Working capital management involves managing a company's current assets and liabilities to ensure sufficient cash
flow for short-term obligations. It optimizes asset-liability balance to enhance efficiency, liquidity, and profitability
while minimizing financial risk.
Net Working Capital (NWC)
Net Working Capital (NWC) measures a company's liquidity by subtracting current liabilities from current assets. It
reflects the cash and short-term assets available to cover short-term obligations.
Formula:
NWC = Current Assets – Current Liabilities
Current Ratio
Current Ratio measures a company's ability to pay short-term obligations using current assets.
Formula: Current Ratio = Current Assets / Current Liabilities
Current assets are expected to convert to cash within a year, while current liabilities are short-term debts due within
the same period.
Managing Working Capital ensures a company has enough cash to meet liabilities while avoiding excess investment
in low-return assets.
• Permanent Working Capital: Minimum required for daily operations.
• Temporary Working Capital: Additional funds needed periodically.
Levels of Working Capital
Maturity-Matching Approach (MMA)
aligns asset and liability maturities to manage risk. Current assets fund short-term liabilities, while non-current assets
are financed with long-term debt or equity. To reduce liquidity risk, minimal current assets may be financed with
long-term borrowing.
The Operating Cycle and the Cash Cycle
Operating Cycle: Time between acquiring inventory and receiving cash from sales.
Formula: Days’ Sales in Receivables + Days’ Sales in Inventory
Cash Cycle (Cash Conversion Cycle): Time between paying for inventory and receiving cash from sales.
Formula: Operating Cycle – Days’ Purchases in Accounts Payable
Alternative Formula: Days in Inventory + Days Sales in Receivables – Days Payables Outstanding
A low operating cycle improves cash flow and liquidity by quickly converting inventory into cash. A high operating
cycle may indicate excess inventory, inefficient management, and financial strain.
Components of Working Capital:
• Cash & Cash Equivalents – Readily available funds.
• Current Marketable Securities – Short-term investments.
• Accounts Receivable – Money owed by customers.
• Inventory – Goods held for sale.
• Accounts Payable – Amounts owed to suppliers.
• Short-Term Financing – Loans and credit for daily operations.
Cash Management
ensures a company has enough cash for short-term obligations and long-term growth. It involves quickly collecting
receivables and delaying payables to optimize cash flow.
Determining Cash Levels depends on:
• Future Cash Needs – Expected short-term expenses.
• Liquidity Risk Tolerance – Risk the company is willing to take.
• Short-Term Assets – How quickly they convert to cash.
• Return on Investments – Potential earnings from short-term investments.
• Operating Cycle Stage – Seasonal businesses hold more cash after peak periods.
Reasons for Holding Cash
Lockbox System
A lockbox system speeds up cash collection by using special post office boxes in various
locations. Customers send payments to the nearest lockbox, reducing mail and processing
time.
Net Benefit Equation:
Net Benefit = (Daily Cash Collected × Reduction in Collection Time × Opportunity Cost)
– Lockbox Cost
Marketable Securities Management
Marketable securities are highly liquid investments that can be quickly sold at a fair price.
They offer lower returns than operating assets but higher than cash savings. Management
focuses on optimizing value while minimizing risk.
Accounts Receivable Management
Accounts receivable are amounts owed by customers for credit sales. Businesses must
balance increased sales from credit with costs like collection expenses, lost interest, and
credit risks.
Credit Policy
A company's credit policy defines how much credit to grant and to whom.
Key Components:
• Credit Standards: Determines eligible customers using credit scoring.
• Credit Terms: Specifies payment period, early payment discounts, and late penalties.
Impact:
• Relaxed standards increase sales but also raise credit losses and default risk.
Monitoring Accounts Receivable
An aging schedule classifies receivables based on how long they’ve been outstanding. It
helps track overdue accounts by grouping them into categories (e.g., current, 1–30 days
past due, etc.) for better evaluation and collection efforts
Inventory Management
Inventory is the stock of goods a business holds to meet demand. Proper management
ensures the right products are available at the right time while minimizing carrying costs.
Key Factors in Determining Optimal Inventory Levels:
• Demand forecasting
• Storage and carrying costs
• Supply chain reliability
• Order quantity and frequency
• Production requirements
Lead Time, Safety Stock, and Reorder Point
• Lead Time: The time between placing an order and receiving inventory. Longer lead
times increase stockout risk.
• Safety Stock: Extra inventory held to prevent stockouts. Required stock depends on:
o Variability in lead time and demand
o Cost of stockouts
o Predictability of demand and supply
• Stockout Risk: Higher when demand and lead time are unpredictable; lower when
both are stable.
Reorder Point
The reorder point is the inventory level at which a business should reorder stock to prevent
stockouts. It ensures a steady supply and avoids disruptions.
Equation:
Where:
• Lead Time Demand = Average Daily Demand × Lead Time
• Safety Stock = Extra inventory to cover demand variability
Economic Order Quantity (EOQ) & Economic Lot Size
EOQ (Economic Order Quantity):
EOQ is the optimal order quantity that minimizes the total cost of ordering and holding
inventory. It helps businesses balance order costs and carrying costs efficiently.
Equation:
Where:
• D = Annual demand
• S = Ordering cost per order
• H = Holding cost per unit per year
Economic Lot Size:
Economic lot size is the optimal production batch size that minimizes the total setup and
carrying costs in a manufacturing environment. It is similar to EOQ but considers production
rates.
