LM: Working Capital & Liquidity
LOS 1: Define primary sources of liquidity and secondary sources of liquidity.
Liquidity management refers to the ability of a company to generate cash when required.
Sources of liquidity can be classified as:
• Primary sources are the sources of cash it uses in its normal day-to-day
operations such as collecting receivables, cash balance, working capital loan from
bank.
• Secondary sources, which provide liquidity at a higher cost than primary sources.
They include negotiating debt contracts, liquidating assets, or filing for
bankruptcy protection.
Using primary sources of liquidity does not usually result in a change in a company's
operations. On the other hand, using secondary sources of liquidity may lead to
significant changes in the company's financial structure and operations, and may indicate
that the company's financial position is deteriorating.
LOS 2: Factors That Influence a Company’s Liquidity Position.
A drag on liquidity occurs when there is a delay in cash coming into the company. Major
drags on liquidity include:
• Uncollected receivables
• Obsolete inventory
• Tight credit: Adverse economic conditions can make it difficult for companies to
arrange short-term financing.
A pull-on liquidity occurs when cash leaves the company too quickly. Major pulls on
payments include:
• Making payments early instead of waiting until the due date to make them.
• Reduced credit limits as a result of a history of not being able to make payments
on time.
LOS 3: Compare a company’s liquidity measures with those of peer companies.
Measures of a company’s short-term liquidity include:
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Current ratio = !"##$%& *+(,+*+&+$)
(!(). / 0(#1$&(,*$ )$!"#+&+$) / #$!$+2(,*$))
Quick ratio = !"##$%& *+(,+*+&+$)
Measures of how well a company is managing its working capital include:
!#$4+& )(*$)
Receivables turnover = (2$#(5$ #$!$+2(,*$)
678
Number of days of receivables = #$!$+2(,*$) &"#%92$#
!9)& 9: 5994) )9*4
Inventory turnover = (2$#(5$ +%2$%&9#;
678
Number of days of inventory =
+%2$%&9#; &"#%92$#
<"#!.()$)
Payables turnover = (2$#(5$ &#(4$ <(;(,*$)
Working Capital & Liquidity
678
Number of days of payables =
<(;(,*$ &"#%92$#
LOS 4: Define operating cycle and cash conversion cycle.
The operating cycle is a measure of the time needed to convert raw materials into cash
from a sale.
Operating cycle = days of inventory + days of receivables.
The operating cycle does not take everything into account, however, because the
available cash flow is increased by deferring payment to suppliers. This deferral is
considered in the net operating cycle, also called the cash conversion cycle. The net
operating cycle is a measure of the time from paying suppliers for materials to collecting
cash from the subsequent sale of goods produced from these supplies. It consists of the
operating cycle minus the number of days of payables:
Cash conversion cycle = days of inventory + days of receivables – days of payables.
Operating and cash conversion cycles that are high relative to a company’s peers suggest
the company has too much cash tied up in working capital.
LOS 5: Cost of trade credit.
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% 4+)!9"%&
Cost of trade credit = [1 + >?% 4+)!9"%&]$%&' )%'* $+',-./* - 1
LOS 6: Short term funding choices
The choice of short-term funding sources depends on a firm’s size and creditworthiness.
Sources available, in order of decreasing firm creditworthiness and increasing cost,
include:
• Commercial paper (issued at discount)
• Bank lines of credit
o Uncommitted
o Committed
o Revolving: line of credit with a bank, allowing the company the flexibility
to borrow and repay any amount of funds as long as the balance does not
exceed the line of credit.
• Collateralized borrowing
• Nonbank financing
• Factoring
Firms that export goods may discount banker’s acceptance.
Summary
Types of company financing are as follows:
v Internal sources:
o operating cash flows: profits from regular business,
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Working Capital & Liquidity
o accounts payable: delaying the payment to creditors increases the cash,
o accounts receivable: receiving payment from customers,
o inventory: selling inventories, and
o marketable securities: liquidating investments.
v Financial intermediaries:
o bank borrowing:
§ uncommitted line of credit
§ committed (regular) line of credit
§ revolving line of credit
o secured (asset-backed) loans,
o loans from non-bank finance companies (more expensive),
o factoring (most expensive).
v Capital markets:
o long-term debt (highest priority),
o preferred equity (next in priority),
o common equity (has a residual claim to firm cash flows and assets).
All can be either private or publicly traded. Debt that is convertible into common shares
and preferred equity that is convertible into common shares are both considered hybrid
securities, having some of the characteristics of debt and some characteristics of
common stock.
A conservative approach to working capital management involves high levels of current
assets financed with long-term debt and equity. Compared to a more aggressive approach,
a conservative approach provides more liquidity and involves less financial risk, but has a
higher financing cost and will reduce returns.
An aggressive approach to working capital management involves lower levels of current
assets and financing working capital needs with short-term debt. Compared to a more
conservative approach, an aggressive approach typically has lower financing costs and
results in higher returns, but decreases liquidity and increases financial risk.
Companies must maintain sufficient short-term borrowing capacity to meet anticipated
peak cash needs. They should also maintain some additional borrowing capacity to meet
unanticipated needs and provide the flexibility to take the advantage of investment
opportunities that may arise.
The primary consideration when choosing short-term funding sources is cost. However,
companies that rely on significant short-term borrowing should, at a minimum, use more
than one type of debt and maintain a relationship with more than one lender, as
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Working Capital & Liquidity
circumstances and market conditions can change. It is important for company managers
to keep up-to-date on the available types of short-term financing and their costs.
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