Study Notes for Working Capital Management

Working Capital Management

Working Capital Management refers to the set of corporate finance activities that deal with the short-term financing requirements of a business.

The key goal of working capital management is to ensure that the company has sufficient funds to carry out its day-to-day operations and meet its short-term debt obligations. Working capital management also ensures that the company's funds are invested in the most effective way.

The working capital represents the operating liquidity available to the business and net working capital is calculated as the firm's current assets minus the current liabilities.

Working capital is an important aspect of running a business because a firm may be rich in assets and may be very profitable, but it still may not have enough liquidity to meet its day-to-day expenses.

A firm needs to manage its working capital effectively by balancing various aspects of short-term finance such as maintaining optimal levels of cash, managing inventory and accounts receivables, and controlling accounts payables and other expenses. To enable this, a company's management will use a combination of policies and techniques. The company will have policies for management of cash, inventory, credit policies for management of debtors, etc. The company will also identify and use short-term sources of finance suitable for them.

The working capital needs of a company may also change from time to time and are affected by many internal and external factors. Internal factors include, the size of the company, growth rate, the structure of the organization, and how effective the company is in managing working capital. External factors include interest rates, current economic conditions, use of technology, competition, and so on.

In the following articles, we will look at the various aspects of working capital management and how to effectively manage the working capital of a business.

What is Working Capital Management?

The liquidity of a firm refers to its ability to meet short-term obligations using firm's assets can be quickly converted to cash. Cash is the most liquid form of asset a firm has. Different assets offer different levels of liquidity. For example a firms inventory is considered a liquid asset but may not be as liquid as other assets such as short-term money market securities that can be converted into cash very quickly.

Liquidity management is the ability of the firm to generate enough cash required to meet the firm's needs.

Some firms operate in industries or conditions where they always have excess cash and liquidity is not a concern. Instead, there the focus is on how to use this excess cash to maximize the shareholders' returns.

In other firms, because of the nature of the industry or the firms financial condition, there may be tight liquidity conditions. In such firms, it's important to effectively manage liquidity to avoid problems.

The various sources of liquidity for a firm can be classified as primary and secondary sources. Let's take a look at these sources of liquidity:
<h2>Primary Sources of Liquidity</h2>
The primary sources of liquidity include the sources that a firm uses for its regular daily operations. This includes:

<ul>
	<li>Cash</li>
<ul>
	<li>Cash received from sales</li>
	<li>Collection of receivables</li>
	<li>Short-term investment, and others</li>
</ul>
<li>Short-term Funding</li>
<ul>
	<li>Trade credit from suppliers</li>
	<li>Working capital loans from banks</li>
</ul>
	<li>Cash flow management</li>
<ul>
	<li>The firm can also generate working capital by effectively managing its cash.</li>
</ul>
</ul>

<h2>Secondary Sources of Liquidity</h2>
These are the sources of liquidity that are not normally a part of the regular operations. However, in times of need, the firm may use these sources. These include:

<ul>
	<li>Renegotiating existing debt contracts</li>
	<li>Liquidating short-term and/or long-term assets</li>
	<li>Filing for bankruptcy</li>
</ul>

Utilizing the secondary sources of funding can impact the company's financial structure and may even affect its operations. This also indicates that the firm's financial condition is deteriorating.
<h2>Factors affecting a firm's liquidity position</h2>
A firm's liquidity position is affected by how the cash inflow or cash outflow is affected.

<strong>Drags on Liquidity</strong>

When the cash inflow is reduced or delayed, it's referred to as drag on liquidity.

<strong>Examples:</strong>

<ol>
	<li>Bad debt</li>
	<li>Obsolete inventory</li>
	<li>Tight credit: Less or expensive trade credit</li>
</ol>

<strong>Pulls on Liquidity</strong>

When the cash out flow increases, it's referred to as pull on liquidity.

<strong>Examples:</strong>

<ol>
	<li>Making payments fast to suppliers, employees, etc.</li>
	<li>Reduced credit limits by suppliers</li>
	<li>Limits on short-term line soy credit</li>
	<li>Poor liquidity conditions</li>
</ol>

A firm should identify these pulls and drags on liquidity quickly in order to improve the liquidity position of the firm.

Sources of Liquidity and Factors Affecting Firm's Liquidity

Different companies operate under different liquidity conditions due to the factors affecting them or due to the nature of the industry they operate in.

An analyst will use various liquidity and other ratios to determine the firm's liquidity position and to compare it with its peers or industry standards.

