Working capital: policy and measurement

CIMA-F1 · Chapter 17

Working capital: policy and measurement

1 What is working capital?

Working capital is the capital tied up in the day-to-day operations of the business: its current assets (inventory, trade receivables and cash) less its current liabilities (principally trade payables).

Working capital = Current assets − Current liabilities

The ability of a company to pay its obligations as and when they fall due is its liquidity, and liquidity is the central concern of anyone assessing a company’s short-term position. A working capital surplus – current assets exceeding current liabilities – provides a cushion: it shows by how much the current assets could shrink in value and still leave enough, once converted into cash, to pay the current liabilities.

There is no single ‘right’ amount of working capital. It varies from industry to industry and company to company:

A business with a short production and sales cycle – a supermarket, buying and selling fast-moving goods for cash – functions satisfactorily with very little working capital (often negative: its payables exceed its inventory and receivables).
A business with a long production cycle – heavy engineering, say – carries months of inventory and work-in-progress and sells on credit, so it needs a much larger investment in working capital.

The nature of the company’s trade and the quality of its current assets must therefore always be considered before judging whether its working capital is adequate.

The first recording predates the 2027 syllabus and needs one correction; the other two need light wording changes only.

Introduction to working capital: where the lecture first calls high working capital — generous inventory, long credit for customers, prompt payment to suppliers — an aggressive policy, that is the conservative policy, and its cost is lower profitability. The aggressive policy cuts working capital to raise profitability at more risk (see “Working capital policy: how much to invest”). Current assets include cash, and payables are a current liability, not a fluctuating current asset.

Measuring working capital: “stock” is inventory, the “asset test” is the acid test, and “operations” is CIMA’s Operational level. The twelve ratio formulae in these notes appear on neither recording.

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2 Working capital policy: how much to invest

Managing working capital means striking a balance for each element:

Inventory must be high enough to meet customer demand, but every extra unit held adds holding costs.
Receivables arise because credit terms win sales, but the longer cash collection takes, the greater the financing cost and the risk of irrecoverable debts.
Payables provide free finance, but stretching suppliers too far loses goodwill – and possibly the supply itself.

A high overall level of working capital lets the business respond to any change in demand, but holding a lot of inventory, receivables and idle cash is expensive and depresses profitability. A low level is cheap and improves profitability – until demand shifts and the business cannot respond, or a payment falls due that it cannot meet. Every business therefore adopts a position on the risk/return spectrum, usually described as one of two policies:

Conservative – reduce risk by holding high levels of working capital: high finished-goods inventory, generous customer credit terms, prompt payment to suppliers. The cost is unproductive assets, a higher financing cost and potential cash flow strain from paying out before collecting in.
Aggressive – cut the investment to raise profitability: minimal inventory, tight credit control, and payment to suppliers delayed as long as relationships allow. The cost is risk – of stock-outs, of lost customer goodwill, and of supplier relationships breaking down.

A moderate policy sits between the two. None of the three is ‘correct’ – the choice should follow the volatility of the business’s demand and the reliability of its cash flows.

3 Financing working capital

A separate policy decision is how the investment in current assets should be financed – with short-term finance (cheaper, but repayable quickly and less certain) or long-term finance (more expensive, but secure). To frame the decision, split the current assets into two layers:

Permanent current assets – the core level of investment that is always present: buffer inventory, the normal underlying level of receivables, a minimum cash balance. Although the individual items turn over constantly, the level is as permanent as a machine.
Fluctuating current assets – the seasonal and month-to-month swings above that core level.

Non-current assets are financed long term as a matter of course. The policy question is where to draw the financing line through the current assets:

Conservative – mostly long-term finance: it funds the permanent current assets and most of the fluctuating layer too, with short-term borrowing used only at the peaks. Low liquidity risk, but expensive – at quiet times the business is paying for long-term finance it is not using (and may hold surplus cash).
Aggressive – mostly short-term finance: it funds all the fluctuating layer and part of the permanent current assets. Cheap and flexible, but the business is permanently dependent on finance that could be withdrawn – an increased risk of liquidity problems.
Moderate (matching) – the duration of the finance matches the life of the asset: permanent current assets are funded long term, fluctuating current assets short term. This is the position shown by the dashed line in the diagram.

4 Measuring working capital: the liquidity ratios

Ratios let us judge whether a business is holding too much or too little working capital, and compare it over time and against other companies. Two ratios measure overall liquidity.

4.1 Current ratio

Current ratio = Current assets ÷ Current liabilities

A current ratio above 1 means current assets exceed current liabilities, suggesting the business can meet its short-term obligations as they fall due; around 1.6–1.7 is typical of many industries. But there are no hard and fast rules. Supermarkets run happily below 1 (little inventory, almost no receivables, powerful credit terms from suppliers) without being illiquid. Interpret the ratio, and its trend, with care:

Asset quality. A rising ratio may reflect a build-up of unsaleable inventory or overdue receivables – assets that will not readily convert into cash – while a falling ratio may simply reflect greater efficiency.
Seasonality. In a seasonal business the ratio moves through the year with the levels of inventory, receivables and payables, so a change may say more about the date of the statement of financial position than about liquidity.

4.2 Quick ratio (acid test)

Quick ratio = (Current assets − Inventory) ÷ Current liabilities

The quick ratio removes inventory – the least liquid current asset, since it must first be sold (perhaps on credit) before it produces cash – and so measures the cover for current liabilities from quick assets only. Comparing the two ratios is itself informative: if the current ratio is rising faster than the quick ratio, inventory levels must be building up.

