Working Capital, Treasury and Risk Management
This domain tests the management of short-term assets and liabilities and the treasury function's role in liquidity and risk control. The exam expects you to compute the cash operating cycle, evaluate inventory and receivables policies, assess early settlement discounts, and explain hedging of foreign exchange and interest rate risk. Treasury manages liquidity, banking relationships and financial risk, not speculation.
Core rules
- Cash operating cycle = inventory days + receivable days - payable days. A shorter cycle reduces financing needs, but too short a cycle may signal lost sales or strained supplier relations.
- Inventory: economic order quantity EOQ = square root of (2 x annual demand x order cost / holding cost per unit). It assumes constant demand, known costs and no shortages.
- Receivables: assess creditworthiness, set credit limits, monitor ageing, use factoring or invoice discounting, and evaluate early settlement discounts. The annualised cost of a discount is (discount / (1 - discount)) x (365 / days saved).
- Payables: trade credit is a source of finance but late payment can damage supplier relationships and reputation.
- Cash management: cash budgets, Baumol and Miller-Orr models, centralised pooling and short-term investment of surplus cash.
- Treasury risk: FX transaction, translation and economic exposure; hedge with forwards, futures, options or money market hedges. Interest rate risk can be hedged with FRAs, futures, options or swaps. Derivatives carry basis risk and counterparty risk.
Worked example
A company has inventory days of 90, receivable days of 60 and payable days of 45, giving a cash operating cycle of 105 days. Annual sales are $730m. If receivables are reduced by 15 days, the cash released is $730m / 365 x 15 = $30m. Reasoning: receivables days fall from 60 to 45, so the cycle falls to 90 days. The firm must weigh the $30m cash release against tighter credit terms that may reduce sales. If a supplier offers a 2% discount for payment in 10 days instead of 60, the annualised cost is (0.02 / 0.98) x (365 / 50) = 14.9%, so borrowing at less than 14.9% makes the discount worthwhile.
Traps that cost marks
- Confusing the cash operating cycle with the working capital investment amount.
- Using sales instead of cost of sales for payable days, or inconsistent bases.
- Ignoring the sales loss from tighter credit policy.
- Treating derivatives as speculative rather than hedging tools.
- Forgetting basis risk and counterparty risk in hedge evaluation.