The important ratios are:

Click the links below to learn more about these ratios
<ul>
	<li><a href="https://financetrain.com/liquidity-ratios-current-ratio-quick-ratio-and-others/">Current ratio, quick ratio and cash ratios</a></li>
	<li><a href="https://financetrain.com/receivables-turnover-and-days-of-sales-outstanding-dso/">Receivables Turnover and Days of Sales Outstanding (DSO)</a></li>
	<li><a href="https://financetrain.com/payables-turnover-and-number-of-days-of-payables/">Payables Turnover and Number of Days of Payables</a></li>
	<li><a href="https://financetrain.com/inventory-turnover-and-days-of-inventory-on-hand-doh/">Inventory Turnover and Days of Inventory on Hand (DOH)</a> -</li>
</ul>
<h2>Evaluating Working Capital Effectiveness</h2>
The analyst can also evaluate the effectiveness of the firm's working capital. There are two tools to do so.

<strong>1. Operating Cycle:</strong>

Operating Cycle refers to the number of days it takes to convert raw material into cash. It is calculated as the sum of days of inventory and days or receivables.

<strong>2. Cash Conversion cycle:</strong>

Cash conversion cycle refers to the number of days it takes to convert the cash invested in business back to cash.

Cash Conversion Cycle = Average days of receivables + Average days of inventory - Average days of payables.

A high cash conversion cycle is undesirable.

Learn more about <a href="https://financetrain.com/cash-conversion-cycle-ccc/">Cash Conversion Cycle</a>.

Comparing a Firm’s Liquidity Position with its Peers

One of the most important activities in a business is to manage its day to day cash position. The goal is to ensure that the net cash position is not negative and at the same time there is not too much excess idle cash.

Ideally, a business would want its cash inflows and outflows to be equal but that is hardly the case. Since, it's difficult to match daily cash inflows and outflows, the companies have to take additional steps to match their cash position.

The companies generally want to avoid negative cash balances because the cost of borrowing funds for daily needs immediately is very expensive. Compared to this, having some additional funds invested in short-term investments is still an acceptable cost. Even while borrowing, the firms will generally borrow a little more than the immediate requirements to be safe, and invest the excess funds in short-term instruments.

The treasurer, who is responsible for managing company's cash, will depend on information from various sources and make decisions based on this information.

Based on regular patterns of how the company collects from its customers, how it pays to its vendors, and many other factors, a company can establish an effective cash flow system. This will involve identifying typical cash flows, the minimum cash requirements, buffer, cash flow forecast, monitoring the usage of capital, short-term investment options, and so on.

The cash flow management system will also be able to help the business in these aspects:

1. Cash flow forecasting

2. Managing the cash flows

3. Maintaining optimal levels of cash

4. Decisions to borrow/invest based on the needs

The short-term investment options include: Treasury bills, short-term agency securities, certificates of deposit, banker's acceptances, time deposits, repos, commercial paper, money-market mutual funds, tax-advantaged securities, etc.

Short-term borrowing options include borrowing from banks, issuing commercial paper, etc.

Managing the Cash Position of a Firm

A key element of working capital optimization is the short-term investment strategies treasurers undertake. They are a vital tool of risk management, but are somewhat more limited in their type and maturity than long term strategies.

Liquidity and security are the twin objectives managers look for in short term investments.

Short- term strategies fall into two broad categories, passive and active. A passive strategy involves having some basic ground rules that dictate how daily investments are done. An active strategy, on the other hand, sees the manager closely monitoring and managing the investments. The active strategy could use matching, mismatching and laddering.

The primary focus of passive strategies is definitely security and liquidity. However this is strategy sometimes becomes the complacent strategy, wherein initial investments on maturing are simply rolled over to the next period without checking for other alternative investments. A passive strategy that measures investment yields on maturity with say a T-bill can mean good returns.

An active strategy as the name suggests requires a more hands-on or involved approach. In this strategy managers scout for more investment products, monitor their yield on maturity and then decide to roll over to the next period. An active strategy is indicative of a company that is more flexible in their investment approach.

Both the approaches are based on cash outflow forecasts. In the active format, the maturity of the investments can either match or mismatch the cash outflows.

A matching strategy could use T-bills as an investment type. It is more conservative and allows for the instrument to be encashed should market conditions turn adverse. The mismatching strategy is more likely to use investment tools like derivatives, which can prove dangerous if the company has little or no experience in dealing with them.

