheets or purpose made software packages should be used to continuously
monitor the performance of portfolios. The overall portfolio return should be weighted according to the size of the
investment, and yield should be calculated on a bond equivalent yield basis for comparability.
MANAGING COMPONENTS OF WORKING CAPITAL

1. Accounts receivable
When we are thinking about the company’s ability to collect on credit sales, longer is obviously worse. We
want the number of days that receivables are outstanding, to be as low as possible, without putting
excessive pressure on customers in case we lose them. The four main tools used to manage accounts
receivables are:

a. Receivables turnover (discussed in Introduction to Liquidity and Liquidity Ratios section)

b. Number of days that receivables are outstanding (discussed in Introduction to Liquidity and
Liquidity Ratios section)

c. Ageing schedule
This is a table of how much money we are owed in receivables, organised by the length of time they
have been outstanding. Following is a very simplistic example for one period in the company’s
history:

Ageing Schedule: Company XYZ

Period outstanding

Receivables Less More than 1

More than
than 1 month but less
2 months
month than 2 months
Customer A $100
Customer B $100
Customer C $200
Total $100 $100 $200

This company has 100 dollars of receivables we would call CURRENT, which is less than 1 month
old, another 100 dollars which is past due, between 1 and 2 months old, and they have 200 dollars’
worth of receivables outstanding for more than 2 months.

The $200 would warrant some investigation. In addition, the $100 that is past due may indicate
further problems later down the line, so may also warrant investigation before the debt becomes
more seriously overdue.

Sometimes it is really helpful, to build an ageing schedule based on the RELATIVE amounts of
receivables in each category, dividing the amount in each box by the total receivables figure for that
period and seeing where the largest portion of our receivables lies and how that balance is changing
over time. In our earlier example this would show that:

 100/400 or 25% is less than a month old

 100/400 or 25% is between one and two months’ old
 200/400 or 50% is outstanding for more than 2 months
 Ageing Schedule: Company XYZ
Period outstanding
More than 1
Receivables Less More
month but
than 1 than 2
less than 2
month months
months
Customer A $100
Customer B $100
Customer C $200
Total $100 $100 $200
Relative
25% 25% 50%
amounts

d. Weighted average collection period

To calculate this number, we look at the amounts due currently, in terms of their relative size. In our
example, we have a total of 400 dollars in receivables, 50% of which has been outstanding for more
than 60 days. From there we record the average number of days that receivables are outstanding in
each category. Suppose the receivables days by category was as follows:

Collection days Amount owed

Under 1 month 25 100
1–2 months 48 100
Over 2 months 75 200
Total 400

We turn the amount owed column into a percentage as before:

So 100 is 100/400 = 25%, and so on

This is the third column:

Collection days Amount owed Proportion

Under 1 month 25 100 100 / 400 = 0.25
1–2 months 48 100 100 / 400 = 0.25
Over 2 months 75 200 200 / 400 = 0.50
Total 400 1

We then simply multiply Collection days by the proportion, then add them up.

This is the final column:

 Collection days Amount owed Proportion Weighted average
Under 1 month 25 100 100 / 400 = 0.25 25 x 0.25 = 6.25
1–2 months 48 100 100 / 400 = 0.25 48 x 0.25 = 12.00
Over 2 months 75 200 200 / 400 = 0.50 75 x 0.50 = 37.50
Total 400 1 55.75

The 55.75 days is the weighted average collection period, a weighted average estimate of the length
of time it takes us to collect on a credit sale.

2. Inventory
In terms of inventory management, a rising inventory turnover, which would mean a falling number of days
of inventory, would indicate that the firm is seeing that inventory levels as they currently stand, may not be
sufficient to cope. There has been some change, which is causing our inventory to move from ready for sale,
to sold, quicker than it was before. Equally, if inventory days increase, this suggests inventory levels are
increasing, which needs funding, the inventory needs warehousing, insuring, and there is an increased risk
of obsolescence.

There are two major risks with inventory management are:

 When Inventory is allowed to fall too low, we risk a stock out, which is when we cannot sell
products, because we don’t have availability when a buyer is interested.
 On the other hand, when inventory is allowed to accumulate, we start to worry about carrying costs.
What is it going to cost us to house and store an increasing amount of inventory?