Liquidity ratios

Ariel has the following balances under current assets and current liabilities:

	$
Current assets
Inventory	50,000
Trade receivables	70,000
Bank	10,000
Current liabilities
Trade payables	88,000
Interest payable	7,000

Calculate the current ratio and the quick ratio.

Liquidity ratios

Current assets = 50,000 + 70,000 + 10,000 = $130,000; current liabilities = 88,000 + 7,000 = $95,000.

Current ratio = 130,000 ÷ 95,000 = 1.37:1

Quick ratio = (70,000 + 10,000) ÷ 95,000 = 0.84:1

Current assets comfortably cover current liabilities, though quick assets alone do not – Ariel is relying on selling its inventory in time to meet its obligations. Whether that is a concern depends on the industry and on how fast the inventory turns over; the bank balance of $10,000 (rather than an overdraft) is reassuring.

5 Measuring the elements: the efficiency ratios

Three further ratios measure how efficiently each element of working capital is being used, each expressed as a number of days. Each takes a statement of financial position figure and divides it by the related figure from the statement of profit or loss, annualised over 365 days. (If the period is six months, use 182.5 days, and so on – exam questions can be picky here.)

5.1 Inventory days

Inventory days = (Inventory ÷ Cost of sales) × 365

How long goods sit in inventory before being sold. Rising inventory days may signal obsolete or unsaleable inventory building up – but could also be a deliberate purchase of raw materials ahead of a price rise. Falling days usually indicate faster selling (possibly helped by discounts) or cheaper buying.

5.2 Trade receivables collection period (receivables days)

Receivables days = (Trade receivables ÷ Credit sales) × 365

How long, on average, credit customers take to pay. Strictly the denominator should be credit sales – use total revenue only when cash sales are negligible or no split is given. Provided sales arise evenly over the year, an increase in receivables days indicates less effective collection: customers may be taking (or being given) longer to pay, or the balance may include long-outstanding debts that should be provided against – with the associated financing cost and irrecoverable-debt risk.

5.3 Trade payables payment period (payables days)

Payables days = (Trade payables ÷ Credit purchases) × 365

How long the company takes to pay its suppliers (use cost of sales as the denominator when purchases are not given). A rise means more reliance on suppliers for finance – deliberate, or a symptom of liquidity trouble. A fall may mean settlement discounts are being taken (which slightly improves profitability through discounts received), or that suppliers have tightened their terms because of doubts about the company’s creditworthiness.

Efficiency ratios

Extracts from a company’s trial balance at the end of its financial year are given below:

	$’000
Sales revenue (85% on credit)	2,600
Cost of sales	1,800
Purchases (90% on credit)	1,650
Inventory of finished goods	220
Trade receivables	350
Trade payables	260

Calculate the following working capital ratios:

(i) Inventory days

(ii) Trade receivables days

(iii) Trade payables days

Efficiency ratios

Inventory days = (220 ÷ 1,800) × 365 = 44.6 days

Receivables days = (350 ÷ (85% × 2,600)) × 365 = 57.8 days

Payables days = (260 ÷ (90% × 1,650)) × 365 = 63.9 days

Note that receivables days uses credit sales (85% × 2,600 = 2,210) and payables days uses credit purchases (90% × 1,650 = 1,485), because the information to make the split is given. These three figures combine into the cash operating cycle below: 44.6 + 57.8 − 63.9 = 38.5 days.

6 The cash operating cycle

The cash operating cycle (also called the working capital cycle) is the length of time between paying out cash for raw materials, wages and other inputs and receiving the cash back from the sale of the goods – in other words, the number of days the business is out of pocket on each round of trading.

Cash operating cycle = Inventory days + Receivables days − Payables days

In the timeline above, goods are bought on day 0 and sold on day 70 (inventory days 70), the customer pays 35 days after the sale (receivables days 35), and the supplier is paid on day 40 (payables days 40). Cash is out of the business from day 40 to day 105: 70 + 35 − 40 = 65 days.

A lengthening cycle means cash is being recovered more slowly – inventory sticking, customers slowing down, or suppliers being paid faster – and it is a classic early warning of cash flow problems. Management shortens the cycle through the techniques of Chapter 18: tighter inventory control, faster collection from customers and full use of supplier credit terms.

A large retailer can have a negative cycle: it sells goods for cash within days but pays its suppliers weeks later, so the suppliers are financing the business. That is not a liquidity problem – it is supplier power at work (with some ethical questions attached).

Working capital requirement

An extract from a company’s statement of profit or loss for the year:

	$’000
Revenue	250
Gross profit	90

The elements of the operating cycle have been measured as:

Inventory	68 days
Receivables	88 days
Payables	114 days

Calculate the investment in working capital.

Working capital requirement

Each ‘days’ ratio is a statement of financial position figure divided by an annual profit or loss figure, times 365. Rearranging gives the balance: days ÷ 365 × the annual figure. Cost of sales = 250,000 − 90,000 = $160,000 (used for both inventory and payables, as purchases are not given separately).

	$
Inventory: 68/365 × 160,000	29,808
Receivables: 88/365 × 250,000	60,274
Payables: 114/365 × 160,000	(49,973)
Investment in working capital	40,109

The receivables balance is built from revenue (sales are what customers owe), while inventory and payables are built from cost. Payables are deducted – supplier credit reduces the net investment the company itself must finance.

Working capital = current assets − current liabilities. Policy sets how much to invest (conservative vs aggressive) and how to finance it (long-term vs short-term, against permanent and fluctuating current assets). It is measured by the current and quick ratios, the three ‘days’ ratios, and the cash operating cycle – inventory days + receivables days − payables days – which tells you how long each pound of trading cash is tied up.

7 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.

Answer the questions one at a time. Your progress is saved so you can leave and come back.

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