A more balanced strategy is the ladder strategy, which has characteristics of a passive strategy and a matching strategy. In this strategy the maturity of the investments are scheduled at systematic intervals just as in a ladde

In the light of the recent sub-prime mortgage crisis, which led to a short-term liquidity crisis, it is important which type of short-term investment strategy a company decides to implement. The short-term investment strategy depends on the risk policy of the company. Everyone seeks high returns on their investments, which can sometimes be detrimental. It is important to assess the risk appetite of the company and align it with its investment strategy. Clear written down guidelines can help implement the short-term investment policy.

Short Term Investment Strategies

Based on their short-term investment policy, the treasurer can effectively manage the short-term funds, including short-term investments, borrowings, etc.

There are sophisticated treasury management software available to do this. A treasury manager based on his needs, size of the funds, and complexity in the portfolio may decide to use a treasury software or simply do so using a spreadsheet software such as excel. For most small operations, excel sheets suffice. These spreadsheets can then be used for effective evaluation of the funds management in terms of effective yields on the investments, and the costs of borrowing.

There are a few things that must be kept in mind while maintaining this data, and generating performance reports.
<ol>
	<li>Record both the short-term investments and the borrowings</li>
	<li>Express the returns on investments as bond equivalent yields so that yields from different instruments can be compared.</li>
	<li>Calculate weighted average returns from the entire portfolio using investment amounts as the weights.</li>
	<li>Follow a consistent format</li>
</ol>
The following table shows a sample short-term funds performance report:
<table class="mytable">
<tbody>
<tr>
<th scope="colspan">Security</th>
<th scope="colspan">Dealer/Bank</th>
<th scope="colspan">Amount ($ ‘000)</th>
<th scope="colspan">Weight</th>
<th scope="colspan">Yield</th>
<th scope="colspan">Maturity</th>
</tr>
<tr>
<td>T-bills</td>
<td>XYZ Bank</td>
<td>50,000</td>
<td>50%</td>
<td>4%</td>
<td>90 days</td>
</tr>
<tr>
<td>Commercial Paper</td>
<td>Alpha Co.</td>
<td>25,000</td>
<td>25%</td>
<td>5%</td>
<td>45 days</td>
</tr>
<tr>
<td>Certificate of Deposit</td>
<td>Li Bank</td>
<td>25,000</td>
<td>25%</td>
<td>5.5%</td>
<td>30 days</td>
</tr>
</tbody>
</table>
Weighted average yield: 4.625%

Benchmark yield: 4.5%

The treasurer will have a benchmark against which he will compare his fund’s performance. In this example, the fund has performed better than the benchmark.

Evaluating the Management of Short-term Funds

In any business it is a usual practice to provide credit to your customers. Granting credit helps the business in increasing sales but at the same time also increases the risk of uncollectible accounts.

The company needs to actively manage and monitor the accounts receivables and evaluate how well the company is managing its receivables. The regular monitoring involves keeping a continuous tab on the outstanding receivables balances, and reporting any deviation from the normal practice. The two important performance measurement reports are Accounts Receivable Aging Schedule and Day's Sales outstanding.

<strong>1. Days of Sales Outstanding (DSO)</strong>

Also known as the Average Collection Period, DSO is calculated by dividing Average Accounts Receivables by Average daily sales.

The <a title="Receivables Turnover and Days of Sales Outstanding (DSO)" href="https://financetrain.com/receivables-turnover-and-days-of-sales-outstanding-dso/">Days of Sales Outstanding</a> tells us on an average how much time it takes to collect the receivables (Time lag). Following analysis can be made from the calculated ACP. Below are a few important points about DSO.
<ul>
	<li>Indicates how quickly the receivables are collected.</li>
	<li>A lower DSO indicates that the company is taking lesser time to collect its receivables.</li>
	<li>A high DSO implies poor credit/collect policy.</li>
</ul>
<strong>Example</strong>

A firm provides 30 days credit period as per their credit policy. Their DSO for the first three quarters is 60 days, 50 days, and 45 days.

From this data we can say that the company has not been able to collect money as per its credit policy (30 days credit) in all three months. However, the trend of the three months shows that the efforts in collecting funds are improving as the Daily Sales Outstanding are coming down.

This method suffers from two limitations. One is that it aggregates all accounts receivable ignoring individual accounts collection. And the other is, sales keep varying that will not give the accurate picture though based on the average.

<strong>2. Accounts Receivables Aging Schedule</strong>

This is one of the key reports used by the accounts receivables managers. The report provides a breakdown of the accounts receivables based on the days outstanding. This breakdown helps the firm in organizing its collection efforts. For example, the accounts that are outstanding for a longer period will need to be collected on priority. The standard breakdown for accounts receivables is ‘&lt;30 days due’, ’31-60 days due’, 61-90 days due’ days, ‘above 90 days due’.

