Working capital management
Components and cycle
Working capital is the investment in current assets less current liabilities: inventory, receivables and cash, financed partly by payables. Management aims to keep sufficient liquidity without over-investing. The operating cycle measures time from buying inventory to collecting cash; the cash conversion cycle is inventory days plus receivable days minus payable days. Shorter cycles release cash but may lose sales or supplier discounts. Overtrading occurs when a business expands faster than its long-term finance, producing profitable but cash-starved growth.
Managing each element
Inventory: use the economic order quantity to balance ordering and holding costs; just-in-time reduces holdings but raises supply risk. Receivables: assess creditworthiness, set credit limits, invoice promptly, monitor ageing, and compare early-settlement discounts with the cost of finance. Payables: delay payment only within agreed terms; losing discounts can be expensive. Cash: prepare cash budgets, use short-term investments or overdrafts, and forecast seasonal peaks.
Traps and rule of thumb
Traps: treating profit as cash; ignoring bad debts when evaluating a discount; using annual sales rather than credit sales in receivable days; forgetting that payable days use credit purchases. A supplier early-settlement discount is worth taking only if the annualised benefit exceeds the borrowing cost.
Worked example: inventory days 60, receivable days 45, payable days 30, so cash cycle = 75 days. If daily operating cash outflow is $20,000, the cycle ties up about $1.5m. Rule of thumb: shorten the cycle by reducing inventory or receivables or extending payables, but test each change against lost margin, bad-debt risk and supplier relationships.