Managing Working Capital

Learning Outcomes

• What is Working Capital?

• Why is it important for business operations?

• What is Liquidity?

• How do we measure Liquidity?

• Defining Operating Working Capital

• Case Study Companies

What is Working Capital?

Working capital management is the management of the short-term investment and financing of a company.

What is Working Capital?

Working Capital = Current Assets - Current Liabilities

Working Capital Formula

Why is Working Capital Important?

Working capital is the cash available for daily operations, to cover short term expenses and also any unplanned expenses.

Working Capital is important for young companies that cannot access capital on the financial markets.

Why is Working Capital Important?

Liquidity is the ability of the company to satisfy its short-term obligations using assets that are readily converted into cash.

Liquidity management is the ability of the company to generate cash when and where needed.

Sources of Liquidity

•Existing cash

•Short-term funds

•Converting customers invoices quickly into cash

•Sale of assets

Current Assets

Current Assets Definition

Cash & Cash Equivalents Cash, money market securities, short-term government bonds

Short-term investments Investments in stocks and bonds that will be redeemed within 12 months

Accounts Receivable Money owed to a business, usually in the form of invoices

Prepaid Expenses Future expenses that have been paid in advance. eg. insurance

Inventories Stock of goods for eventual sale

Question

Which of the follow is not a current asset?

A. Cash

B. Accounts Payable

C. Accounts Receivable

Question

Which of the follow is not a source of liquidity?

A. Sale of assets

B. Capital Expenditure

C. Converting customers’ invoices

Current Liabilities

Current Liabilities Definition

Short term loans Money owed to the bank within 12 months.

Accounts Payable Total amount owed to suppliers (creditors) for goods and services received but not paid

Accrued Income Taxes Income tax payable to the Government within 12 months

Accrued Liabilities Includes salaries, dividends payable. Typically booked on balance sheet before payment takes place

London Coffee Company

View of the Balance Sheet

Question

Which of the following is not a current liability:

A. Accrued Income Taxes

B. Prepaid Expenses

C. Short-term Loans

Current Liabilities

If accounts receivable is: money owed to a business, usually in the form of invoices

What are some strategies can we use to manage accounts receivable?

Question for you

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Accounts Receivable

• Strategies to manage accounts receivable:

- Effective processing and tracking of invoices

- Invoice clients sooner

- Establish credit policies

- Extend payment methods

- Review accounts receivable regularly and prepare performance measurement reports

Current Liabilities

If accounts payable is the: Total amount owed to suppliers (creditors) for goods and services received but not paid What are some strategies can we use to manage accounts payable?

Question for you

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Accounts Payables

• Effective strategies for accounts payable management include:

- Use technology to centralise the accounts payable process

- Negotiate vendor terms (30days, 90 days etc.)

- Trade credit and the cost of alternative forms of short-term financing

Inventories

Inventory (stock) is the goods that a business holds for the eventual purpose of selling.

Inventory management involves preserving a balanced level of inventory that meets market demand.

Why hold inventory? • For regular sales operations • Incase of excess demand / To guarantee stock

Current Liabilities

If inventories are the goods that a business holds for the eventual purpose of selling. What are some strategies can we use to manage inventories?

Question for you

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Inventory Management

What might be different ways to manage inventory?

•A system where actual orders indicate when a unit should be produced (‘demand-pull’) - Just in Time

•Determining the number of units produced with each order to minimise holding/order/storage costs - Economic order quantity

Measuring Liquidity: Ratios

By measuring liquidity, we can tell how easy it will be for the company to raise cash or convert assets into cash.

In the below formulas, we include current assets such as accounts payable, short term investments and receivables as they can be ‘liquidated’ converted into cash quickly.

Measuring Liquidity: Ratios

1. Current Ratio

2. Quick Ratio

3. Cash Ratio

4. Accounts Payable Days

5. Accounts Receivable Days

6. Inventory Days

7. Cash Conversion Cycle

Liquidity Ratios - Current Ratio

Current Ratio

Indicates if a company has sufficient resources to cover its short term obligations.

Current AssetsCurrent Liabilities

Current Ratio =

Liquidity Ratios - Current Ratio

Quick Ratio

Indicates if a company has sufficient resources to cover its short term obligations using its assets which are as near to cash.

Quick Ratio = Current Assets− Inventories

Current Liabilities

Liquidity Ratios - Current Ratio

Cash Ratio

A more specific measure of a company’s liquid assets relative to its short term obligations.

Cash Ratio = Cash& Cash Equivalents

Current Liabilities

Question

Current assets DIVIDED BY current liabilities is:

A. Quick Ratio

B. Cash Ratio

C. Current Ratio

Question

The quick ratio EXCLUDES which of the following?

A. Accounts receivable

B. Inventories

C. Cash

Liquidity Ratios - Inventory Days

Inventory days

Tells us how many days inventories eg. products stored in a factory take to be sold.

InventoriesCost of Goods Sold

x 365 days

Liquidity Ratios - Receivables Days

Accounts ReceivableTotal Sales

x 365 days

Receivables days

Calculates how many days it takes for debtors (someone who owes us money) eg. client invoices to pay us.

Liquidity Ratios - Payables Days

Accounts PayableCost of Goods Sold

x 365 days

Payables days

How many days we need to make payments to creditors.

Question

To improve our cash flow position, should we aim to:

1. Decrease Payables Days?

2. Decrease Receivables Days?

3. Increase Inventory Days?

Liquidity Ratios: Cash Conversion Cycle

Cash Conversion Cycle

How long does it take for these assets and liabilities to convert into cash overall?

Inventory Days + Receivables Days - Payables Days =

Cash Conversion Cycle

Case Study: Working Capital Reporting

Case Study: Working Capital Reporting

• Working capital is a measure of a company’s short term financial

health.

• The objective of working capital management is to ensure a smooth

operating cycle.

• Companies can use a number of operational strategies to improve

their working capital positions.

• Financial analysts measure liquidity by calculating ratios from a

company’s financial statements.

Recap