Working Capital

Management

Introduction, Operating
Cycle, & Approaches to
managing WC
Key learning points

• Introduction to working capital management

• Approaches to working capital management
• Cash operating cycle
• Working capital financing
Introduction to Working Capital Management

What is working capital?

WC = Current Assets – Current Liabilities

(Also referred to as Net Current Assets)

Current Assets:
• Cash
• Bank
• Inventory
• Receivables

Current Liabilities:
• Payables
• Bank overdraft
Introduction to Working Capital Management

What is working capital?

WC = Current Assets – Current Liabilities

If a company had following balances on their SoFP: -

$000
Inventory = 40
Receivables = 30
Cash = 20
Payables = 35

WC =
The level of working capital

The level of working capital required is affected by the following factors:

• The nature of the business, e.g. manufacturing companies need more stock than
service companies

• Uncertainty in supplier deliveries - uncertainty would mean that extra stocks need to
be carried in order to cover fluctuations

• The overall level of activity of the business - as output increases, debtors, stock,
etc. all tend to increase

• The company’s credit policy - the stricter the company’s policy the lower the level of
debtors

• The length of the operating cycle - the longer it takes to convert material into
finished goods into cash the greater the investment in working capital
Working Capital Management

What is Working Capital Management?

This is simply the process of managing the individual elements of working capital
and working capital as a whole.

For example:

• A decision by managers to operate a just-in-time policy for inventory management

• This may reduce the average level of inventory within the business

• Therefore reducing the overall level of working capital required

Profitability and Liquidity – A trade-off

When deciding how much working capital is required the two key factors that must be
considered are the impacts upon profitability and liquidity:-

• Lower levels of WC = Improved profitability and vice versa

• For example lower levels of inventory release cash for investment elsewhere in the
business!!!...

This leads onto the notion of different approaches to the management of working
capital:-

• Aggressive – minimum levels of cash; inventory and receivables

• Conservative – high levels of cash; inventory and receivables

• Moderate – this is balanced approach to the levels of cash; inventory and

receivables that are held
Profitability and Liquidity – A trade-off

 Aggressive: –

• Hold lower levels of inventory

• Lower levels of receivables
• Lower cash levels
• Higher levels of payables

Advantages:

• Cash is made available to use elsewhere in the business i.e. for investment
• Using payables is a cheap (free) source of finance
• Warehousing costs are reduced
• Potentially improved profitability

Disadvantages:

• Risk of stock-outs
• Aggressively chasing debts could annoy customers
• Lack of cash means a lack of liquidity
• Not paying suppliers may damage the relationship
Profitability and Liquidity – A trade-off

 Conservative: -

• Hold higher levels of inventory

• Higher levels of receivables
• Higher cash levels
• Lower levels of payables

Advantages:

• Always have a good level of liquidity

• Reduced risk of stock-outs
• Good relationships with customers and suppliers

Disadvantages:

• Cash is tied-up on the balance sheet and not used for investment
• Increased warehousing costs of holding stock
• Customers take advantage of a liberal credit policy
• Potential reduction in profitability
 Cash Operating Cycle (working capital ratios)

The operating cycle is a way to analyse how efficiently WC is being managed.

We can calculate the cash operating cycle and it can be expressed in days, weeks or
months, but most commonly in days.

Operating cycle for a retail or wholesale company: -

Inventory days = Inventory / Cost of sales x 365 X

Receivables days = Receivables / Credit sales x 365 X

less Payables days = Payables / Credit purchases* x 365 (X)

Operating cycle = X

*if purchases is not available then use cost of sales

 Cash Operating Cycle (working capital ratios)

Operating cycle for a manufacturing company: -

RM days = RM Inventory / Credit purchases* x 365 X

WIP days = WIP Inventory / Cost of sales x 365 X

FG days = FG Inventory / Cost of sales x 365 X

Receivables days = Receivables / Credit sales x 365 X

less Payables days = Payables / Credit purchases* x 365 (X)

Operating cycle = X

*if purchases is not available then use cost of sales

Liquidity ratios

Current ratio = CA / CL

Quick ratio = (CA – Inventory) / CL

Example - Bold Co.
Example - Bold Co.

Required:

Calculate the following for Bold Co.

 Cash operating cycle
 Net working capital requirement
 Liquidity ratios
 Sales to net working capital ratio
Bold Co – exam style question

 Part (b) – calculate cash operating cycle

 Inventory days

• (Inventory / Cost of sales) x 365

 Receivables days

• (Receivables / Sales) x 365

 Payables days

• (Payables / Cost of sales) x 365

Cash operating cycle =

Bold Co – exam style question

 Level of working capital

• CA – CL

 Liquidity ratios

• Current ratio = CA / CL

• Quick or acid test ratio = (CA – Inventory) / CL

 Sales to net working capital

Financing of Working Capital

When deciding on the level of WC a business needs to consider how it is going to finance
the WC requirement.

WC is comprised of inventory, receivables and payables. Bank overdrafts or loans (short

and medium) are considered to be ways of financing working capital.

Different types of net current asset:

i. Permanent net current assets

ii. Fluctuating net current assets

Financing of Working Capital

Different types of net current asset:

i. Permanent net current assets

• This is the minimum level of NCA that a business is likely to hold

• The level of NCA is not likely to fall below this point
• For example:
 certain base levels of inventory are always carried
 cash balances never fall below a certain level
 a certain level of ready credit is always extended

ii. Fluctuating net current assets

• Businesses will often have a level of WC that fluctuates between a minimum (the
permanent NCA) and maximum levels
• For example when you are building inventory towards Christmas
• Post Christmas inventory levels fall back to a lower level
• This is the fluctuating element of net current assets
How should working capital be financed?

The choice is between using long-term finance (loans, debt, equity) and short-term
financing (loans, bank overdraft).

The following factors need to be considered:

Finance costs:

• The costs of long-term financing is greater than short-term financing

Flexibility:

• Short-term financing offers greater flexibility the long-term finance

• An overdraft does not necessarily need to be arranged in advance and can be repaid
without penalty

Risk:

• Sort-term financing is more risky than long-term financing

• An overdraft can be repayable on demand causing liquidity problems for the company
 Financing of Working Capital

Moderate (Matching) Financing Policy

Fluctuating
net current Short-term
assets financing

Permanent
net current Long-term
assets financing

Time

Permanent current assets are financed through This policy is a

long-term sources and fluctuating current balance between risk
assets through short-term finance. and reward.
 Financing of Working Capital

Aggressive Financing Policy

Fluctuating
net current
assets
Short-term
financing

Permanent
net current
assets Long-term
financing

Time
Short-term financing is used to finance a proportion This policy can result in
of the permanent net current assets as well as the lower financing costs but
fluctuating net current assets. carries greater risk.
 Financing of Working Capital

Aggressive Financing Policy

Short-term
Fluctuating financing
net current
assets

Long-term
Permanent financing
net current
assets

Time
Long-term financing is used to finance a proportion
of the fluctuating net current assets as well as the
permanent net current assets.
This policy is very safe in terms of
avoiding liquidity problems but is a
more expensive way of financing
working capital.
Key learning points

• Introduction to working capital management

• Approaches to working capital management
• Cash operating cycle
• Working capital financing
 Working Capital
Management

Introduction, Operating
Cycle, & Approaches to
managing WC