## **Learning Outcomes**

This article explains how to analyze and manage working capital in an exam setting, including:

- analyzing a company’s working capital position using the composition and trends of current assets and current liabilities;
- calculating, interpreting, and comparing cash conversion cycles, and linking changes in CCC to operational efficiency and short-term funding needs;
- evaluating liquidity with current, quick, and cash ratios, and reconciling ratio signals with qualitative information from the case vignette;
- distinguishing conservative, moderate, and aggressive working capital management policies, and explaining their risk-return trade-offs;
- assessing primary and secondary sources of liquidity, and identifying specific drags and pulls that threaten a firm’s cash position;
- determining how credit terms, inventory policies, and receivables management decisions alter liquidity ratios, the CCC, and reliance on external financing;
- connecting working capital choices to broader capital structure and payout decisions, including effects on debt levels, refinancing risk, and financial flexibility;
- applying these concepts to typical CFA Level 1 item sets by diagnosing liquidity problems and recommending policy adjustments consistent with firm objectives.

## **CFA Level 1 Syllabus**

For the CFA Level 1 exam, you are expected to understand how companies manage working capital, how this affects liquidity and short-term financing needs, and how working capital policies interact with capital structure and payout decisions, with a focus on the following syllabus points:

- Define and interpret components of working capital (current assets and liabilities)
- Calculate and analyze the cash conversion cycle and its elements
- Evaluate liquidity using the cash ratio, quick ratio, and current ratio
- Compare conservative, moderate, and aggressive working capital management strategies
- Identify primary and secondary sources of liquidity, as well as drags and pulls
- Understand how working capital management shapes capital structure decisions

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. Which action will **decrease** a firm’s cash conversion cycle?
2. What is the difference between conservative and aggressive working capital management?
3. Why might a company forgo a supplier’s prompt-payment discount to address a short-term cash need?
4. Define a liquidity “drag” and give one example.

## **Introduction**

Efficient working capital management is fundamental for financial stability and value creation. Companies must balance the investment in current assets with the financing of current liabilities to avoid liquidity crunches and minimize the cost of capital. Understanding how to analyze the cash conversion cycle and evaluate liquidity plays a central role in financial analysis, directly impacting payout policy and the firm’s capital structure.

> **Key Term: working capital**
> The difference between a company's current assets and current liabilities; a measure of short-term financial health and efficiency.
>
> **Key Term: cash conversion cycle**
> The number of days it takes for a company to convert an investment in inventory back into cash, calculated as days of inventory on hand plus days sales outstanding minus days payable outstanding.

## Working Capital: Definition and Components

Working capital consists of short-term assets (like cash, receivables, and inventory) minus short-term liabilities (like payables and accrued expenses). Net working capital excludes non-operating current items (such as cash, marketable securities, and short-term debt not tied to operations). The management of working capital aims to ensure liquidity while minimizing idle resources.

> **Key Term: net working capital**
> Current assets (excluding non-operating assets) minus current liabilities (excluding non-operating liabilities); isolates working capital tied directly to business operations.

## The Cash Conversion Cycle

The **cash conversion cycle (CCC)** measures the speed with which a company turns cash into inventory and receivables, and then back into cash via sales and collection. It is an indicator of operational efficiency and short-term funding requirements.

**Formula:**

Cash conversion cycle = Days of Inventory on Hand + Days Sales Outstanding – Days Payable Outstanding
A shorter CCC means less time capital is tied up; a longer CCC puts pressure on liquidity and may require short-term borrowing.

### **Worked Example 1.1**

**Question:**  
Retailer A has an average of 45 days sales outstanding (DSO), 40 days of inventory on hand (DOH), and 35 days payable outstanding (DPO). Calculate the cash conversion cycle and interpret the result.

> **Answer:**
> CCC = 40 + 45 – 35 = 50 days. Retailer A ties up cash in operations for 50 days before recovering it. A shorter CCC would improve liquidity and reduce short-term financing needs.

## Liquidity Ratios: Current, Quick, and Cash

Liquidity is a core concern for analysts, as it signals a company’s ability to meet short-term obligations. The standard metrics are:

- **Current ratio** = Current assets / Current liabilities
- **Quick ratio** = (Cash + Short-term marketable instruments + Receivables) / Current liabilities
- **Cash ratio** = (Cash + Short-term marketable instruments) / Current liabilities

A current ratio above 1 indicates more current assets than current liabilities, but the quick and cash ratios more conservatively assess immediate payment capacity.

