Eduzan

Eduzan / MODULE 05 — Corporate Finance (renamed from Corporate Issuers)

CI 4 Working Capital and Liquidity

How an issuer turns its operations into cash and stays able to pay what falls due within a year. Check-yourself items are study aids.

This module deals with the short-term side of the balance sheet: the assets and liabilities that turn into cash inflows or outflows within a year. Their behavior is driven mainly by the payment and delivery terms an issuer agrees with its customers and its suppliers. These accounts matter because they largely decide whether a firm can generate cash for its investors, and because a mismatch between when assets convert to cash and when liabilities come due can prove fatal even to a profitable company. For that reason analysts study an issuer’s cash conversion and liquidity closely.

The operating cycle

For a manufacturer that produces and sells physical goods, operations run through a sequence: buy materials, build inventory, sell the goods on credit, and finally collect cash. That sequence is the operating cycle, and it may repeat once or many times a year. The cash flows attached to each step rarely land at the same moment as the step itself. Materials are received now but paid for weeks later; goods are shipped now but the cash arrives later; and some inventory takes a long time to become saleable, as with aged spirits such as whiskey that mature for years before sale.

Future inflows inside the operating cycle sit on the balance sheet as short-term assets, and future outflows sit there as short-term liabilities. Each account is recognized when its underlying activity occurs and is removed when the related cash actually moves.

Selected short-term accounts and when they are recognized

Account	Meaning	Recognized when	Removed when
Accounts receivable	Amounts owed by customers for goods or services sold	Product or service is sold to a customer on credit	Cash is received from the customer
Inventory	Cost of products produced or bought for resale	The issuer takes ownership of materials or goods	Product is sold to a customer
Accounts payable	Amounts owed to suppliers for goods or services received	Product or service is received and payment is deferred	Cash is paid to the supplier

Defining the cash conversion cycle

The average time each account stays on the books has a name: days payable outstanding (DPO) for payables, days of inventory on hand (DOH) for inventory, and days sales outstanding (DSO) for receivables. The exact activity-ratio formulas for these come later in the curriculum. The quantity analysts care about here is the cash conversion cycle: the gap between the day an issuer pays its suppliers and the day it collects from its customers, that is, the time between removing a payable and removing the matching receivable.

Figure 1: The cash conversion cycle on the operating timeline

The operating cycle runs from receiving inventory to collecting cash (DOH then DSO). The cash conversion cycle is the shorter stretch from paying suppliers to collecting cash: DOH plus DSO, less DPO.

The cash conversion cycle counts the days it takes to turn an inventory investment back into cash from customers. A longer cycle means a firm must finance its bills, such as payroll, for longer before the cash comes in. In 2020 the average US-listed company ran a cycle of 78 days, but the spread across industries was wide. Pharmaceutical makers carry heavy inventories and so run long cycles; airlines, a service with almost no goods inventory and mostly prepaid fares, run very short ones.

2020 S&P 1500 industry average cash conversion cycles (days)

Industry	Average cycle
Pharmaceuticals	180
Apparel Retail	123
Semiconductors	121
All companies	78
Auto and Auto Parts	66
Oil and Gas	61
Software	40
Media	22
Airlines	12

Source: JPMorgan Working Capital Index 2021, authors’ analysis.

The ideal is a short, or even negative, cycle, because cash tied up in inventory is quickly freed for reuse. A negative cycle arises when customers pay before suppliers are paid, which throws off spare cash and cuts the need for outside financing. The apparel group Inditex, whose largest brand is ZARA, is the classic case: a vertically integrated supply chain, limited runs of fast-turning stock, off-the-rack sales settled instantly in cash or card, and heavy bargaining power over a large base of suppliers together produce a deeply negative cycle.

Inditex operating metrics (millions of EUR unless noted)

	2021	2020
Accounts receivable	842	715
Inventories	3,042	2,321
Accounts payable	6,199	4,659
Sales	27,716	20,402
Cost of goods sold	11,902	9,013
Days sales outstanding	11	13
Days of inventory on hand	93	94
Days payable outstanding	190	189
Cash conversion cycle	−86	−82
Net working capital	−2,315	−1,623
Net working capital as % of sales	−8.4%	−8.0%

Shortening the cycle

An issuer can compress its cash conversion cycle along three levers:

Cut days of inventory on hand by dropping low-demand or niche lines, arranging more frequent just-in-time deliveries, and sharpening demand forecasts with data analytics.
Cut days sales outstanding by giving prompt-payment discounts, charging late fees, tightening credit standards, requiring upfront deposits, and using collection agencies.
Raise days payable outstanding by negotiating longer supplier terms, often as a preferred buyer purchasing in volume. This may cost higher prices or deposits, and it depends heavily on the balance of power: a sole-source supplier that sells to many buyers gives a firm little leverage.

