Working Capital Management

Working capital = Current assets − Current liabilities. The main components: inventory, trade receivables, trade payables, and cash.

Working capital cycle (cash operating cycle) measures the number of days between cash going OUT (to pay suppliers for inventory) and cash coming IN (from customers paying):

Where:

• Inventory days = Inventory / Cost of sales × 365 — how long inventory sits before being sold
• Receivables days = Trade receivables / Revenue × 365 — how long customers take to pay
• Payables days = Trade payables / Cost of sales × 365 — how long the business takes to pay suppliers

Example: Inventory days 60, Receivables days 45, Payables days 30. Cash operating cycle = 60 + 45 − 30 = 75 days. The business must finance 75 days of operations from its own resources.

Objectives of working capital management:

• Liquidity: Ensure sufficient cash to meet obligations as they fall due. Avoid insolvency.
• Profitability: Minimise the cost of capital tied up in working capital (inventory, receivables) — this capital has an opportunity cost
• Balance: Too little working capital = risk of stockouts, lost sales, inability to pay suppliers. Too much = capital tied up unproductively.

Key trade-off: Shortening the cycle (lower inventory, faster collection, longer payment to suppliers) RELEASES CASH but may have costs: stockouts, lost customers (if credit tightened), damaged supplier relationships.

Negative cycles (common in supermarkets, retail): if customers pay fast (cash on delivery) and suppliers are paid slowly (60-90 days), inventory days + receivables days < payables days. Suppliers effectively finance the business. Very efficient.

Industry differences:

• Manufacturing: longer cycles (lead times, raw material inventory, work-in-progress)
• Retail/supermarkets: short or negative cycles (fast inventory turnover, cash sales)
• Professional services: low inventory but long receivables (client payment cycles)
• Construction: very long cycles (long projects, delayed final payments, retentions)

Holding inventory incurs costs — but stockouts are also costly. Management seeks the optimal balance.

Costs of holding inventory:

• Financing cost — opportunity cost of capital tied up (often the dominant cost)
• Storage — warehouse space, utilities, insurance
• Handling — staff, equipment
• Deterioration and obsolescence — especially for perishables, technology, fashion items
• Theft and damage
• Insurance

Costs of stockouts:

• Lost sales (customers buy elsewhere)
• Damaged customer relationships / loss of goodwill
• Production delays (if raw materials)
• Emergency purchasing at premium prices
• Overtime / expedited shipping

Costs of ordering:

• Administrative costs (placing orders, processing receipts)
• Delivery costs (if fixed per order)
• Quality inspection on receipt

Economic Order Quantity (EOQ) model:

The EOQ minimises the sum of ordering costs and holding costs for a given annual demand.

Where:

• Co = cost of placing one order (£ per order)
• D = annual demand (units)
• Ch = holding cost per unit per year

Assumptions:

• Demand is constant and known
• Lead time is zero (or constant and known)
• Orders are placed and received in a single instant (no partial deliveries)
• No bulk discounts
• No stockouts allowed

Worked example: Annual demand 12,000 units. Cost per order £50. Holding cost £3 per unit per year.

• EOQ = √(2 × 50 × 12,000 / 3) = √400,000 = 632 units
• Number of orders per year = 12,000 / 632 ≈ 19 orders
• Average inventory = 632 / 2 = 316 units
• Annual holding cost = 316 × £3 = £948
• Annual ordering cost = 19 × £50 = £950 (approximately equal to holding cost at EOQ — a check)
• Total annual cost = £948 + £950 ≈ £1,898

EOQ with bulk discounts: If the supplier offers a price break for larger orders, compare: total annual cost at EOQ vs total annual cost at each discount quantity (including the price discount). Choose the option minimising total cost (inventory purchase + holding + ordering).

Buffer stock (safety stock):

• Extra inventory held to cover UNCERTAINTY in demand or lead time
• Higher buffer = lower stockout risk but higher holding costs
• Determined by: demand variability, lead time variability, service level target (e.g., 95% probability of no stockout), cost of stockouts vs cost of holding
• Reorder point = (Average demand × Lead time) + Buffer stock

Just-In-Time (JIT):

• Philosophy of minimising inventory — receive materials/components EXACTLY when needed for production; produce finished goods EXACTLY when demanded by customers
• Benefits: dramatically reduced inventory holding costs, less obsolescence, quality issues exposed faster, frees up capital
• Requirements: Reliable suppliers with short lead times, high-quality components, stable demand, close supplier integration, reliable transport
• Risks: supply chain disruption catastrophic (COVID-19, Suez Canal 2021, supplier bankruptcy) — NO buffer; heavy reliance on partners
• Pioneered by Toyota (Kaizen, lean manufacturing); widely adopted in manufacturing and retail

