Working Capital Management
Operating Decisions
Working Capital Management
Syllabus tag: KASNEB CPA | Intermediate Level | CA22 Financial Management | Topic 5 Working Capital Management
Lesson objectives
By the end of this topic, you will be able to:
- Compute inventory, receivable and payable days and the cash operating cycle
- Compute the economic order quantity and the resulting order frequency
- Evaluate whether an early settlement discount is worth taking
- Compute and interpret the current and quick ratios
- Explain the trade-off between liquidity and profitability
Why this matters
A profitable company can still fail. Profit is an accounting measure; wages and suppliers are paid in cash. Working capital management is about making sure the cash is there when it is needed.
Words to know
- Working capital — current assets less current liabilities.
- Cash operating cycle — the days between paying for goods and being paid for them.
- Overtrading — expanding sales faster than the working capital to support them.
- Economic order quantity (EOQ) — the order size that minimises total ordering plus holding cost.
- Settlement discount — a reduction for paying early.
The cash operating cycle
Three figures, one subtraction. Cost of sales 1,800,000; sales 2,500,000; inventory 400,000; receivables 350,000; payables 300,000.
| Component | Working | Days |
|---|---|---|
| Inventory days | 400,000 / 1,800,000 × 365 | 81.11 |
| Receivable days | 350,000 / 2,500,000 × 365 | 51.10 |
| Payable days | 300,000 / 1,800,000 × 365 | (60.83) |
| Cash operating cycle | 71.38 |
So the company funds about 71 days of trading out of its own pocket. The longer that cycle, the more finance the business needs simply to stand still.
Note which denominator each uses. Inventory and payables are measured against cost of sales; receivables against sales. Using sales throughout is a frequent and costly slip.
:::checkpoint A company shortens its cash cycle from 71 days to 45 days without changing sales. Where does the released cash come from, and name one risk attached to each of the three ways it might have achieved this. :::
Economic order quantity
EOQ = square root of (2 × D × Co / Ch)
Annual demand 24,000 units, order cost KES 600, holding cost KES 8 per unit per year:
EOQ = square root of (2 × 24,000 × 600 / 8) = square root of 3,600,000 = 1,897 units
Orders per year = 24,000 / 1,897 = 12.65, so about 13 orders.
The logic is a balance. Order in large quantities and you place few orders but hold expensive stock. Order little and often and holding costs fall while ordering costs climb. EOQ is the point where the two are equal.
Early settlement discounts
A supplier offers 2/10 net 40 — 2% off if paid within 10 days, otherwise the full amount at 40 days. Is the discount worth taking?
Taking it means giving up 30 days of credit to save 2%:
Annualised cost of refusing = (2 / 98) × (365 / 30) = 24.83%
That is the effective annual rate the company pays by declining. Unless it can borrow more cheaply than 24.83%, it should take the discount. Terms like this are usually worth accepting, which is exactly why suppliers offer them.
Liquidity ratios
Current assets 900,000, of which inventory 400,000; current liabilities 500,000.
- Current ratio = 900 / 500 = 1.8 times
- Quick ratio = (900 − 400) / 500 = 1.0 times
The quick ratio strips out inventory because it is the current asset least certain to convert to cash quickly. A wide gap between the two ratios says the company is carrying a lot of stock, which may or may not be justified.
There is no universally correct level. A supermarket runs on a current ratio well below 1.0 quite safely, because it sells for cash and buys on credit.
The trade-off
Holding plenty of cash, generous inventory and easy credit terms makes a company safe and unprofitable. Holding little of each makes it profitable and fragile. The judgement in this topic is always about where between those two a particular business should sit — and the answer depends on how predictable its cash inflows are.
:::checkpoint A company's sales double in a year while its overdraft limit stays the same. Explain why this is dangerous even though the extra sales are profitable, and name the term for it. :::