LM05 Working Capital & Liquidity

LM05 Working Capital & Liquidity 2023 Level I Notes
LM05 Working Capital & Liquidity

1. Introduction ...........................................................................................................................................................2
2. Financing Options ................................................................................................................................................2
Internal Financing ..............................................................................................................................................3
External Financing: Financial Intermediaries .........................................................................................4
External Financing: Capital Markets ...........................................................................................................4
3. Working Capital, Liquidity, and Short-Term Funding Needs .............................................................6
4. Liquidity And Short-Term Funding ..............................................................................................................8
Primary Sources of Liquidity .........................................................................................................................9
Secondary Sources of Liquidity .....................................................................................................................9
Drags and Pulls on Liquidity ....................................................................................................................... 10
5. Measuring Liquidity......................................................................................................................................... 10
6. Evaluating Short-Term Financing Choices ............................................................................................. 11
Summary................................................................................................................................................................... 14
This document should be read in conjunction with the corresponding learning module in the 2023
Level I CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are
copyright 2022, CFA Institute. Reproduced and republished with permission from CFA Institute. All
rights reserved.
Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of
the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are
trademarks owned by CFA Institute.
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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.
External
Internal
Financial Intermediaries Capital markets
 After-tax operating  Uncommitted lines of  Commercial
cash flows credit paper
 Accounts payable  Committed lines of
Short-term  Accounts receivable credit
 Inventory  Revolving credit
 Marketable securities  Secured loans
 Factoring
 Long-term debt
Long-term  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?
Solution:
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
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?
Solution:
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 Higher debt financing cost with an upward-
not require regular refinancing; reduced sloping yield curve
rollover risk
Financing costs are known upfront High cost of equity
Certainty of working capital needed to Permanent financing dismisses the
purchase the necessary inventory opportunity to borrow only as needed
(increasing ongoing financing costs)
Extended payment term reduces short-term A longer lead time is required to establish
cash needs for debt service the financing position
Improved flexibility during times of stress, Long-term debt may require more
with excess liquidity in marketable covenants that restrict business operations
securities
Aggressive approach
Pros Cons
Short-term lines of credit provide the Higher levels of short-term cash may be
flexibility to access financing only when needed to meet short-term debt maturities
needed—particularly appropriate for
seasonality—reducing overall interest
expense
Short-term loans involve less rigorous Potential difficulty in rolling the short-term
credit analysis, as the lender has greater loans, thus increasing bankruptcy risk,
clarity as to the short-term operations of particularly during times of stress
the firm
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 Access to short-term capital may be
approach restricted when needed for inventory build
Flexibility to increase financing for seasonal Potential difficulty in rolling the short-term
spikes while maintaining a base level for loans, thus increasing bankruptcy risk,
ongoing needs particularly during times of stress
Diversifying sources of funding with a more Greater reliance on trade credit (expensive
disciplined approach to balance sheet financing) may be necessary if the business
management 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 from the curriculum summarizes the relationship between financing requirements,
costs, risks, and return on equity based on funding approach.
4. Liquidity And Short-Term Funding

Liquidity is the extent to which a company is able to meet its short-term obligations using
cash flows and those assets that can be readily transformed into cash.
The liquidity of an asset can be evaluated along two dimensions:
 The type of the asset
 The speed at which the asset can be converted into cash (by sale or financing)
Liquidity management refers to the company’s ability to generate cash when needed, at the
lowest possible cost.
Two sources of liquidity for a company are:

 primary sources of liquidity, such as cash balances

 secondary sources of liquidity, such as selling assets
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.
Primary Sources of Liquidity
They represent the most readily accessible resources available to the company. Primary
sources include:
 Free cash flow: The firm’s after-tax operating cash flow less planned short- and long-
term investments.
 Ready cash balances: Cash available in bank accounts.
 Short-term funds: Include items such as trade credit, bank lines of credit, and short-
term investment portfolios.
 Cash management: Refers to the company’s effectiveness in its cash management
system and practices, and the degree of decentralization of the collections/payments
processes. The higher the degree of decentralization, the more the cash tied up in the
system.
Secondary Sources of Liquidity
Secondary sources include:
 negotiating debt contracts
 liquidating assets
 filing for bankruptcy protection and reorganization
Example: Estimating Costs of Liquidity
A company facing a liquidity crisis has the following options to raise funds. The estimated
fair value and liquidation costs for each source of funds is listed below:
Source of Funds Fair Value (C$, Liquidation
millions) Costs (%)
Sell short-term marketable securities 10 0
Sell select inventories and receivables 20 10
Sell excess real estate property 50 15
Sell a subsidiary of the firm 30 20
Net of liquidation costs, how much liquidity can the company raise if all four sources of funds
are used?
Solution:
The costs and net funds raised are summarized in this table:

