Chapter 7 – Working capital management

Chapter agenda

What is working
capital
management

Basics of working
Main objectives
capital

How working
capital is managed

Chatper 6 Liqudity ratios

How is working Cash operating

capital measured cycle

How to predict
Working capital
future working
turnover ratio
capital investments

What is working capital?

Working capital = Current assets (CA) – Current liabilities (CL)

Working capital is aka capital available for a business to conduct its day-to-day operations

What is working capital management?

This is all about managing the different elements of current assets and current liabilities

Element of CA – Inventories, receivables, cash & bank balances

Elements of CL – Payables & overdrafts

To invest in working capital, a business must bear a cost. This can be also thought of as an
opportunity cost arisen due to cash being tied up in working capital.

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What are the objectives of working capital management?
The main objective is to achieve the BEST BALANCE of CA & CL

Having too much or too less of CA & CL can impact liquidity and profitability.

E.g., Cash held in the current account does not attract interest income. Hence there is a loss
of interest income, if a business maintains a huge sum of cash in its current account.
However, cash in hand, improves the overall liquidity of the business.

Therefore, there is a trade – off between liquidity and profitability.

Mismanagement of working capital can often lead to issues such as

Overstocking
Overtrading
Inability to meet short term obligations as they become due which translate into
insolvency.

Thus, working capital management, a crucial factor in the long-term success of an

organisation.

READ THE ARTICLE BELOW TO OBTAIN A GOOD UNDERTSTANDING OF WC MANAGEMENT

https://www.accaglobal.com/hk/en/student/exam-support-resources/fundamentals-
exams-study-resources/f9/technical-articles/wcm.html

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How is working capital managed?
There are two main policies of working capital management.

Aggressive policy Conservative policy

Maintaining a low level of working capital Maintaining a high level of working capital
than competitors (Low inventories, than competitors (High inventories,
receivables & higher payables) receivables and lower payables)

Low working capital funding cost Higher working capital funding cost

Higher risk Lower risk

High risk in aggressive

Low stocks can lead to stock-outs and as a result dissatisfied customer.

Low receivables mean shorter credit terms for customers. This may lead to customer
switching to other sellers in the market.

Higher payables mean delaying payments to supplier which means suppliers reducing
supplies to the business.

Lower risk in conservative

Having higher levels of inventories, receivables & cash and lower levels of payables means,
the business has too much cash tied up in working capital. This is known as an
overcapitalised situation

Cash is the lifeblood of a business. When the business runs out of cash, its survival is
threatened.

When a business grows, it is essential that they invest in more non-current assets (NCA) and
working capital.

When a business does not have enough cash to fund increases in working capital or non-
current assets then it is said to be an overtrading situation

In the exam you may be required to diagnose, symptoms of overtrading from the available
information set. These are typically
o A rapid increase in sales
o Increases in receivable and payable payment periods
o Drop in liquidity ratios

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How is working capital measured?
Through working capital ratios

Current ratio
Liqudity ratios
Acid test ratio

Working capital Inventory Raw material

ratios holding period holding period

Inventory WIP holding

holding period period
Cash Operating
cycle
FG holding
Receivable days
period

Payable days

Liquidity ratios
There are two main liquidity ratios.

RATIO Equation Interpretation

CURRENT RATIO 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 A ratio > 1 is preferred.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

QUICK RATIO (ACID 𝐶𝑢𝑟𝑟𝑒𝑛 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 A ratio > 1 is preferred.

TEST RATIO) 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

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Cash operating cycle
This is the length of time that it takes for a business to convert material and other input
resources into cashflows from sales.

The lower the length of time, lower the investment in working capital.

Purchase of
Cash from
RM from
receivables
suppliers

Work In
Receivables Progress
(WIP)

FG

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Interpreting the cash operating cycle

Purchasing of raw
material from
suppliers

Production process
Cash is paid to starts (Use of
suppliers material, labour
and overheads)

Cash is received Labour & overhead

from customers progresses

Goods are sold to Completed goods

customers are stored

How to measure the cash operating cycle?

The cycle is measured in days/weeks/months.

For a manufacturer For a whole seller

RM holding period X Inventory holding period X
WIP holding period X Receivables collection period X
FG holding period X Payable payment period (X)
Receivable collection period X
(-) Payable payment period (X) Cash operating cycle X

Cash operating cycle X

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Cash operating cycle ratios
Ratio Equation Interpretation

RM inventory 𝑅𝑀 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 The average number of days that RM

𝑋 365
holding period 𝑅𝑀 𝑢𝑠𝑎𝑔𝑒 inventory is held for

WIP holding period 𝑊𝐼𝑃 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 The average number of days that WIP
𝑋 365
𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡 is held for

FG holding period 𝐹𝐺 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 The average number of days that

𝑋 365
(Aka Inventory 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡 inventory is held for
holding period)

Lower inventory holding periods are always preferred

For each inventory ratio, the TURNOVER ratio can be calculated

Typically, it is calculated for FG

𝑪𝒐𝒔𝒕
𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝒉𝒆𝒍𝒅

This measures how many times FG inventory has been turned into sales

Receivables 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 The average period it takes for a

𝑋 365
(debtor) collection 𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠 collect debt from their debtors.
period
If credit sales are not available, sales
can be used

Payables (creditor) 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 The average period it takes for a

𝑋 365
period 𝐶𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 company to pay for its purchases.

If credit purchases are not available,

‘purchases’ or ‘cost of sales can be
used.

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Points to note when calculating ratios
• If the period is required in days multiplied by 365, in months by 12 & in weeks by 52

• Average values must be in inventory, payables and receivables when calculating

ratios
•
𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠 + 𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠
𝑋 365
𝐶𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠

• For each ratio above turnover ratio can be calculated by inverting the ratio and
removing the multiplication

What are the factors affecting the length of the cash operating cycle?
Management efficiency – Lower the attention to short-term assets and liabilities longer the
length

Industry norms – The cash operating cycle in some industries are longer. E.g., Construction
industry compared to the retail industry

What is the working capital turnover ratio?

𝑆𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑁𝑒𝑡 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

The more the sales per net working capital, the better it is.

A higher ratio indicates the management is efficiently using its short-term assets and
liabilities to generate sales.

A lower ratio indicates that management has invested too much in working capital. This
could translate into obsolete inventory and or bad debts.

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Example – Cash operating cycle

A company estimates the following figures for the coming year.

Sales $4,000,000 (All on credit)

Receivables $340,000
GP margin 25% on sales
Finished goods $222,000
Work in progress $388,500
Raw materials (balance held) $166,500
Trade payables $144,300
Raw materials 80% of cost of sales

Calculate the cash operating cycle.

How to predict future levels of working capital investment?

This is done by re-arranging the working capital formulas calculated above.

As an example

𝑇𝑟𝑎𝑑𝑒 𝑟𝑒𝑐𝑒𝑖𝑎𝑏𝑙𝑒𝑠 𝑑𝑎𝑦𝑠

𝑇𝑟𝑎𝑑𝑒 𝑟𝑒𝑐𝑒𝑖𝑎𝑏𝑙𝑒𝑠 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 = 𝑥 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠
365

What are the factors affecting the level of working capital?

Nature of the business - Manufacturing companies need require more investments in
working capital than service providers

Uncertainty of supplier delivery – Extra inventory needs to be maintained if highly uncertain.

Level of activity – Higher activity requires higher investments in working capital

Credit policy – If the credit policy is tight, lower receivables

Credit policy of suppliers – Tight credit policy means, lower payables, higher investment in

What is the most optimal level of working capital?

This is level of CA and CL at which there are no idling cash balances or unused inventory

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