This data can also be compared with the company’s past performance or its competitors to notice the key trends. Generally, a huge percentage of accounts receivables in a higher bracket indicate poor management of receivables and a weak credit policy.

Evaluating Management of Accounts Receivables

Management of inventory is another important aspect of a business. The goal here is to maintain an optimal level of inventory. If the inventory levels are too low, it can lead to a loss of sales because of stock-outs. At the same time, if there is too much inventory, it indicates that the firm's excess capital is tied up in inventory, which could have otherwise been used to invest in short-term securities, or to clear debt.

To evaluate inventory management, the manager can observe the average days of inventory, or inventory turnover ratio. If the average days of inventory is increasing (turnover ratio decreasing), this indicates a very large inventory and the manager should take steps to bring it down to a reasonable level.

The <a title="Inventory Turnover and Days of Inventory on Hand (DOH)" href="https://financetrain.com/inventory-turnover-and-days-of-inventory-on-hand-doh/">average days of inventory and inventory turnover</a> can also be compared to peers in the industry and with the company's past performance to see the trends. Comparing these ratios with companies in other industries can provide false signals, as each industry will have a different benchmark. For example, retail stores will have a high turnover ratio compared to automobile show rooms.

Companies also employ innovative techniques and technology to bring their levels of inventory down. One such approach is the economic-order quantity-reorder point, under which the company forecasts demand. These forecasts help the company determine the levels at which the new inventory is ordered. Another method is the just-in-time method, which is based on the philosophy of producing and delivering finished goods just in time for selling.

The key to effectively managing inventory levels is to strike a balance between the risks and returns from overinvestment and underinvestment in inventory.

Management of Inventory

Accounts payable are the amounts that are due to the suppliers of goods and services to the business. For example, a furniture chain buys its raw material from various suppliers on credit. Accounts payable arise from trade credit, which is an important portion of working capital.  It works in favor of both the buyer and the supplier. The buyer is able to get short-term financing from the seller itself. The seller, by offering credit for purchase, is able to push its product and build relationship with the buyer.

When an item is purchased on credit, the seller will usually specify a period within which the payment should be made. The seller may also provide a discount if the buyer is willing to make an early payment.  The terms of the trade credit will specify these details. For example, the terms “2/10, net 60” indicate that the buyer will get a 2% discount if he makes the payment within 10 days of purchase. If the buyer doesn’t want to make use of the discount period, then the payment will be due within 60 days. These credit terms differ across industries and also depend on competition, economic conditions, prevailing interest rates, etc.

Just like <a title="Management of Inventory" href="https://financetrain.com/management-of-inventory/">inventory</a> and <a title="Evaluating Management of Accounts Receivables" href="https://financetrain.com/evaluating-management-of-accounts-receivables/">accounts receivables</a>, it is important for a firm to manage its accounts payable effectively. If the accounts payable are paid too early, then it is unnecessarily using its cash, which could have been utilized elsewhere (opportunity cost). However, if it delays too much in making payments beyond payment due date, it may spoil its relationship with the suppliers, which will lead to stricter credit terms in the future. Some suppliers may also charge interest if payments are made beyond due dates.

In order to ensure that the company manages its accounts payables effectively, it needs to have a formal guideline or policy in place. Such a policy will address several factors that will help them streamline the processes and bring transparency to the whole system. Some of the factors are listed below:
<ol>
	<li>Whether payables are handled from a centralized location or decentralized.</li>
	<li>Details of the supply chain such as the number, size and location of vendors. For example, a company may restrict buying from vendors that are below a certain size, or it may want to buy only from local vendors.</li>
	<li>Details of the trade credit, and the alternative costs of borrowing.</li>
	<li>Details of inventory management system as they affect how fast payables can be processed.</li>
	<li>Adoption of commerce and electronic payments for improved efficiency.</li>
</ol>
An important tool used by companies to measure the effectiveness of payables management is the <a title="Payables Turnover and Number of Days of Payables" href="https://financetrain.com/payables-turnover-and-number-of-days-of-payables/">average days of payables outstanding</a>. A short payables period indicates that the company is paying faster. It could be because the company is taking advantage of discounts available for paying early. A long payables period indicates that either the company is a dominant player and can afford to pay late and take advantage of the extra credit period, or it indicates poor payables management or liquidity problems within the company.

Management of Accounts Payable

Trade credit is an important source of liquidity and financing for any company. The company needs to <a href="https://financetrain.com/management-of-accounts-payable/" title="Management of Accounts Payable">manage its accounts payables</a> effectively and take advantage of the credit period to minimize its cost of funds.

