Unit 8: Working Capital Management


8a. Illustrate the objectives of working capital management

  • What is working capital?
  • How do you define a current asset?
  • What is a current liability?
  • What are the tradeoffs involved when managing working capital?

Working capital is defined as current assets minus current liabilities. Current assets are expected to be sold or used up in the next year or operating cycle. Examples of current assets include cash, accounts receivable, and inventory. Current liabilities are debts that must be paid in the next year or operating cycle. Current liabilities include accounts payable, wages payable, and short-term debt.

Working capital is a measure of liquidity (whether a company has enough short-term assets available to pay expected short-term obligations). Current assets generally don't earn a high return, so companies try to ensure they have enough to pay their short-term obligations, but not too much, so they lose earnings potential. Having too little working capital can mean that a company cannot meet its short-term obligations. However, having too much can mean assets are not being invested as productively as possible.

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8b. Explain the principles of cash management

  • What is cash management?
  • Why is it important for a company to have cash on hand?
  • Why is the cash conversion cycle important?

Cash management refers to the process of collecting, managing, and (short-term) investing a company's cash to ensure it has enough liquidity to meet its obligations while optimizing returns on any excess cash.
Companies need cash on hand to meet their financial obligations, including paying their vendors, paying their employees, and reacting to emergencies. However, since cash is a relatively low-earning asset, companies do not want to maintain cash reserves that are too high and could be invested into higher-earning assets. Managing cash involves balancing the tradeoff between liquidity and earnings.

The cash conversion cycle (CCC) is the time between when a firm collects cash from customers and has to pay out cash related to the purchase of inventory or inputs of production. By managing this process, a company aims to minimize the amount of earnings tied up in cash. Some strategies for improving the cash conversion cycle include speeding up the collection of funds and slowing down the disbursement of funds. A shorter CCC means the firm converts resources into cash faster. It helps firms avoid liquidity issues and maintain smooth operations. CCC shows how well the company is managing inventory, receivables, and payables. It also signals efficiency in the supply chain, credit policy, and cash management.

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8c. Identify the sources of short-term financing for a firm

  • What is short-term financing, and how does it differ from long-term financing?
  • Why do firms need short-term financing?
  • What are the main sources of short-term financing for a business?

Short-term financing is any funding option a firm uses to meet its operational needs and obligations due in the short term, usually within 12 months. Short-term financing is quick, flexible, and used for day-to-day needs, while long-term financing is geared toward strategic investments and growth. A balanced mix of both helps firms remain liquid while pursuing expansion.

Firms need short-term financing to cover working capital gaps, finance inventory purchases, handle unexpected expenses, take advantage of discounts, fund seasonal or cyclical fluctuations, maintain liquidity and creditworthiness, and avoid selling long-term assets.

Firms that need cash to cover short-term obligations have a variety of products available to obtain funds. They can borrow money with short-term loans such as overdrafts, credit cards, payday loans, and money market loans. They can also factor their accounts receivable, which involves selling their accounts receivable to a third party at a discount. Companies can also issue commercial paper to meet their short-term obligations.

Commercial paper is a short-term money market instrument that can provide a cheaper source of financing for the company and increased returns for the investor. Companies can also use trade credit, which involves using the accounts payable from their suppliers.

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8d. Identify factors involved in setting inventory management policies

  • What are the different types of inventory?
  • What are the different types of inventory accounting techniques?
  • What factors are involved in deciding the appropriate inventory levels?

Inventory in manufacturing organizations is divided into raw materials, works in process, and finished goods.

Raw materials are materials used in making a product. Works in process are units that are started but not completed. Finished goods are goods completed and ready to sell to the customer. Companies can account for their inventory using LIFO, FIFO, or the average cost method. The last-in, first-out (LIFO) method of inventory accounting where the latest purchase price is used to calculate the cost of goods sold (COGS). With first-in, first-out (FIFO), the oldest purchase price is used to calculate the COGS.

The average cost method takes a weighted average of all the inventory purchases and calculates the COGS using that average. The choice of accounting technique can influence the reported COGS on the income statement and the balance of inventory on the balance sheet.

When determining the appropriate amount of inventory to hold, companies must consider their demand, seasonality, economies of scale, cost pressures, and perishability, among other factors. Companies generally want to have enough inventory on hand to service customers, but do not want to tie up excess funds in inventory or risk obsolescence or spoilage. One method businesses use to determine the appropriate level of inventory to hold is the economic order quantity (EOQ) technique. The EOQ is the order quantity that minimizes total inventory holding costs and ordering costs.

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Unit 8 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • average cost method
  • cash conversion cycle (CCC)
  • cash management
  • commercial paper
  • current asset
  • current liability
  • economic order quantity (EOQ) technique
  • factor
  • finished good
  • first-in, first-out (FIFO)
  • last-in, first-out (LIFO)
  • liquidity
  • raw material
  • short-term financing
  • trade credit
  • working capital
  • work in process
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