Source of Funds Fair Value Liquidation Liquidation Net Proceeds

(C$, Costs (%) Costs (C$, (C$, millions)
millions) millions)
Marketable securities 10 0 0 10
Inventories and receivables 20 10 2 18
Real estate property 50 15 7.5 42.5
Subsidiary of the firm 30 20 6 24
Total 15.5 94.5
Drags and Pulls on Liquidity
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, uncollected receivables, obsolete
inventory, tight credit etc.
Pulls on liquidity accelerate cash outflows. For example, earlier payment of vendor dues,
reduced credit limits (by suppliers), limits on short-term lines of credit (by banks) etc.
5. 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.
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.
Ratios used for assessing a company’s liquidity
Financial ratios can be used to assess a company’s liquidity as well as its management of
assets over time. The commonly used ratios are:
Liquidity Ratios
Ratio Formula Interpretation
Current Current assets ÷ Current liabilities The greater the current ratio the
ratio higher the company’s liquidity
Quick ratio (Cash + Marketable securities + The higher the quick ratio the higher
Receivables) ÷ Current liabilities the company’s liquidity
Cash ratio (Cash + Marketable securities) ÷ The higher the cash ratio the higher
Current liabilities the company’s liquidity
Activity Ratios

Receivable Credit Sales ÷ Average receivables It is a measure of how many times, on

turnover average, accounts receivable are
created by credit sales and collected
on during the fiscal period.
Number of 365 or days in period ÷ Receivable It tells the number of days on average
days of turnover the company takes to collect on the
receivables credit accounts
Inventory Cost of goods sold ÷ Average It is a measure of how many times, on
turnover inventory average, inventory is created or
acquired and sold during the fiscal
period
Number of 365 or days in the period ÷ Inventory It is the length of time, on average,
days of turnover that the inventory remains within the
inventory company
Payables Average day’s purchases ÷ Average It is a measure of how long it takes
turnover trade payables the company to pay its own suppliers
Number of 365 or days in the period ÷ Payables It tells the number of days on average
days of turnover the company takes to make payments
payables to its suppliers.
Cash Days of inventory + Days of It measures the time from paying
conversion receivables – Days of payables suppliers for raw materials to
cycle collecting cash from customers. The
shorter the cycle, the better is the
cash-generating ability of a company
Liquidity ratios are used to measure a company’s ability to meet its short-term obligations.
Activity ratios measure how well key current assets and working capital is managed over
time.
The levels of these ratios, and their trends, or changes over time, in addition to comparisons
with competitors or the industry, are used to judge a firm’s liquidity position.
6. Evaluating Short-Term Financing Choices
Since many short-term financing alternatives are available, a company should evaluate these
options and create a planned borrowing strategy that will maximize its cost savings.
Companies seek to implement a short-term financing strategy that will help achieve the
following objectives:
 Ensure sufficient capacity to handle peak cash needs.
 Maintain sufficient and diversified sources of credit.
 Ensure rates are cost-effective.

 Ensure both implicit and explicit funding costs are considered.

Factors that will influence a company’s short-term borrowing strategies are:
 Size and creditworthiness: Larger companies have additional and cheaper options as
compared to smaller companies. The borrower’s creditworthiness determines the
access to and the cost of borrowing.
 Legal and regulatory considerations: Legal and regulatory constraints on specific
industries can restrict how much a company can borrow and under what terms.
 Asset nature: Depending on their business model, some companies may have assets
that are considered attractive as collateral for secured loans.
 Flexibility of financing options: Flexibility allows a company to better manage its debt
maturities. Cash budgeting exercises can help businesses avoid issues when credit
markets are tight and a company's ability to roll a particular maturity is limited.
Example: Meeting Short-Term Financing Need
(This is Example 9 from the curriculum.)
Keown Corp. has accounts payable of C$2 million with terms of 2/10, net 30. Accounts
receivable also stands at C$2 million. In addition, the company has C$5 million in marketable
securities. Keown has a short-term need of C$200,000 to meet payroll. Which of the
following options makes the most sense for raising the C$200,000?
A. The company should issue long-term debt.
B. The company should issue common stock.
C. The company should delay paying accounts payable and forgo the 2% discount.
D. The company should sell some of its accounts receivable to a factor at a 10% discount.
E. The company should sell some of its marketable securities at a 0.5% brokerage cost.
Solution
A and B would not be appropriate for raising C$200,000 for a short-term need. These
options take time to arrange, and they are more appropriate for long-term capital needs and
for much larger financing amounts.
C, D, and E are all appropriate options for meeting short-term financing needs. However, C
and D are costly.
The options for raising C$200,000 are summarized in this table:
Liquidation Costs
Source of Funds Action % C$
C. Accounts payable (2/10, Delay C$200,000 in payment and 2.0 4,000
net 30) forgo 2% discount