An important decision here is whether it is beneficial for the company to pay within the discount period or pay only by the end of the payment due period.

A company can evaluate trade discounts using the following formula:
<div class="formula1">
[latex background="F0F0F0" size="1.5"]Cost\ of\ Trade\ Credit = (1+\frac{Discount}{1-Discount})^{\frac{365}{Days\ after\ discount\ period}}-1[/latex]
</div>
During the discount period, the cost of funds is 0, so the company can benefit by paying at the end of the discount period. After the discount period the cost of credit increases for the buyer and then starts decreasing till the final due date reaches.

Let's take an example to understand this.

Assume that the trade credit terms are 2/10, net 60. This means that the customer will get a discount of 2% if paid within 10 days, and if discount is not availed the amount is due in 60 days.

If the company pays on 30th day and on 50th day, the cost of trade credit will be:

Cost of trade credit (payment on day 30) = (1+0.02/0.98)^(365/20) - 1 = 44.58%

Cost of trade credit (payment on day 50) = (1+0.02/0.98)^(365/40) - 1 = 20.24%

As you can see, after the discount period is over, the cost of trade credit comes down as the net day approaches, and it will be the lowest on the net day.

The company can compare its cost of funds or short-term investment rate with the cost of trade credit to make a decision about availing the discount. If the cost of funds or short-term investment rate is lower that the cost of trade credit, the company will benefit by paying its bills within the discount period.

Calculating the Cost of Trade Credit

A company has access to many short-term sources of funding. These include funding from both bank and non-bank sources.
<h2>Short-term Funding from Banks</h2>
A company can avail short-term funding from banks in the following forms:

<strong>Lines of Credit</strong>

This is the most common form of funding for working capital needs. In this case a bank extends a line of credit to a company for its working capital requirements. The bank specifies the maximum loan that the company can avail at any time. Based on its needs the company will draw funds from this line of credit upto the maximum limit allowed. The advantage with a line of credit is that the company pays interest only for the funds borrowed and for the period for which the funds are borrowed.

A line of credit can take many forms:
<ul>
	<li>In an uncommitted line of credit, the bank extends the line of credit but may refuse to lend when the circumstances change. This makes uncommitted lines of credit very unreliable.</li>
	<li>Committed lines of credit are the regular lines of credit in which the bank is committed to fulfill any fund requirements for the company. The commitment is usually for a specified period of time, usually, 364 days, which makes it a short-term funding. Committed line of credit are usually unsecured.</li>
	<li>Revolving lines of credit are similar to regular lines of credit, with the difference that they are usually effective for multiple years, and are generally for much larger amounts compared to regular lines. Revolving lines of credit are considered to be the strongest form of short-term bank borrowing.</li>
</ul>
<strong>Secured Loans</strong>

It is not possible for all companies to be able to get a line of credit from a bank. In such a case, a company may borrow from the bank in the form of a secured loan. In a secured loan, the company will keep its assets as the collateral. For short-term secured loans, the assets kept as collateral are usually its current assets such as accounts receivables and inventory.

The banks funds are secured by the collateral and may also have a blanket lien on the current and future assets of the company.

<strong>Banker’s Acceptance</strong>

A <a title="Introduction to Bankers’ Acceptance" href="https://financetrain.com/introduction-to-bankers-acceptance/">banker’s acceptance</a> is a bill of exchange drawn to finance trade (exports and imports) and accepted by a bank as good for payment. Its a guarantee from the bank of the buying firm that the payment will be made once the goods are received. The exporter can even sell this banker's acceptance at a discount to receive immediate funds.

<strong>Factoring</strong>

Factoring is another form of short-term financing from banks. In this arrangement, the company will sell its receivables to the bank at a discount and receive immediate funds. Here the factor is the buyer of receivables, usually the bank. The factor will be responsible for collection of bills and will also bear the risk of nonpayment. The amount of discount in factoring will depend on factors such as the credit period extended, the creditworthiness of the buyer, collection history and so on.
<h2>Short-term Funding from Non-banks Sources</h2>
Companies may also use funding from non-bank sources. For example, large companies may issue <a title="Introduction to Commercial Paper (CP)" href="https://financetrain.com/introduction-to-commercial-paper-cp/">commercial paper</a>, which is a popular form of borrowing and also offers favorable interest rate compared to bank borrowing.

Many small companies with poor credit also resort to non-bank sources for their short-term funding needs. However, such funds are generally very expensive are used only when bank funding is not available.

Choices of Short-term Funding Available to a Company

This quiz is a part of the CFA Level 1 reading 'Working Capital Management'. 

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