Corporate Finance II
Reading 35. Working Capital Management
Learning Outcome Statements
a. describe primary and secondary sources of liquidity and factors that influence a company's liquidity position;
b. compare a company's liquidity measures with those of peer companies;
c. evaluate working capital effectiveness of a company based on its operating and cash conversion cycles and compare the company's effectiveness with that of peer companies;
CFA Curriculum, 2020, Volume 4
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Subject 1. Managing and Measuring Liquidity
Liquidity management refers to the ability of a company to meet its short-term financial obligations. There are two sources of liquidity. The main difference between the two sources is whether or not the company's normal operations will be affected.
- Primary sources of liquidity include cash, short-term funds, and cash flow management. These resources represent funds that are readily accessible at relatively low cost.
- Secondary sources include negotiating debt contracts, liquidating assets, and filing for bankruptcy and reorganization. They provide liquidity at a higher price and may impact a company's financial and operating positions.
Almost all liquidity measures are covered in Reading 24 [Understanding Balance Sheet] and Reading 26 [Financial Analysis Techniques].
Operating cycle = Number of days in inventory + Number of days of receivables
Net operating cycle (cash conversion cycle) = Number of days in inventory + Number of days of receivables - Number of days of payables
Average accounts receivable: $25,400
Average inventory: $48,290
Average accounts payable: $37,510
Credit sales: $325,700
Cost of goods sold: $180,440.
Total purchases: $188,920
How many days are in the operating cycle? How many days are in the cash cycle?
1. The receivable turnover rate tells you the number of times during the year that money is loaned to customers. Credit sales / Average accounts receivable = 325,700 / 25,400 = 12.8228.
Receivables period = 365 days / 12.8228 = 28.46 days. This tells you that it takes customers an average of 28.46 days to pay for their purchases.
2. The inventory turnover rate indicates the number of times during the year that a firm replaces its inventory. COGS / Average inventory = 180,440 / 48,290 = 3.7366
Inventory period = 365 days / 3.7366 = 97.68 days. This means inventory sits on the shelf for 97.68 days before it is sold. That's ok for a furniture store but you should be highly alarmed if a fast food restaurant has a 98-day inventory period.
3. The accounts payable is matched with total purchases to compute the turnover rate because these accounts are valued based on the wholesale, or production, cost of each item.
Payables turnover = Total purchases / Average accounts payables = 188,920 / 37,510 = 5.0365
Payables period = 365 / 5.0365 = 72.47 days. On average, it takes 72.47 days to pay suppliers.
The operating cycle begins on the day inventory is purchased and ends when the money is collected from the sale of that inventory. This cycle consists of both the inventory period and the accounts receivable period. Operating cycle = 97.68 + 28.46 = 126.14 days
The cash cycle is equal to the operating cycle minus the payables period. It is the number of days for which the firm must finance its own inventory and receivables. During the cash cycle, the firm must have sufficient cash to carry its inventory and receivables.
Cash cycle = 126.14 - 72.47 = 53.67 days
In this example, the firm must pay for its inventory 53.67 days before it collects the payment from selling that inventory. Controlling the cash cycle is a high priority for financial managers.
User Contributed Comments 5You need to log in first to add your comment.
Good explanations. Concise and well summarized. Thank you AN.
Agreed! These notes are saving me so much time.
A little confusing at first with the terminology switch on "number of days" and "period". But nice and concise.
the cash cycle here is written cash conversion cycle in the text book which confused me big time.