Working Capital Management — Liquidity and Short-Term Financing

1. What Is Working Capital?

Working Capital: The funds required for a firm’s day-to-day operations.

\text{Net Working Capital} (NWC) = \text{Current Assets} − \text{Current Liabilities}

Current Assets: Cash, Short-term investments, Accounts receivable, Inventory
Current Liabilities: Accounts payable, Short-term borrowings, Accrued expenses

Working Capital Management Goal: Maintain sufficient liquidity while avoiding excessive idle investment.

2. Cash Conversion Cycle (CCC)

CCC: The number of days between paying cash for inputs and collecting cash from customers.

\begin{aligned} CCC &= \text{Days Inventory Outstanding} (DIO) \\ &+ \text{Days Sales Outstanding} (DSO) \\ &− \text{Days Payable Outstanding} (DPO) \\ DIO &= \frac{365}{\text{Inventory Turnover}} \\ &= \frac{\text{Average Inventory}}{COGS} \times 365 \\ DSO &= \frac{365}{\text{Receivables Turnover}} \\ &= \frac{\text{Average Accounts Receivable}}{\text{Net Sales}} \times 365 \\ DPO &= \frac{365}{\text{Payables Turnover}} \\ &= \frac{\text{Average Accounts Payable}}{\text{Purchases}} \times 365 \end{aligned}

Shorter CCC = Cash is tied up for less time → more efficient use of working capital.

3. Cash Management

(1) Optimal Cash Balance Models

Baumol Model: Balances transaction costs against opportunity costs.

Optimal Cash Balance:

C* = \sqrt(2 \times F \times \frac{T}{r})

F: Fixed cost of converting securities to cash
T: Total cash demand over the period
r: Opportunity cost (interest rate on short-term investments)

\begin{aligned} \text{Total Cost} &= \text{Transaction Cost} + \text{Opportunity Cost} \\ &= (T/C) \times F + (C/2) \times r \end{aligned}

Miller-Orr Model: Sets upper and lower cash balance limits for firms with irregular cash flows.

4. Accounts Receivable Management

Granting Credit — Trade-Off

Costs: Opportunity cost of tied-up funds + Bad debt expense + Admin costs
Benefits: Incremental profits from higher sales

Relaxing Credit Standards

↑ Sales → ↑ Contribution margin
↑ A/R → ↑ Opportunity cost
↑ Bad debt → ↑ Credit losses

The 5 Cs of Credit:

Character: Credit history and willingness to pay
Capacity: Ability to repay (cash flow analysis)
Capital: Net worth / financial strength
Collateral: Assets pledged as security
Conditions: Economic environment and industry outlook

5. Inventory Management

EOQ (Economic Order Quantity):

EOQ = \sqrt(2 \times D \times \frac{O}{H})

D: Annual demand (units)
O: Fixed cost per order
H: Annual holding (carrying) cost per unit

\begin{aligned} \text{Total Inventory Cost} &= \text{Ordering Cost} + \text{Holding Cost} \\ &= (D/Q) \times O + (Q/2) \times H \end{aligned}

\text{At} Q = EOQ, \text{ordering cost} = \text{holding cost} \to \text{total cost is minimized}

6. Short-Term Financing

Short-Term Financing Instruments:

Invoice discounting / A/R financing (receivables as collateral)
Factoring: Outright sale of receivables
Bank line of credit / revolving credit facility
Commercial Paper (CP): Unsecured short-term notes issued by corporations
Trade credit: Maximize the use of accounts payable payment terms

Spontaneous Financing: Accounts payable, accrued expenses (interest-free)
Negotiated Financing: Bank loans (interest-bearing)

7. Key Concept Cards

Cash Conversion Cycle (CCC) ★★★★★ : DIO + DSO − DPO. The shorter the CCC, the more efficiently cash is being used. Memory tip: CCC = Inventory + Receivables − Payables

EOQ ★★★★★ : √(2DO/H). The order quantity that minimizes total inventory cost (ordering + holding costs equal at EOQ). Memory tip: EOQ = √(2DO/H)

5 Cs of Credit ★★★★☆ : Character · Capacity · Capital · Collateral · Conditions. Memory tip: Character, Capacity, Capital, Collateral, Conditions

8. Practice Quiz

Q. Annual demand = 1,200 units, fixed order cost = $50, annual holding cost per unit = $2. What is the EOQ?

EOQ = √(2 × 1,200 × $50 / $2) = √(60,000) ≈ 245 units

Q. DIO = 30 days, DSO = 45 days, DPO = 50 days. What is the CCC?

CCC = 30 + 45 − 50 = 25 days