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
Working capital management is primarily concerned with:
- current assets and current liabilities — correct
- property, plant and other fixed assetsWhy not: Long-lived assets, handled through capital budgeting rather than working capital management.
- long-term debt and equity issuanceWhy not: A capital structure decision, made over a horizon of years rather than weeks.
It is about the short-term resources that fund day-to-day operations, not the long-term financing decision.
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.
Less time between paying suppliers and collecting from customers means less financing needed to run the same volume of business.
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
Supplier financing is not free even when it carries no explicit interest — it is paid for in pricing and in the reliability of supply.
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