The cost of forgoing a prompt-payment discount

Stretching payables helps the cycle, but suppliers often reward early payment. A common term such as 2/10, net 30 means the full amount is due in 30 days, yet a 2 percent discount applies if payment arrives within 10 days. A firm that forgoes the discount and pays on day 30 is in effect borrowing from the supplier for 30 minus 10, that is 20 days, at a price equal to the discount given up. To compare that implicit loan against a real one, express the forgone discount as an effective annual rate.

Discount is stated as a decimal. The exponent annualizes the extra days of credit obtained.

Example 1 · Worked

Keown Corporation makes custom paddleboards in Canada and sells only through its website. Its supplier offers terms of 2/10, net 30. Keown lacks the cash to pay within 10 days, so its CFO must choose between borrowing from the bank at an effective annual rate of 7.7 percent to capture the discount, or simply paying on day 30 and forgoing it.

1. Which is cheaper: the bank loan plus the discount, or forgoing the discount?

Solution. Price the trade credit as an effective annual rate. The interest cost is the 2 percent forgone discount and the term is the extra 30 minus 10, that is 20 days of credit. The trade credit costs about 44.6 percent, far above the 7.7 percent bank rate. Keown should borrow from the bank, pay the supplier within 10 days to take the discount, and preserve cash at the lower financing cost.

Example 2 · Worked

Activity ratios for five large US discount retailers for the 2021 calendar year are shown below.

Activity ratios, 2021 (days)

	Walmart	Target	Costco	TJX	Ross
Days sales outstanding	5	2	3	7	2
Days of inventory on hand	48	68	29	63	61
Days payable outstanding	47	75	34	47	63

1. Which company has the shortest cash conversion cycle, and which the longest?

Solution. Applying DSO plus DOH less DPO: Walmart 5 + 48 − 47 = 6; Target 2 + 68 − 75 = −5; Costco 3 + 29 − 34 = −2; TJX 7 + 63 − 47 = 23; Ross 2 + 61 − 63 = 0. Target has the shortest cycle at −5 days, and TJX the longest at 23 days.

2. These firms take payment at the moment of sale, in cash or by card. Does that fit the ratios?

Solution. Yes. Days sales outstanding is very low, in line with card settlements clearing within a day or two while cash sales settle immediately.

3. About 54 percent of what Costco sells is food or food-related, a larger share than at its peers. Does that fit?

Solution. Yes. Perishable goods must be sold soon after arrival or they spoil, so a food-heavy mix pushes days of inventory on hand down, which is why Costco shows the lowest DOH of the group at 29 days.

Working capital and its link to the cycle

A second efficiency gauge is the amount of working capital a firm ties up, usually stated relative to sales so it can be compared over time and across firms. Total working capital is the broad measure; net working capital strips out accounts that relate less to operations, namely cash, marketable securities, and short-term debt.

Consider Licht Vernieuwend N.V. at 31 December 20X2. Total working capital equals current assets of EUR335 million minus current liabilities of EUR220 million, which gives EUR115 million. Net working capital excludes cash, marketable securities, and the short-term bank loan, giving EUR225 million less EUR160 million, or EUR65 million.

Licht Vernieuwend N.V. working capital at 31 December 20X2 (millions of EUR)

Item	Total working capital view	Net working capital view
Cash	40
Marketable securities	70
Accounts receivable	85	85
Inventory	130	130
Prepaid accounts	10	10
Current assets	335	225
Accounts payable	130	130
Accrued expenses	30	30
Short-term bank loan	60
Current liabilities	220	160
Working capital	115	65

The cycle and the working-capital ratio move together. Receivables and inventory are usually the large short-term assets and payables the large short-term liability, so a short cycle pairs with a small working-capital-to-sales ratio, and a long cycle with a large one. Inditex, for instance, runs not only a negative cycle but negative net working capital, roughly −8 percent of sales in both years shown above.