Now when it comes to putting together an inventory management analysis, a company’s efforts to maintain
this balance between too low and too high is built on:

a. Inventory turnover ratio (discussed in Introduction to Liquidity and Liquidity Ratios section)

b. Number of days of inventory (discussed in Introduction to Liquidity and Liquidity Ratios section)

c. Economic Order Quantity, Re Order Point (EOQ ROP)

With this method the company will minimize their stock, ordering only when the inventory level
reaches a certain re-order point based on factors like ordering costs, carrying costs, expected
demand and expected lead times. Overall, we’re looking for the cost minimising level of inventory.

The company might implement a safety stock level, or an anticipation stock level, amounts of
inventory they perceive to be an appropriate cushion, given an analysis of both continuous and
seasonal demand. When inventory levels reach that safety level, the order is placed and inventory
repeats its cycle. The amount that they order, is called the Economic Order Quantity, the amount
that will satisfy use, while maintaining the safety cushion.

This can be seen in the following graph:

 The stock levels follow a ‘saw-tooth’ pattern as stock is replenished, then run down to the safety
stock level, then replenished, and so on

d. Just In Time (JIT)

With the Just in Time method, the company will be looking at minimising their in-process stock, raw
materials and stock not ready for sale. This is a system of analysis based on the entire production
cycle, aiming to order stock based on historical levels of demand. The idea is that inventory is
ordered so that it arrives ‘just in time’ for manufacture, then the good are then ideally sold almost
immediately.

This not only minimises inventory levels, but amounts often to ‘manufacturing to order’ for customers,
enabling products to be more closely customised to customer requirements.

e. Manufacturing resource planning method

With the manufacturing resource planning method, the scope of analysis widens to include both the
acquisition of materials, and the production cycle. This system aims to add a schedule of materials
acquisition to the production schedule, building in the timing of labour and machinery usage in the
production process, so gaining a broader base of information and analysis to improve efficiency and
reduce inventory costs. It essentially works backwards from required output, to calculate the
resources needed, and when they are needed. These resources include labour, machinery, and
inventory as well.

3. Accounts payable
When we look at accounts payable, we’re thinking about the length of time it takes for us to send cash to
those we have bought goods from on credit. If we are paying them too soon, or sooner than is necessary,
we’re losing out on interest we could be earning on the balance. If we take too long, we may damage our
reputation, and lose potentially favourable terms with these credit suppliers.

Just like when a company puts themselves into potential financial difficulty when they don’t manage their
receivables well, companies who pay their payables before they are due sacrifice interest that they could
earn, and potentially, will wind up needing to borrow funds if they have spent cash too early.

To assess how well a company manages their accounts payable, we will use:

a. Payables turnover (discussed in Introduction to Liquidity and Liquidity Ratios section)

b. Number of days of payables (discussed in Introduction to Liquidity and Liquidity Ratios section)

c. Cost of trade credit

 The cost of trade credit is a tool we can use to evaluate the benefit of a trade discount, a discount on
the price offered by the supplier, often for settling our account with them early.

For example, if the terms offered by the supplier are 2/10, net 30, this is telling you that there is a 2%
discount if some payment is made within 10 days. The net balance should then be paid within 30
days.

In this example the supplier is offering us a 2% discount if we pay within 10 days. So within this
timeframe, not only do we have free money, in that we owe it to the supplier but we don’t owe any
interest and we can use it as we see fit for 10 days, but we are also going to receive a 2% discount
on the purchase price.

Now, if we don’t pay within that 10-day timeframe, our cost of funds skyrockets (as we lose the 2%
discount) and then falls from there to the date where the net balance is due, reflecting the fact that
we will have the benefit of our funds from day 11 to day 30.

To assess the benefit of taking the discount, we compare this cost of trade credit to the purchasing
company’s cost of borrowed funds. If it’s cheaper to borrow than the cost of missing out on the
discount, then we should borrow and pay within that discount timeframe.

The cost of trade credit is calculated using following formula:

365
Discount ( a
)
(1 + ) −1
1 − Discount

This discount value inserted in the formula is the discount offered for paying the supplier within a
certain timeframe, and ‘a’ is the ‘days past discount figure’ which is pretty self-explanatory. This is
the number of days AFTER the last day for the discount, that we did actually end up paying.

