05/08/2023

CORPORATE ISSUERS
• READING 1: ORGANIZATIONAL FORMS, CORPORATE ISSUER FEATURES, AND OWNERSHIP
• READING 2: INVESTORS AND OTHER STAKEHOLDERS
• READING 3: CORPORATE GOVERNANCE: CONFLICTS, MECHANISMS, RISKS AND BENEFITS
• READING 4: WORKING CAPITAL AND LIQUIDITY
• READING 5: CAPITAL INVESTMENTS AND CAPITAL ALLOCATION
• READING 6: CAPITAL STRUCTURE
• READING 7: BUSINESS MODELS

READING 4
WORKING CAPITAL AND LIQUIDITY
• MODULE 4.1: CASH CONVERSION CYCLE
• MODULE 4.2: LIQUIDITY
• MODULE 4.3: MANAGING WORKING CAPITAL AND LIQUIDITY

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MODULE 4.1: CASH CONVERSION CYCLE

• Short-term Asset:
o Accounts receivable:
 Represent the amounts owed to a company from customer sales it has made on credit.
 Typically an important source of cash over the short term.
o Selling inventory:
 Generates funds, and there is a cost to having funds invested in inventory.
 Firms attempt to shorten production times and the time between getting goods ready for sale and the actual sales.
 On the other hand, carrying too little inventory may result in lost sales when orders cannot be filled immediately.
• Short-term Liability:
o Accounts payable:
 Represent the amounts a company owes to its suppliers.
 Delaying payment of accounts payable increases the cash a company has available, but doing so may have explicit costs.
 Credit terms offer a discount for earlier payment. Terms of “2/15 net 45,” mean that if an invoice is paid within 15 days, the
customer receives a 2% discount. The full amount of the invoice must be paid within 45 days.

MODULE 4.1: CASH CONVERSION CYCLE

• Receivables turnover: measure of accounts receivable liquidity.
receivables turnover =

• Number of days of receivables (average days’ sales outstanding): the average number of days it takes for the company’s
customers to pay their bills.
number of days of receivables = =

o A collection period that is too high might mean that customers are too slow in paying their bills, which means too much capital is
tied up in assets.
o A collection period that is too low might indicate that the firm’s credit policy is too rigorous, which might be hampering sales.
• Inventory turnover: measure of a firm’s efficiency with respect to its processing and inventory management.
inventory turnover =

• Number of days of inventory (Average inventory processing period): the average time a company keeps its inventory before it is
sold.
number of days of inventory = =

o A processing period that is too high might mean that too much capital is tied up in inventory and could mean that the inventory
is obsolete. A processing period that is too low might indicate that the firm has inadequate stock on hand, which could hurt
sales.

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MODULE 4.1: CASH CONVERSION CYCLE

• Payables turnover ratio: measure of the use of trade credit by the firm.
payables turnover =

• Number of days of payables (payables payment period): the average amount of time it takes the company to pay its bills.
number of days of payables = =

• Operating cycle: the average number of days that it takes to turn raw materials into cash proceeds from sales.
operating cycle = days of inventory + days of receivables
• Net operating cycle (cash conversion cycle): the length of time it takes to turn the firm’s cash investment in inventory back into
cash, in the form of collections from the inventory sales.
Cash conversion cycle = days of receivables + days of inventory – days of payables
o High cash conversion cycles are considered undesirable. A conversion cycle that is too high implies that the company has an
excessive amount of investment in working capital.
• Working capital = current assets - current liabilities.
• Net working capital = current assets, excluding cash and marketable securities – current liabilities, excluding short-term and
current debt
o To control for size and for comparability across firms, total or net working capital is often expressed as a percentage of annual
sales.

