Working Capital and Liquidity

Profitable companies still fail when they run out of cash, and the day-to-day management of inventory, receivables, payables and short-term funding decides whether they do. This module shows how to measure the cash conversion cycle, assess a company's liquidity and its sources, compare working-capital strategies, and calculate the true cost of trade credit and other short-term financing.

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What you will learn

1. Calculate and interpret the cash conversion cycle and its components, and compare the cash conversion cycles of different issuers.

DIO = inventory / COGS x 365; DSO = receivables / revenue x 365; DPO = payables / COGS x 365.
Operating cycle = DIO + DSO; cash conversion cycle = DIO + DSO - DPO.
A shorter CCC means less financing is needed; a negative CCC means suppliers finance operations.
Cash released by cutting days = days saved x daily revenue (for DSO) or daily COGS (for DIO and DPO).
Compare CCCs within an industry and look at each component; too short a cycle can signal lost sales or strained suppliers.

2. Explain primary and secondary sources of liquidity and the drags and pulls on liquidity, and calculate and interpret the current, quick and cash ratios.

Primary sources: cash and marketable securities, operating cash flow, trade credit, bank lines.
Secondary sources (signal stress): cut dividends and capex, sell assets, issue equity, renegotiate debt, bankruptcy reorganization.
Drags slow inflows (bad receivables, obsolete inventory); pulls speed outflows (tighter supplier or bank terms).
Current ratio = CA / CL; quick ratio = (cash + marketable securities + receivables) / CL; cash ratio = (cash + marketable securities) / CL.
Too much liquidity has an opportunity cost; compare ratios with peers and over time.

3. Describe the objectives of working capital management, compare conservative, moderate and aggressive approaches to investing in and financing working capital, and explain how firms manage receivables, inventory and payables.

Goal: enough liquidity at the lowest total cost of capital tied up in current assets.
Conservative investment holds more current assets; aggressive holds less and risks stockouts and lost sales.
Conservative financing uses long-term funds for permanent and some variable needs; aggressive uses short-term funds, creating rollover risk.
Moderate (matching) approach: long-term funds for permanent needs, short-term funds for seasonal needs.
Manage receivables through credit policy, inventory through carrying vs stockout costs, payables through terms and discounts.

4. Compare short-term financing sources and calculate the effective annual cost of trade credit and of bank and commercial paper borrowing.

Cost of trade credit = (1 + d / (1 - d))^(365 / (N - D)) - 1, where d is the discount, D the discount period and N the net period.
Take the discount unless alternative financing costs more than the cost of forgoing it.
Committed lines carry commitment fees; uncommitted lines can be withdrawn; revolvers can be drawn and repaid repeatedly.
Effective cost of borrowing = (interest + all fees) / usable funds, annualized.
Commercial paper is cheap but needs backup lines because of rollover risk.

Module at a glance

CCC = DIO + DSO - DPO; DIO and DPO use COGS, DSO uses revenue.
A shorter or negative CCC means less financing is needed; growth with a negative CCC releases cash.
Primary liquidity: cash, operating cash flow, trade credit, bank lines; secondary: asset sales, dividend cuts, debt renegotiation, bankruptcy.
Current, quick and cash ratios get progressively stricter; the quick ratio excludes inventory and prepaids.
Aggressive working-capital financing is cheaper but carries rollover risk; conservative is safer but costlier.
Cost of forgoing a trade discount = (1 + d / (1 - d))^(365 / (N - D)) - 1, often 20-45% a year.
Effective borrowing cost includes every fee; commercial paper needs backup lines because markets can freeze.

This free module has 4 lessons, 15 practice questions with full explanations.

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