When a high working-capital ratio is normal

A large working-capital-to-sales ratio sometimes reflects the nature of the business rather than poor management. Spirits producers must age inventory for years before sale, and pharmaceutical firms hold large stocks, at times to satisfy regulation. Outside such cases of necessity or compliance, a firm is usually better off holding less working capital and redirecting the freed capital to higher-return projects or back to investors.

Example 3 · Worked

An issuer with limited cash is comparing three suppliers’ credit terms and wants the one with the lowest implicit cost.

1. Rank the effective annual rates of 1/10 net 50; 2/15 net 40; and 3/15 net 60.

Solution. The implicit cost is the forgone discount financed over the extra days beyond the discount period. The terms 1/10, net 50 are cheapest at about 9.6 percent, because they combine a small 1 percent discount with a long 40-day extension. Next is 3/15, net 60 at 28.0 percent, and the most costly is 2/15, net 40 at 34.3 percent.

Example 4 · Worked

An issuer reports the following balances: cash 100; marketable securities 20; accounts receivable 600; inventory 800; prepaid expenses 30; accounts payable 980; accrued expenses 70; short-term debt 1,000.

1. What is net working capital?

Solution. Net working capital excludes cash, marketable securities, and short-term debt. Current assets to include are receivables 600, inventory 800, and prepaid 30, summing to 1,430. Current liabilities to include are payables 980 and accrued 70, summing to 1,050. Net working capital is 1,430 − 1,050 = 380. Leaving cash and marketable securities in the assets, or short-term debt in the liabilities, would wrongly return total working capital instead.

Check yourself

An issuer forgoes a supplier discount and pays on the net date rather than early. What happens to its cash conversion cycle?

It shortens. Delaying payment raises days payable outstanding, which is subtracted in the cycle formula, so the cycle falls. The firm reduces its need for financing at the price of the forgone discount.

Which lengthens the cycle: tightening customer credit standards, or increasing safety stocks of inventory?

Increasing safety stocks lengthens it, by raising days of inventory on hand. Tightening credit standards tends to shorten the cycle by lowering days sales outstanding.

For a single item, liquidity is its nearness to cash or to settlement. Cash is already cash and so is the most liquid asset, while inventory can take a long time to sell and collect and is therefore less liquid. On the liability side, a payable owed to a supplier within five days is more liquid than next month’s lease payment. Issuers list balance-sheet items in descending order of liquidity, and anything not expected to convert or settle within 12 months sits among long-term assets and liabilities.

For a firm as a whole, liquidity means the ability to meet short-term liabilities, and it turns on how large and how liquid its short-term assets and liabilities are, which themselves follow from the business model and cash conversion cycle. A firm with 100 in cash against 20 of short-term liabilities is comfortably liquid; reverse those figures, 20 in cash against 100 of liabilities, and it must reach for other sources to pay what is due.

Primary sources of liquidity

Primary sources are the most readily available cash and normally do not disrupt operations:

Cash and marketable securities on hand: money in bank accounts, or securities that can be sold quickly without a material loss in value.
Borrowing from banks, from bondholders, or from suppliers via trade credit. This raises cash but creates an obligation to repay later.
Cash flow from the business, which takes time to build but is a large source for profitable firms. A firm expecting to generate 100 of operating cash over six months can meet a 40 liability due then without touching cash on hand or borrowing. Early-stage or loss-making firms may not generate enough.

Because operating cash flow is the primary long-term source, analysts track the statement of cash flows. Cash flow from operations measures the cash profit of the core business over a period: cash collected from customers, plus interest and dividends earned on investments, less the cash paid to staff and suppliers, less taxes, and less interest owed to lenders. It ignores capital investment, so analysts also compute free cash flow.

One variant adds back interest paid, giving cash available to both debt and equity investors.

Secondary sources of liquidity

Secondary sources raise cash at a higher cost and often signal deteriorating health, since they disadvantage existing debt or equity holders, employees, and other stakeholders. They include:

Suspending or cutting dividends to shareholders.
Delaying or reducing capital expenditure, which preserves near-term cash but may forfeit opportunities and long-term value.
Issuing equity, publicly or privately, which brings cash but dilutes existing owners.
Reworking contract terms, for instance refinancing short-term debt into long-term, easing interest, rent, or lease conditions, restructuring covenants, or renegotiating customer and supplier terms.
Selling assets, depending on how far short-term or long-term assets can be liquidated without heavy loss.
Filing for bankruptcy protection and reorganization to keep operating while debts are restructured and assets possibly sold.

