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Subject 1. Managing and Measuring Liquidity

Working capital management involves the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.

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.

Measuring Liquidity

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.

Study notes from a previous year's CFA exam:

1. Managing and Measuring Liquidity