Explain how firms manage working capital
The idea
Working capital management is the handling of current assets and current liabilities so the firm can meet obligations as they fall due. The cash conversion cycle - days of inventory plus days of receivables minus days of payables - measures how long cash is tied up in operations; shortening it frees cash. The balance to strike is that holding more liquidity is safer but earns little, while running lean raises returns and the risk of a funding squeeze. Profitable firms still fail when they run out of cash.
Formulas
Cash conversion cycle
cash conversion cycle = DOH + DSO − DPO
- DOH
- days of inventory on hand
- DSO
- days sales outstanding, how long customers take to pay
- DPO
- days payables outstanding, how long the company takes to pay suppliers
The days between paying for stock and being paid for it, which is the working capital the business must fund. Shortening it releases cash without earning a penny more, and a negative cycle means suppliers are funding the business.
Working capital
working capital = current assets − current liabilities
- current assets
- cash, receivables and inventory
- current liabilities
- payables and other obligations due within a year
The buffer between what is owed soon and what will be collected soon. More is not better without limit: idle cash and slow-moving inventory both raise it while earning nothing.
A practice question
The cash conversion cycle equals days of inventory plus days of receivables:
- divided by days of payablesWhy not: The three are all measured in days and combine by addition and subtraction, not by division.
- minus days of payables - correct
- plus days of payablesWhy not: Adding payables reverses their effect. Supplier credit funds part of the cycle, so it shortens it.
The cash conversion cycle counts the days between paying for inventory and getting cash from customers. Formula: Cash conversion cycle = Days of inventory + Days of receivables - Days of payables. Inventory days and receivables days are time the firm waits for cash, so they are added. Payables days is the time suppliers let the firm wait before paying, which means someone else is funding the firm for that time, so it is subtracted.
A harder one
A firm that shortens its cash conversion cycle, all else equal, most likely:
- ties up more cash in operationsWhy not: A shorter cycle means cash returns sooner, so less is tied up rather than more.
- frees up cash tied up in operations - correct
- experiences no change in liquidityWhy not: The cycle measures how long cash is committed, so shortening it releases funds.
The cash conversion cycle is the time money is tied up between paying suppliers and collecting from customers. Formula: Cash conversion cycle = Days of inventory + Days of receivables - Days of payables. If this number falls, cash comes back to the firm sooner. That means less money is stuck in stock and unpaid customer bills, so cash is freed up. Liquidity improves, not worsens.
The hardest tier
A firm aggressively extends its payment terms with suppliers to shorten its cash conversion cycle. The most likely risk is:
- an immediate rise in inventory levelsWhy not: Paying later does not change how much stock is held.
- a fall in reported revenue growthWhy not: Revenue is recognised on sale to customers and is unaffected by when suppliers are paid.
- suppliers raising prices or pulling credit - correct
The firm stretches out how long it takes to pay suppliers. Formula: Cash conversion cycle = Days of inventory + Days of receivables - Days of payables. Longer payables days shorten the cycle and keep cash in the firm. But suppliers are not lending for free. They may raise their prices, demand payment earlier or stop supplying on credit, which is the real risk. Paying later does not change how much stock is held or the firm's sales.
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