Early in the COVID-19 pandemic, airlines leaned on such sources as revenue collapsed: Lufthansa took in EUR600 million from a convertible bond, Singapore Airlines gathered SGD 8.8 billion in a rights issue, and Delta Airlines pushed back USD500 million of capital expenditure.

Example 5 · Worked

Keown Corporation is in a liquidity crisis and has identified four ways to raise funds. Each asset carries a liquidation cost, covering fees, commissions, and any discount to value forced by illiquidity.

Keown potential sources of liquidity

Source of funds	Fair value (CAD m)	Liquidation cost %	Liquidation cost (CAD m)	Net proceeds (CAD m)
Sell short-term marketable securities	10	0	0	10
Sell select inventories and receivables	20	10	2	18
Sell excess real estate property	50	15	7.5	42.5
Sell a subsidiary of the firm	30	20	6	24
Total	110		15.5	94.5

1. Using all four sources, how much liquidity can Keown raise net of costs, and what are the total liquidation costs?

Solution. Each liquidation cost is the fair value times the cost percentage: 0, 2, 7.5, and 6, summing to CAD15.5 million. Net proceeds are fair value less cost: 10, 18, 42.5, and 24, summing to CAD94.5 million. So Keown raises CAD94.5 million net and incurs CAD15.5 million of liquidation costs.

Drags and pulls on liquidity

Two negative forces act on liquidity. A drag arises when cash inflows lag, leaving a shortfall. A pull arises when cash outflows speed up, or when access to trade credit is cut, so a firm must spend before its sales proceeds arrive. Major drags on receipts include:

Uncollected receivables: the longer they stay outstanding, the higher the chance of non-collection.
Obsolete inventory: finished goods held a long time may no longer sell, or sell only at a discount.
Borrowing constraints: when credit tightens, short-term debt turns costly or unavailable.

Stricter credit and collection can ease drags, but they may also cut sales if customers will not buy on cash-only terms. Major pulls on liquidity include:

Making payments early with no benefit, which gives up the use of funds; good practice is to avoid early payment.
Reduced credit limits, which suppliers may impose after a history of late payment.
Limits on short-term lines of credit, whether government mandated, market related, or firm specific.
Chronic low liquidity, often from industry conditions or a weak balance sheet, sometimes worsened by an aggressive working-capital stance.

Example 6 · Worked

An analyst notes three recent trends at Keown Corporation: a rise in average days sales outstanding; a rise in days of inventory on hand; and higher credit limits granted by its lenders.

1. Which trend does not add to the firm’s liquidity challenges?

Solution. The increase in credit limits. Higher credit limits provide liquidity rather than pull on it, so they do not worsen the strain. A longer average collection period is a drag, since inflows slow, and holding inventory longer is also a drag, since it stretches the cash conversion cycle.

Measuring liquidity with ratios

To compare firms of different sizes, analysts use liquidity ratios alongside the activity ratios above. The broadest is the current ratio, current assets divided by current liabilities. Any firm whose total working capital is positive has a current ratio above one, and a higher reading means more liquidity on this all-inclusive measure.

Two narrower measures strip out the less liquid short-term assets. The quick ratio removes inventory, so a value above one means a firm could cover current liabilities without selling inventory, though it would still need to collect every receivable on time. The cash ratio is the most conservative, counting only cash and short-term marketable securities; a value of one or more means all short-term obligations could be met without waiting to sell inventory or collect receivables.

Example 7 · Worked

Balance-sheet data for Licht Vernieuwend N.V. for 20X2 and the prior year 20X1 are below.

