Working Capital Management
Working Capital Management
The exam tests the cash conversion cycle, liquidity measurement, credit policy, inventory control, and the true cost of short-term financing sources.
Core rules
- Net working capital = current assets − current liabilities. Current ratio = CA/CL; quick ratio = (CA − inventory)/CL.
- Cash conversion cycle = days inventory outstanding + days sales outstanding − days payable outstanding. Shorter (or negative) is better because less cash is tied up.
- DIO = 365/inventory turnover (COGS-based); DSO = 365/receivables turnover; DPO = 365/payables turnover (COGS-based).
- Credit terms 2/10, net 30: cost of forgoing the discount = (0.02/0.98) × (365/20) = 37.2% annualized, usually far above the borrowing rate.
- EOQ = √(2DS/H), where D is annual demand, S order cost, H holding cost per unit. Reorder point = lead-time demand + safety stock.
- Short-term financing options: trade credit, bank line of credit, commercial paper, factoring, pledging receivables.
- Cost of a discount-interest loan = interest/(principal − interest); a compensating balance also goes in the denominator.
Worked example
A firm has inventory turnover 6, receivables turnover 8, and payables turnover 12. DIO = 365/6 = 60.8 days; DSO = 365/8 = 45.6 days; DPO = 365/12 = 30.4 days. CCC = 60.8 + 45.6 − 30.4 = 76.0 days. If daily operating outlays are $50,000, the cycle absorbs roughly $3.8 million of cash. Cutting DSO by 5 days frees about $250,000-cash that can repay debt or fund growth without new financing.
Traps
- Using sales instead of COGS for inventory days and payables days.
- Assuming a high current ratio is always good; idle cash and obsolete inventory hurt returns.
- Ignoring that forgoing a 2/10, net 30 discount is effectively borrowing at about 37%.
- Confusing pledging (borrower keeps receivables, lender has a claim) with factoring (receivables are sold, usually at a discount).
- Mixing up EOQ (how much to order) with reorder point (when to order).