ABC (Pareto) analysis:

• Categorise inventory by annual usage value: Class A (high value, typically 20% of items accounting for 80% of value), Class B (moderate — 30% of items, 15% of value), Class C (low value — 50% of items, 5% of value)
• Apply tight controls to Class A (frequent counts, EOQ, supplier monitoring); looser controls on Class C (periodic review, bulk orders)
• Concentrates management effort where it matters most

Trade receivables represent cash tied up while waiting for customer payment. Effective receivables management balances SALES GENERATION (relaxed credit = more sales) with BAD DEBT RISK and CASH FLOW (strict credit = safer cash).

Key elements of a credit policy:

• Credit standards: who will be granted credit? Creditworthiness checks (credit references, credit bureau data, trade references, financial statements)
• Credit terms: Payment period (e.g., 30 days, 60 days), early payment discounts, late payment penalties, interest on overdue amounts
• Credit limits: Maximum exposure per customer
• Collection procedures: Invoice promptly, send statements regularly, chase overdue amounts (letters, calls, visits), legal action as a last resort, debt collection agencies
• Bad debt provisioning: Expected credit loss modelling under IFRS 9

Evaluating a proposed credit policy change:

Compare incremental benefits with incremental costs:

Benefits (of relaxing credit):

• Additional contribution from new sales: Δ Sales × Contribution margin

Costs (of relaxing credit):

• Additional financing cost of extra receivables: Δ Receivables × Cost of capital
• Additional bad debt: Δ Sales × Incremental bad debt rate
• Additional administration costs

Accept the change if net benefit > 0.

Early payment discounts (offering to customers):

If a discount is offered (e.g., "2% discount for payment within 10 days, net 30"), customers accepting will pay faster, reducing receivables days. Cost to the company: the discount itself. Benefit: cash flow released + reduced bad debts + reduced financing costs.

Worked example: A company with £5m receivables and 60-day collection period considers offering a 2% discount for payment within 15 days. Expected 70% of customers will take up the offer. Cost of capital 10%. Remaining 30% continue at 60 days.

• Current receivables: £5m (60 days)
• New receivables = (70% × 15 days + 30% × 60 days) / 60 × £5m ≈ (10.5 + 18) / 60 × £5m = £2.375m
• Reduction in receivables = £5m − £2.375m = £2.625m
• Saving on financing cost: £2.625m × 10% = £262,500 per year
• Cost of discount: Assume £30.4m annual sales (£5m × 365/60); 70% × £30.4m × 2% = £425,600 per year
• Net effect: £262,500 − £425,600 = −£163,100 (worse off)

In this case, offering the discount is not cost-effective. General rule: only offer a discount if financing savings + bad debt reductions exceed the discount cost.

Factoring and invoice discounting:

See the Business Finance topic for details. Briefly: both provide cash advances against receivables. Factoring also provides collection services (customers know the factor); invoice discounting retains control confidentially. Both typically "with recourse".

Bad debt management:

• Credit checks before extending credit — proportionate to exposure
• Credit limits and exposure monitoring
• Credit insurance (trade credit insurance) — transfer bad debt risk to insurer for a premium
• IFRS 9 expected credit loss modelling — recognise losses earlier (forward-looking)
• Write off bad debts when recovery is remote; maintain records for potential future recovery

International trade considerations:

• Currency risk — see Risk Management topic
• Country risk — political, economic, regulatory risks in customer's country
• Payment instruments: letters of credit (L/C), bills of exchange, open account, documentary collections

Trade credit from suppliers is an important source of short-term finance. Effective payables management balances:

• Use of free credit — suppliers offering 30/60/90-day terms provide interest-free finance
• Supplier relationships — paying too late damages relationships, access to supply, quality
• Discount opportunities — early payment discounts offered by suppliers
• Reputation — slow-paying reputation raises prices and may reduce credit terms offered

Key principle — take the discount if financing cost is lower than the effective discount cost. From Business Finance:

Where: d = discount %, N = net credit period (days), D = discount period (days).

Example: "2/10 net 30" → (2/98) × (365/20) = 37.2% per annum. If your financing cost is lower than 37.2%, TAKE the discount.

