Working capital management

On Sep 7, 2024

Working capital management is a process of balancing different goals by management. On one hand, every company must be certain that they have enough cash to be able to pay their liabilities as they come due to avoid technical insolvency which could lead to bankruptcy proceedings. On the other hand, the short-term assets (cash, inventory, receivables) that the company holds provide very little, if any, return. Therefore, the more short-term assets held by the company, the lower the chance of insolvency, but the lower the return that is earned on company assets.

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Working Capital Liquidity

10 questions in 10 minutes

Pass Score 70%

1 / 10

A company increasing its credit terms for customers from 1/10, net 30 to 1/10, net 60 will most likely experience :

an increase in the average collection period

a lower level of uncollectible accounts

an increase in cash on hand

2 / 10

Selected liquidity ratios for three firms in the leisure products industry are given in the table below. The most recent fiscal year ratio is shown along with the average of the previous five years.

Company S		Company J		Company H
Five-year average	Most recent	Five-year average	Most recent	Five-year average	Most recent
2.53	3.05	3.04	3.67	2.51	5.37	Current ratio
1.44	1.78	2.01	2.6	2.19	5.01	Quick ratio
0.67	0.96	1.28	1.96	0.97	3.66	Cash ratio

Relative to its peers and relative to its own prior performance, which company is in the most liquid position ?

Company H

Company S

Company J

3 / 10

An analyst is examining the cash conversion cycles and their components for three companies that she covers in the leisure products industry. She believes that changes in the investments in these working capital accounts can reveal liquidity stresses on a company.

2016	2017	2018	2019	2020	2021
						Company H
59.8	59.8	57.8	60	70.5	68.4	Days of inventory on hand
93.3	94.7	92.4	95.6	103.4	101.8	+ Days of receivables
35.9	36.8	41.9	48	54.6	52.1	– Days of payables outstanding
117.2	117.7	108.3	107.6	119.3	118.1	= Cash conversion cycle
						Company J
101.4	103.2	105.2	96.3	101.4	105.6	Days of inventory on hand
38	37.8	36.3	32.9	29.4	27.7	+ Days of receivables
40.2	37.8	39.3	35.3	38.5	36.6	– Days of payables outstanding
99.2	103.2	102.2	93.9	92.3	96.7	= Cash conversion cycle
						Company S
81.7	63.4	69.2	118.9	131	135.8	Days of inventory on hand
38.3	29.1	36.2	54.2	42.5	49.1	+ Days of receivables
35.9	31.8	29.8	34.6	27.9	30.9	– Days of payables outstanding
84.1	60.7	75.6	138.5	145.6	154.0	= Cash conversion cycle

Which company’s operating cycle appears to have caused the most liquidity stress ?

Company J’s

Company S’s

Company H’s

4 / 10

Which of the following are considered internal sources of financing for a company’s working capital management ?

Committed and uncommitted lines of credit

Accounts payable and accruals

Accounts receivable and inventory

5 / 10

Which is most likely considered a secondary source of liquidity ?

Centralized cash management system

Trade credit

Liquidating long-term assets

6 / 10

XY1 Corporation’s CFO has decided to pursue a moderate approach to funding the firm’s working capital. Which of the following methods would best fit that particular approach ?

Finance permanent and variable current assets with long-term financing

Finance permanent and variable current assets with short-term financing

Finance permanent current assets with long-term financing and variable current assets with short-term financing

7 / 10

Data for a firm are presented in the following table :

thousands	As of 31 December
200	Cash
350	Accounts receivable
1,250	Inventory
300	Accounts payable
200	Taxes payable
600	Installment loan payable, due in three equal annual payments on 30 June

The current ratio for the firm’s industry is 3.2. Based on the current ratio, the firm’s liquidity compared with the industry is best described as being :

equivalent

higher

lower

8 / 10

Kwam Solutions must raise €120 million. Kwam has two primary sources of liquidity: €60 million of marketable securities (which can be sold with minimal liquidation/brokerage costs) and €30 million of bonds (which can be sold with 3% liquidation costs). Kwam can sell some or all of either of these portfolios. Kwam has a secondary source of liquidity, which would be to sell a large piece of real estate valued at €70 million (which would incur 10% liquidation costs). If Kwam sells the real estate, it must be sold entirely. (A fractional sale is not possible.) What is the lowest cost strategy for raising the needed €120 million ?