D. Accounts receivable Sell C$222,222 in value at 10% 10.0 22,222

discount to raise CA$200,000
E. Marketable securities Sell C$200,000 in value 0.5 1,000
Choosing C means forgoing a 2% discount, which on C$ 200,000 amounts to a cost of
C$4,000. To net C$200,000 using option D, the company would have to sell C$222,222 of
accounts receivable to a factor, representing a cost of C$22,222. E appears to be the best
choice. Marketable securities are liquid and can be easily sold for market value, less the
relatively minor brokerage cost of C$1,000.

Summary
LO. Compare methods to finance working capital.
The main internal and external sources of capital for a company.
External
Internal
Financial Intermediaries Capital markets
 After-tax operating  Uncommitted lines of  Commercial
cash flows credit paper
 Accounts payable  Committed lines of
Short-term  Accounts receivable credit
 Inventory  Revolving credit
 Marketable securities  Secured loans
 Factoring
 Long-term debt
Long-term  Equity
LO. Explain expected relations between working capital, liquidity, and short-term
funding needs.
Exhibit 2 from the curriculum summarizes the relationship between financing requirements,
costs, risks, and return on equity based on funding approach.
LO. Describe sources of primary and secondary liquidity and factors affecting a
company’s liquidity position.
Liquidity is the extent to which a company is able to meet its short-term obligations using
cash flows and those assets that can be readily transformed into cash.
Liquidity management refers to the company’s ability to generate cash when needed, at the
lowest possible cost.

Two sources of liquidity for a company are:

 Primary sources of liquidity, such as free cash flow, ready cash balances, short-term
funds, cash management.
 Secondary sources of liquidity, such as negotiating debt contracts, liquidating assets,
filing for bankruptcy protection.
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, uncollected receivables, obsolete
inventory, tight credit etc.
Pulls on liquidity accelerate cash outflows. For example, earlier payment of vendor dues,
reduced credit limits (by suppliers), limits on short-term lines of credit (by banks) etc.
LO. Compare a company’s liquidity position with that of peers.
Financial ratios can be used to assess a company’s liquidity as well as its management of
assets over time. The commonly used ratios are:
Liquidity Ratios
Ratio Formula Interpretation
Current Current assets ÷ Current liabilities The greater the current ratio the
ratio higher the company’s liquidity
Quick ratio (Cash + Marketable securities + The higher the quick ratio the higher
Receivables) ÷ Current liabilities the company’s liquidity
Cash ratio (Cash + Marketable securities) ÷ The higher the cash ratio the higher
Current liabilities the company’s liquidity
Activity Ratios
Receivable Credit Sales ÷ Average receivables It is a measure of how many times, on
turnover average, accounts receivable are
created by credit sales and collected
on during the fiscal period.
Number of 365 or days in period ÷ Receivable It tells the number of days on average
days of turnover the company takes to collect on the
receivables credit accounts
Inventory Cost of goods sold ÷ Average It is a measure of how many times, on
turnover inventory average, inventory is created or
acquired and sold during the fiscal
period

Number of 365 or days in the period ÷ Inventory It is the length of time, on average,
days of turnover that the inventory remains within the
inventory company
Payables Average day’s purchases ÷ Average It is a measure of how long it takes
turnover trade payables the company to pay its own suppliers
Number of 365 or days in the period ÷ Payables It tells the number of days on average
days of turnover the company takes to make payments
payables to its suppliers.
Cash Days of inventory + Days of It measures the time from paying
conversion receivables – Days of payables suppliers for raw materials to
cycle collecting cash from customers. The
shorter the cycle, the better is the
cash-generating ability of a company
LO. Evaluate short-term funding choices available to a company.
Companies seek to implement a short-term financing strategy that will help achieve the
following objectives:
 Ensure sufficient capacity to handle peak cash needs.
 Maintain sufficient and diversified sources of credit.
 Ensure rates are cost-effective.
 Ensure both implicit and explicit funding costs are considered.
Factors that will influence a company’s short-term borrowing strategies are:
 Size and creditworthiness
 Legal and regulatory considerations
 Asset nature
 Flexibility of financing options

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LM05 Working Capital & Liquidity 2023 Level I Notes