If for example supplier is offering term of 2/20, net 30, we chose to pay on the 20th day after
purchase, we lose the 2% discount for the benefit of holding the purchase cash for 10 extra days.
Using the formula, that indicates a cost of trade credit of:

365
2 ( 10 )
(1 + ) − 1 = 109%
98

Ultimately managing working capital is a matter of balance, too little and you run the risk of annoying customers
for collecting too early, annoying suppliers for taking too long to pay, running out of inventory. However too much
requires financing, if customers take too long to pay, we have access inventory and suppliers are paid too
quickly, all this is a drain on our cash.
SHORT-TERM FUNDING

It’s important to remember that although a company’s goal of maintaining a sound liquidity position is central and
we can use liquidity ratios and cash forecasts to measure and assess the company’s position, how they achieve
the best results requires some further thought.

One major factor which is often a shortcoming of a company’s cash management policy, is a detailed knowledge
of the various available sources of short term financing. For example:

1. Bank options:

a) Line of credit
 An uncommitted line of credit, is where the bank offers to lend short term funding to a large, generally
financially sound company. The word UNcommitted, implies that the bank has the option to pull the plug
if the circumstances of the borrower changes significantly.

 A committed line of credit, or an overdraft line of credit means that the bank, to some extent anyway,
are locked in to lend some amount up to the credit limit, for some pre-agreed period of time. This gives
the borrower some level of assurance that funding will be there if they need it, even if they get into
financial distress, but that assurance, the banks willingness to commit, comes at a price.

 A revolving line of credit then is a further commitment by the bank, typically in terms of the length of
the loan. Revolving lines of credit generally imply loans up to and including terms of more than a year.

Now when a company seeks a line of credit, it is possible that the bank will require certain pre-conditions. For
example, the bank may seek some collateral, some asset or assets of the company to be pledged to guarantee
the credit. This might mean inventory, or receivables, or noncurrent assets in some cases. The bank may also
want a blanket lien, which means that the bank has some claim on all current and future assets of the company
in the event of a default, where the original collateral is insufficient.

b) Banker’s acceptance
A Banker’s Acceptance is related to exporting goods. When a company has shipped goods internationally, they
may receive a guarantee from the buyer. This guarantee, the Banker’s Acceptance, written by the bank of the
buyer, is basically a note to say that the buyer will pay, once the shipment arrives. If the selling company needs
immediate funding, and they cannot wait for the shipment to reach its destination and the subsequent payment,
they may choose to SELL ON this Banker’s Acceptance at some discount.

c) Factoring
Factoring is another term used to describe the direct sale of receivables. Generally, receivables are sold at some
discount from their face value based on time outstanding, creditworthiness of the customer and the firm’s history
of collection.

2. Non-Bank options:
a) Partnering with a financing company
These companies offer short term funding, generally at premium rates. These higher rates are accepted by
companies who cannot access short term funding through a normal channel, from a bank.

b) Commercial paper
A company might consider issuing commercial paper. This is a practice generally reserved for large, highly
creditworthy, stable companies. They may choose to place, or sell, the paper directly with investors themselves,
or through a dealer. It is common that the rates of interest paid out on such paper would be less than that
charged by a bank.

Commercial paper is in essence short term, usually unsecured borrowing by issuing loan notes, or ‘paper’
acknowledging the debt. The ‘paper’ is usually sold at less than face value, and repaid at face value. No interest
as such is generally paid; the return is the difference between what was given at the start compared to what is
repaid at the end. The lender can often sell their paper to another investor on the secondary market if they want
funds to be repaid before the maturity date.

Cost of borrowing
The cost of borrowing can generally be calculated as:

(Interest + Arrangement Fees)

Loan Amount
If the interest is stated as ‘inclusive’, meaning it is effectively taken out of the amount borrowed, in this case the
cost becomes:

(Interest + Arrangement Fees)

(Loan Amount − Interest)

Factors to consider
The best financing method depends on various factors, including:

 The cost
 The required term
 Repayment schedules – is the capital repayable at the end or does it need to be repaid back over the
term of the loan?
 Security available to offer – better security lowers the cost
 Conditions attaching to the borrowing
 Flexibility in terms of repayment amount/dates if needed