MODULE 4.2: LIQUIDITY

• Liquidity: ability to meet short-term liabilities.
• Primary sources of liquidity: the sources of cash it uses in its normal day-today operations.
o Cash and marketable securities on hand: could be sold quickly without significant loss of value.
o Borrowings: from banks, bondholders, or suppliers’ trade credit.
o Cash flow from the business: though it takes time to generate, is a substantial source of liquidity for profitable firms.
o Cash and securities on hand and borrowings are an important source of liquidity in the short run, an issuer’s cash flow from its
business is the primary long-term source of liquidity.
o Using its primary sources of liquidity is unlikely to change the company’s normal operations.
• Secondary sources of liquidity:.
o Suspending or reducing dividends to shareholders.
o Delaying or reducing capital expenditures.
o Issuing equity.
o Renegotiating contract terms.
o Selling assets.
o Filing for bankruptcy.
o Resorting to secondary sources of liquidity can change the company’s financial structure and operations significantly and may
indicate that its financial position is deteriorating.

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MODULE 4.2: LIQUIDITY

• Liquidity position improves if firms can get cash to flow in more quickly and flow out more slowly.
• Drags on liquidity: delay or reduce cash inflows, or increase borrowing costs. (uncollected receivables and bad debts, obsolete
inventory and borrowing constraints).
• Pulls on liquidity: accelerate cash outflows. (making payments early, reduced credit limits, limits on short-term lines of credit and
low liquidity positions).
• Current ratio: the best-known measure of liquidity.
current assets
current ratio =
current liabilities
o The higher the current ratio, the more likely it is that the company will be able to pay its short-term bills.

• Quick ratio (acid-test ratio): a more stringent measure of liquidity because it does not include inventories and other assets that
might not be very liquid.
cash + short − term marketable securities + receivables
quick ratio =
current liabilities

• Cash ratio: compares cash and short-term marketable securities with current liabilities and is the most conservative

cash + short − term marketable securities

cash ratio =
current liabilities

MODULE 4.3: MANAGING WORKING CAPITAL AND LIQUIDITY

• Liquidity in the form of cash and equivalents is important for managing day-to-day fluctuations in cash outflows.
• A company’s working capital needs depend largely on the nature of its business.
• Companies have some latitude in how they manage working capital. The basic trade-off is between greater financial flexibility
(conservative) and greater return on assets (aggressive).
• Approaches to financing working capital (i.e., short-term funding) also range from conservative to aggressive.
o Financing current assets with equity or long-term debt is more conservative because the costs tend to be stable and predictable.
o Financing with short-term debt is more aggressive in that it brings a risk that renewed financing may become difficult to obtain
or unavailable.
o A moderate working capital approach strikes a balance between the use of long-term financing for more permanent current
asset needs and short-term debt for variable needs.
• A company’s short-term funding plan should ensure that it maintains sufficient borrowing capacity to meet its ongoing needs.
• The primary consideration when choosing a strategy for short-term funding is cost.
• Even companies that rely primarily or exclusively on one particular type of funding may find it advantageous to work with more
than one lender.
• Companies that rely on significant short-term financing should use more than one type of financing and multiple lenders for a given
type of financing, because markets and lender circumstances can change over time, sometimes suddenly.
• Maintaining excess funding for unforeseen events or to take advantage of business opportunities is also an important
consideration. Ensuring access to funds may increase borrowing costs.

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READING 4: WORKING CAPITAL AND LIQUIDITY

Question 1: A firm has average days of receivables outstanding of 22 compared to an industry average of 29 days. An analyst would
most likely conclude that the firm:
A. may have credit policies that are too strict.
B. has a lower cash conversion cycle than its peer companies.
C. has better credit controls than its peer companies.

Question 2: Liquidating short-term assets and renegotiating debt agreements are best described as a firm's:
A. primary sources of liquidity.
B. pulls and drags on liquidity.
C. secondary sources of liquidity.

Question 3: The Lucor Corporation is seeking to raise liquidity and is evaluating two potential actions
Option 1 Selling accounts receivable to a financial intermediary at a 5% discount off their carrying value
Option 2 Accelerating payments to suppliers to receive a 5% discount
Which of the options would achieve Lucor’s objective?
A. Option 1.
B. Option 2.
C. Neither, because they both incur liquidation costs.