Supply chain finance (reverse factoring):

• Large buyer's invoices approved; financier (bank) pays the supplier early at a discount based on BUYER'S credit rating
• Supplier: paid sooner (improved cash flow), at a cost based on buyer's (better) credit
• Buyer: holds onto cash longer; pays financier on original due date
• Growing popularity; some accounting scrutiny (classification of balances as trade payables vs debt)

Managing supplier relationships:

• Pay on time (per agreed terms) — reputation is important
• Communicate proactively if late payment is unavoidable
• Pay key strategic suppliers earlier to secure better terms, priority, quality
• Consider rationalising supplier base (fewer, larger relationships — better negotiating position)
• Prompt Payment Code (UK) encourages businesses to pay SMEs promptly — 95% within 60 days; some businesses commit to 30 days
• UK Payment Practices Reporting: large companies must report payment practices twice yearly

Risks of excessive payables stretching:

• Damaged supplier relationships → priority given to other customers
• Loss of bulk discounts
• Higher prices negotiated to offset late payment risk
• Supply chain disruption if suppliers fail (they depend on being paid)
• Reputational damage (publicly reported payment practices)
• Eventually, some suppliers may refuse to supply on credit (COD only)

Cash is the most liquid but least productive asset — earning low (or no) returns. Excessive cash is inefficient; insufficient cash risks insolvency. Optimal cash management minimises the total cost.

Motives for holding cash (Keynes):

• Transactional: Day-to-day payments to employees, suppliers, tax authorities
• Precautionary: Buffer against unexpected outflows (machine breakdown, customer default, market downturn)
• Speculative: Available for investment opportunities (acquisitions, favourable market conditions)

Cash budgets:

• Detailed monthly (or weekly) forecast of cash receipts and payments
• Shows expected cash balance at each period end
• Identifies financing needs (overdraft peaks) or surpluses (investment opportunities)
• Key inputs: sales forecasts with timing of receipts (allowing for credit periods), purchase forecasts, payroll, tax payments, capital expenditure, dividends, interest, debt repayments
• Used to: negotiate overdraft facilities, schedule investments, manage short-term surpluses

Baumol model (cash as an inventory problem — EOQ-style):

Assumes STEADY, PREDICTABLE cash outflows. Cash is replenished periodically by selling marketable securities or drawing from an account. Trade-off: cost of converting securities/transferring funds (order cost) vs opportunity cost of holding cash (= forgone interest on securities).

Where:

• F = fixed cost per transfer (transaction cost of converting securities to cash)
• T = total cash needed in the period (e.g., annual)
• K = opportunity cost of holding cash (interest rate foregone per period)

Average cash balance = Q*/2. Number of transfers = T/Q*.

Worked example: Annual cash requirement £1.2m (assumed steady). Transfer cost £25 per transaction. Interest rate on securities 5%.

• Q* = √(2 × 25 × 1,200,000 / 0.05) = √(1,200,000,000) = £34,641
• Average cash balance = £34,641 / 2 = £17,321
• Number of transfers per year = £1,200,000 / £34,641 ≈ 35 transfers
• Annual cost: transfer cost 35 × £25 = £866; opportunity cost £17,321 × 5% = £866 (equal at optimum)
• Total annual cost ≈ £1,732

Baumol limitations:

• Assumes STEADY, PREDICTABLE cash outflows — unrealistic in practice
• Only models cash outflows — doesn't capture the reality of cash also coming IN unpredictably
• Rigid assumptions — not useful for most real businesses

Miller-Orr model (stochastic cash flows — more realistic):

Assumes cash flows are random (unpredictable). Sets three levels:

• Lower limit (L): Set by management (can be zero or a positive floor)
• Return point (Z): Target cash balance
• Upper limit (H): When cash balance hits this, invest excess in securities to return to Z

When cash reaches L: sell securities to return to Z. When cash reaches H: invest excess to return to Z. Within [L, H], let cash fluctuate naturally.

Where:

• F = transaction cost of converting securities/cash
• σ² = variance of daily cash flows
• K = daily interest rate (opportunity cost)

Example: Variance of daily cash flows £500,000 (so σ = £707). Transaction cost £25. Annual interest rate 5%, so daily K ≈ 0.000137. Lower limit L = £5,000.