Sell €60 million of the marketable securities, €30 million of the bonds, and €34.3 million of the real estate property

Sell the real estate property and €57 million of the marketable securities

Sell the real estate property and €50 million of the marketable securities

9 / 10

The SOA Company needs to raise 75 million, in local currency, for substantial new investments next year. Specific details, all in local currency, are as follows :

Investments of 10 million in receivables and 15 million in inventory will be made. Fixed capital investments of 50 million, including 10 million to replace depreciated equipment and 40 million of net new investments, will also be made .
Net income is expected to be 30 million, and dividend payments will be 12 million. Depreciation charges will be 10 million .
Short-term financing from accounts payable of 6 million is expected. The firm will use receivables as collateral for an 8 million loan. The firm will also issue a 14 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.

What additional financing does SOA require ?

SOA will need to issue 19 million of bonds

SOA will need to issue 26 million of bonds

SOA can repurchase 2 million of common shares

10 / 10

Paloma Villarreal has received three suggestions from her staff about how to address her firm’s liquidity problems.

Suggestion 1 ⇒ Reduce the firm’s inventory turnover rate.

Suggestion 2 ⇒ Reduce the average collection period on accounts receivable.

Suggestion 3 ⇒ Accelerate the payments on accounts payable by paying invoices before their due dates.

Which suggestion should Villarreal employ to improve the firm’s liquidity position?

Suggestion 3

Suggestion 2

Suggestion 1

Your score is

Notes :

Working capital and net working capital are two terms that mean exactly the same thing.
Net Working Capital = Current Assets – Current Liabilities
Short-term investments usually in trading securities (marketable securities)
Current assets (C.A) and Current Liabilities (C.L) are classified based on operating cycle or one year whichever is longer .
Working capital is one of the measures of a company’s short-term solvency, which is its ability to pay liabilities as they become due.
Working capital finance concerns the optimal level, mix and use of current assets and current liabilities.

Levels of Working Capital

1- A Company that adopts a conservative working capital policy seeks to minimize liquidity risk by increasing the amount of working capital that it holds. The result is that the company gives up the potentially higher returns available from using the additional working capital to acquire long-term assets, but is in a safer position with respect to liquidity and possible insolvency because of the greater amount of working capital.

2- An aggressive working capital policy reduces the amount of working capital and the current ratio and accepts a higher risk of short-term cash flow problems in exchange for a greater return on investment. A company with an aggressive policy will have a very low (or possibly even negative) level of working capital, but will also have a higher amount of return on its assets.

3- Neutral working capital policy balances the liquidity risk and return considerations.

Types of Working Capital

Because a company may have different cash needs throughout the year, it is possible that it will maintain different levels of working capital at different times of the year. The minimum amount of working capital that is maintained at all times is called permanent working capital, and the increases that occur from time to time are called temporary working capital.

Effective working capital management

Operating cycle = Inventory conversion period + Receivable collection period.

Cash conversion cycle (cash flow cycle) = Inventory conversion period + Receivable collection period – Payables deferral period.

Effective working capital management involves shortening the cash conversion cycle as much as possible without harming operations. This strategy improves profitability because the longer the cash conversion cycle, the greater the need for financing thus financing charges increases which lead to a decreased profitability.

Philosophy of Working Capital management

The cash conversion cycle can be shortened by :

Reducing the inventory conversion period.
Reducing the receivables conversion period.
Lengthening the payables deferral period.

When a company is able to shorten the cash conversion cycle, profits may improve as financing costs are reduced. However, these savings must be compared with costs related to shortening the cash conversion cycle.

Examples of costs related to shortening the cash conversion cycle include:

Sales lost due to strict credit and collection standards.
Costs of having to stop production due to materials stockout (resulted from decrease in the inventory levels).
Costs of stretching payables beyond the due date, such as lost discount opportunities or late charges.
Higher prices charged by vendors and suppliers to slow or delinquent payers.
Lost sales from not selling to slow-paying customers for fear of non- payment.
The benefits of lower cash financing cost strategies should be compared with the increased costs and lost sales that may result from shortening the cash conversion cycle if benefits exceed costs of the strategies, including foregoing the profit from lost sales the strategies should be implemented.

Conclusion: In analyzing working capital strategies, it is important to determine how all decisions regarding inventory, receivables payables impact the cash conversion cycle.

Amount (local, millions)	Source
6	Accounts payable
8	Bank loan against receivables
14	Short-term note
28	Net income + depreciation – dividends
56	Total sources