Licht Vernieuwend N.V. balance sheet (millions of EUR)

	20X2	20X1
Cash	40	45
Marketable securities	70	90
Accounts receivable	85	90
Inventory	130	66
Prepaid accounts	10	15
Accounts payable	130	140
Accrued expenses	30	15
Short-term bank loan	60	70

1. Did net working capital change from 20X1 to 20X2, and what mainly drove it?

Solution. Net working capital adds receivables, inventory, and prepaid accounts, then subtracts payables and accrued expenses. For 20X1: 90 + 66 + 15 − 140 − 15 = 16. For 20X2: 85 + 130 + 10 − 130 − 30 = 65. It rose from EUR16 million to EUR65 million, driven mainly by inventory climbing from 66 to 130.

2. Did liquidity change from 20X1 to 20X2 on the cash, quick, and current ratios?

Solution. Current liabilities are payables plus accrued expenses plus the bank loan: 140 + 15 + 70 = 225 in 20X1 and 130 + 30 + 60 = 220 in 20X2. The cash and quick ratios fell while the current ratio rose. The rise in the current ratio comes from the larger inventory, which the quick and cash ratios exclude.

3. On the most conservative measure, did the firm become more or less liquid?

Solution. The cash ratio is the most conservative, using only the most liquid assets. It fell from 0.60 to 0.50, so on that basis Licht became less liquid.

Check yourself

A firm reports cash 200, marketable securities 40, receivables 600, inventory 800, prepaid 60, payables 500, accrued 50, and short-term debt 600. What are its cash and quick ratios?

Current liabilities are 500 + 50 + 600 = 1,150. Cash ratio = (200 + 40) / 1,150 = 0.2087. Quick ratio = (200 + 40 + 600) / 1,150 = 0.7304.

Cash flow from operations is 1,400 and investment in long-term assets is 800. What is free cash flow?

Free cash flow = 1,400 − 800 = 600.

Is issuing equity a primary or a secondary source of liquidity?

Secondary. Primary sources are cash on hand, borrowing, and operating cash flow; issuing equity raises cash at greater cost and dilutes existing owners.

The goal when managing working capital and liquidity is to maximize firm value while keeping ready access to the funds needed for daily operations and for obligations to creditors. In practice that usually means shortening the cash conversion cycle, estimating the liquidity actually required, and holding as little excess as prudence allows, so surplus cash can go to higher-return projects or back to shareholders.

What is realistic depends on the business model. Complex manufacturing may hold inventory for weeks or months, while a distributor of simple goods may hold only a few days. Retailers with many outlets and credit sales need more working capital in inventory and receivables, whereas service and software firms, holding no inventory and often paid upfront, need far less.

Permanent versus variable current assets

Firms first set an optimal level of working capital relative to revenue, then forecast future levels from their revenue forecast. They separate permanent current assets, the base level of inventory, staffing, and receivables that stays fairly constant, from variable current assets, the extra inventory and labor needed during a seasonal peak or a growth phase. Along the way, managers weigh trade-offs: more inventory guards against shortfalls but raises obsolescence risk, and easier credit terms can lift sales but also raise billing costs and delinquencies.

Three approaches to working capital

Firms differ both in how large a current-asset position they carry and in how they finance it. Three broad stances range from the costliest to the cheapest for a given level of sales.

Working-capital management approaches

Approach	Short-term asset position vs sales	Financing emphasis	Main trade-off
Conservative	Larger	More long-term debt and equity	Most flexibility, highest cost
Moderate (matched)	Moderate	Long-term for permanent needs, short-term for variable needs	Balanced cost and risk
Aggressive	Smaller	More short-term liabilities	Lowest cost, highest rollover risk

A conservative approach holds more cash, receivables, and inventory relative to sales and funds them with more permanent capital. Stable financing avoids the rollover risk of short-term debt and gives certainty of funds, but long-term debt carries a higher rate, equity is costly, and permanent financing removes the option to borrow only as needed. Early-growth firms with limited access to short-term debt often lean this way, as do established, high-margin firms that can pass the cost on. Other motives include a wish to avoid capital markets during stress, an expectation of flat to rising rates, and a wish for stable cash flow rather than the rollover risk of short-term debt.

An aggressive approach minimizes excess cash, receivables, and inventory and relies more on short-term funding for variable and even some permanent needs. It trades short-term flexibility for higher investor returns: financing cost is lower and borrowing can flex with need, but interest expense can swing with short-term rates and rollover risk raises bankruptcy risk in a market disruption, as many firms found in 2008 to 2009 and again in early 2020. Low-margin firms may adopt it to gain a cost edge, especially when they can forecast cash needs precisely, expect stable or falling rates, and can liquidate inventory and minimize receivables quickly.