• Spread (Z − L) = (3 × 25 × 500,000 / (4 × 0.000137))^(1/3) = (6.84 × 10¹⁰)^(1/3) ≈ £4,091
• Z = £5,000 + £4,091 = £9,091
• H = 3 × £9,091 − 2 × £5,000 = £27,273 − £10,000 = £17,273
• Average cash balance = (4 × £9,091 − £5,000) / 3 = £31,364 / 3 = £10,455

Intuition: Miller-Orr gives a range [£5,000 − £17,273] within which cash fluctuates. Outside this range, trigger a transaction to return to £9,091. Unlike Baumol, this handles UNPREDICTABLE cash flows.

Factors affecting the limits:

• Higher volatility (σ²) → wider spread (more uncertainty)
• Higher transaction cost → wider spread (fewer transactions)
• Higher interest rate → narrower spread (more incentive to invest idle cash)

Overtrading (also called "undercapitalisation" or "spiralling") occurs when a business tries to support a LEVEL OF SALES GREATER THAN ITS WORKING CAPITAL RESOURCES can sustain. It's a classic problem for RAPIDLY GROWING businesses, especially SMEs.

The mechanism:

1. Business wins new orders, grows rapidly
2. Needs more inventory to fulfil orders → cash outflow
3. Receivables grow in proportion to sales → cash "stuck" in customers
4. Must invest in additional capacity (staff, equipment) → further cash outflow
5. But profits on additional sales take time to come through (and even then, part is working capital reinvestment)
6. Cash runs out → cannot pay suppliers, wages, tax → liquidity crisis
7. Even though the business is PROFITABLE on an accruals basis, it runs out of CASH and may fail

Symptoms of overtrading:

• Rapid increase in sales (20%+ per year)
• Increased reliance on short-term finance (overdraft, trade credit stretching)
• Deteriorating liquidity ratios (current ratio falling, quick ratio particularly)
• Lengthening cash conversion cycle — particularly receivables days growing
• Declining profit margins (discounts given to win business, inefficiencies from rushing)
• Increasing bad debts (as credit standards are relaxed to grow)
• Payables days extending (cannot pay suppliers on time)
• Difficulty meeting payroll, tax payments
• Suppliers refusing credit; insisting on cash terms

Solutions to overtrading:

Key insight: Overtrading is a CASH problem, not a PROFIT problem. Profitable businesses can fail from liquidity issues. Cash management is as important as profit generation — often more so for SMEs and rapidly-growing businesses.

Working capital can be split into two components:

• Permanent working capital: the minimum amount always needed (core inventory, base receivables, minimum cash)
• Fluctuating working capital: seasonal or cyclical requirements above the baseline

Three financing policies differ in how these components are financed:

1. Aggressive policy:

• SHORT-TERM finance used for ALL fluctuating working capital AND SOME permanent working capital
• Higher reliance on short-term sources (overdraft, trade credit, short-term loans)
• Advantage: Short-term finance is CHEAPER (yield curve typically upward-sloping)
• Disadvantage: Higher LIQUIDITY RISK — if short-term facilities are withdrawn or not renewed, the business is in trouble. Also exposed to interest rate rises
• Best suited to: stable economic conditions, strong cash generation, large companies with robust banking relationships

2. Conservative policy:

• LONG-TERM finance used for ALL working capital — permanent AND fluctuating
• When fluctuating demand is low, excess cash is invested in short-term securities
• Advantage: LOW LIQUIDITY RISK — stable, long-term financing. Minimises refinancing risk
• Disadvantage: More EXPENSIVE — long-term finance typically has higher interest rates; also paying interest on financing that isn't always needed
• Best suited to: volatile environments, businesses that value stability, investment-grade companies with strong balance sheets, capital-intensive businesses

3. Moderate (matching) policy:

• LONG-TERM finance for PERMANENT working capital; SHORT-TERM finance for FLUCTUATING working capital
• "Matching" principle — match the maturity of assets with the maturity of financing
• Advantage: Balance of cost and risk. Appropriate match of timing — fluctuating assets financed by fluctuating sources
• Middle-ground approach — most common in practice

Visual:

Choice of policy depends on:

• Risk appetite: conservative for risk-averse; aggressive for risk-tolerant with strong cash generation
• Cost of capital: if yield curve is steep (big gap between short and long rates), aggressive is relatively more attractive
• Volatility of cash flows: volatile cash flows favour conservative (buffer against surprises)
• Economic cycle: recession/uncertainty → conservative; boom/stability → aggressive
• Access to credit: strong relationships with banks → aggressive feasible; weak access → must be conservative
• Industry norms: some industries (e.g., utilities with steady cash flows) can be more aggressive