> **Key Term: current ratio**
> Ratio of current assets to current liabilities; a basic measure of short-term liquidity.
>
> **Key Term: quick ratio**
> Ratio of liquid assets (excluding inventory) to current liabilities; reflects ability to meet obligations without selling inventory.
>
> **Key Term: cash ratio**
> Ratio of cash and near-cash assets to current liabilities; measures ability to pay short-term debts with available cash.

### **Worked Example 1.2**

**Question:**  
Firm B has cash of \$40, receivables of \$80, inventory of \$90, and payables, accruals, and short-term debt totaling \$150. Calculate the quick and cash ratios.

> **Answer:**
> Quick ratio = (40 + 80) / 150 = 0.80  
> Cash ratio = 40 / 150 = 0.27  
> Firm B may face liquidity risk if creditors demand immediate payment.

## Working Capital Management Strategies

Approaches range from **conservative** (large buffer of liquid assets, more long-term financing) to **aggressive** (minimal cash and inventory, heavier use of short-term debt). Each strategy involves tradeoffs:

- Conservative: Lower risk of cash shortfall, higher financing costs (from long-term funds).
- Aggressive: Lower financing costs, but higher risk—firm may need to sell assets, delay payments, or use expensive credit during a liquidity crunch.

> **Key Term: conservative working capital policy**
> Strategy maintaining high levels of current assets and relying more on long-term financing; prioritizes liquidity and stability over cost.
>
> **Key Term: aggressive working capital policy**
> Strategy with minimal current assets relative to sales and greater reliance on short-term financing; seeks efficiency but increases liquidity risk.

## Liquidity Sources and Management

**Primary sources** of liquidity include cash, cash receipts from customers, and available credit lines. Firms can often obtain cash by managing working capital more efficiently—by collecting receivables faster or delaying payables.

**Secondary sources** may be required in a crisis: asset sales, equity issuances, or renegotiation of contracts. These sources are usually more expensive, may dilute shareholders, and signal distress.

> **Key Term: drag on liquidity**
> Any factor that slows cash inflows, such as uncollected receivables or obsolete inventory; increases the cash conversion cycle.
>
> **Key Term: pull on liquidity**
> Any event that accelerates cash outflows or restricts credit, such as early payments to suppliers or reduced access to credit facilities; puts pressure on short-term cash needs.

### **Worked Example 1.3**

**Question:**  
Company C forgoes a prompt-payment discount in order to pay suppliers later and conserve cash. What is the impact on the cash conversion cycle and overall liquidity?

> **Answer:**
> The cash conversion cycle lengthens as days payable outstanding increases. Liquidity pressure is reduced in the short term, but the company pays more for its supplies in the long run (through forgone discounts).

### **Exam Warning**

> Many students confuse a shorter cash conversion cycle with higher liquidity. While a shorter CCC generally reflects better management, a firm could still have liquidity problems if current liabilities greatly exceed current assets—so always analyze ratios alongside the CCC.

## Working Capital Management and Capital Structure

How a company finances its working capital affects its capital structure. Conservative policies (more long-term funding) reduce the risk of refinancing under stress but may result in a higher weighted-average cost of capital (WACC). Aggressive working capital policies (greater use of short-term debt) can lower WACC but increase the risk of financial distress and may ultimately force asset sales or equity issues to restore liquidity.

## **Summary**

Efficient working capital management is essential for maintaining liquidity and minimizing capital costs. Analyzing the cash conversion cycle and liquidity ratios provides key signals about operational efficiency and financial health. Approaches range from conservative to aggressive, with tradeoffs between risk and cost. The choice of working capital policy directly impacts capital structure, payout policy, and long-term value.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Calculate and interpret the cash conversion cycle
- Evaluate liquidity using current, quick, and cash ratios
- Distinguish between conservative, moderate, and aggressive working capital management approaches
- Identify and analyze primary and secondary sources of liquidity
- Recognize drags and pulls on liquidity and their effects
- Connect working capital management to capital structure and financial strategy

## **Key Terms and Concepts**

- working capital
- cash conversion cycle
- net working capital
- current ratio
- quick ratio
- cash ratio
- conservative working capital policy
- aggressive working capital policy
- drag on liquidity
- pull on liquidity

Capital structure and payout - Working capital management