A moderate, or matched, approach funds stable permanent needs from long-term financing, and the less predictable seasonal or growth needs from short-term debt. It costs less than the conservative stance and carries less refinancing risk than the aggressive one, and it suits firms that can forecast base current-asset needs well but are less certain about variable needs.

Sales strategy pulls working capital with it

The tie between how a firm sells and its working-capital stance matters to analysts. Extending more credit, or more generous terms, to lift sales also lifts working capital: receivables rise, and delinquencies often rise too, both needing extra financing. The extra cost of monitoring, billing, and chasing collections over a longer period, together with higher borrowing costs, has to be set against the added profit the new strategy is meant to earn.

Liquidity and short-term funding

Even profitable firms can hit trouble by failing to hold enough liquidity for current liabilities. A firm gains flexibility by building a short-term financing strategy and regularly reviewing its options; firms that neglect this face higher costs or, at worst, an inability to borrow at all. A sound strategy for when and how to borrow aims to keep diversified sources of credit so it does not depend on one lender, to secure enough capacity for peak seasonal or growth needs, to confirm that rates and terms stay competitive across different conditions, and to weigh both implicit costs (such as supplier financing) and explicit costs in the effective cost of borrowing.

Several firm characteristics shape short-term funding choices:

Size: a small private firm may be limited to a single bank line, while very large firms can tap short-term fixed-income markets. Many options carry minimum sizes or fixed costs that price out smaller firms.
Creditworthiness: it drives whether a loan is approved, at what rate, and with what operating restrictions, since weaker borrowers may face conditions on how they use or sell assets.
Legal considerations: firms operating in emerging or frontier markets, where legal systems are less developed, may have fewer intermediary or market options and lean more on supplier trade credit.
Regulatory considerations: heavily regulated industries, utilities or banks among them, may be limited in how much and what type of borrowing they can access, though some, such as financial institutions, reach unique sources like central bank funding.
Underlying assets: firms with assets such as inventory that work well as collateral can obtain secured short-term funding.

Good planning helps regardless of size or industry. Forecasting cash positions over the cash conversion cycle and beyond reduces the chance of distress in adverse markets, and matching debt maturities to expected cash receipts, while spacing maturities out over time, lowers short-term funding risk.

Example 8 · Worked

Keown Corporation has accounts payable of CAD2 million on terms of 2/10, net 30, accounts receivable of CAD2 million, and CAD5 million of marketable securities. It must cover CAD200,000 of payroll in the short term.

1. Which action raises the CAD200,000 at the lowest cost: forgoing the 2 percent supplier discount, selling receivables at a 10 percent discount, or selling marketable securities at a 0.5 percent brokerage cost?

Solution. Forgoing the discount costs 2 percent of 200,000, that is CAD4,000. To net 200,000 by selling receivables at a 10 percent discount, the firm must sell CAD222,222 of value, at a cost of CAD22,222. Selling CAD200,000 of marketable securities at 0.5 percent costs only CAD1,000. Selling marketable securities is cheapest and best: they are liquid and sell near market value for a minor brokerage fee.

Check yourself

Classify each as conservative or aggressive: leaning more on long-term financing; holding a smaller level of short-term assets; leaning more on short-term bank loans.

Greater reliance on long-term financing is conservative. A lower level of short-term assets and greater reliance on short-term bank loans are both aggressive.

A firm extends credit to less creditworthy customers. Is this a drag or a pull on liquidity, and why?

A drag. Weaker customers bring more delinquent or uncollectible accounts and a higher days sales outstanding, which slows cash inflows and raises working-capital needs.

End of lesson.

Back to MODULE 05 — Corporate Finance (renamed from Corporate Issuers)

CI 4 Working Capital and Liquidity

Overview

The Cash Conversion Cycle

The operating cycle

Defining the cash conversion cycle

Shortening the cycle

The cost of forgoing a prompt-payment discount

Working capital and its link to the cycle

Liquidity and Its Sources

Primary sources of liquidity

Secondary sources of liquidity

Drags and pulls on liquidity

Measuring liquidity with ratios

Managing Working Capital and Liquidity

Permanent versus variable current assets

Three approaches to working capital

Liquidity and short-term funding