3.4 Working Capital Management

Working Capital Fundamentals

Net working capital = Current Assets - Current Liabilities. Working capital management balances liquidity (the ability to pay obligations) against profitability (idle cash earns little).

• Aggressive policy: hold minimal current assets and rely on short-term financing; higher expected return but higher liquidity risk.
• Conservative policy: hold ample current assets and finance with long-term capital; lower risk but lower return.

Cash Management

The goal is to hold the least cash needed for operations while meeting obligations. Float is the time lag between initiating a payment and the funds actually clearing. Firms speed up collection float (lockboxes, electronic payment) and deliberately slow disbursement float. Cash-balance models include the Baumol model (treats cash like inventory with fixed conversion costs) and the Miller-Orr model (sets upper and lower control limits for fluctuating cash). Marketable securities (Treasury bills, commercial paper) park excess cash safely while earning a return until it is needed.

Receivables and Credit Policy

Receivables management trades higher sales from generous credit against the cost of carrying receivables and bad debts. Credit policy has four levers: credit standards (who qualifies), credit terms (the discount and net period), the collection policy, and the credit period length. Loosening credit raises sales but increases days sales outstanding (DSO), carrying cost, and default risk. The decision rule: extend credit only if the incremental contribution margin exceeds the incremental carrying and bad-debt costs.

Inventory Management

Inventory ties up cash and incurs ordering and holding costs. The Economic Order Quantity (EOQ) minimizes total inventory cost:

EOQ = square root of (2DS / H)

where D = annual demand (units), S = ordering cost per order, and H = holding cost per unit per year. EOQ is the order size where total ordering cost equals total holding cost.

EOQ Worked Example

Annual demand D = 10,000 units, ordering cost S = $40 per order, holding cost H = $5 per unit per year.

EOQ = square root of (2 x 10,000 x 40 / 5) = square root of (800,000 / 5) = square root of 160,000 = 400 units per order.

Reorder Point, Safety Stock, and JIT

• Reorder point = (daily usage x lead time) + safety stock. It is the inventory level that triggers a new order so stock arrives before running out.
• Safety stock is a buffer held against variability in demand or lead time, reducing stockout risk at the cost of extra holding cost.
• Just-in-Time (JIT) drives inventory toward zero by receiving materials only as needed, slashing holding costs but demanding reliable suppliers and exposing the firm to supply disruptions.

Reorder example: daily usage 50 units, lead time 6 days, safety stock 100 units. Reorder point = (50 x 6) + 100 = 300 + 100 = 400 units.

Payables and the Cost of Trade Credit

Suppliers often offer cash discounts such as 2/10 net 30 (2% off if paid within 10 days, otherwise full amount due in 30 days). Forgoing the discount is an implicit loan. Its annualized cost:

Cost = [Discount % / (100% - Discount %)] x [365 / (Pay Period - Discount Period)]

For 2/10 net 30: [2 / 98] x [365 / (30 - 10)] = 0.0204 x 18.25 = 0.372, or about 37.2%. Because 37% far exceeds most borrowing rates, a firm should borrow if needed and take the discount.

Short-Term Financing

Sources include trade credit (often free within the discount period), lines of credit, commercial paper (unsecured notes for high-credit firms, the cheapest market source), and secured loans using receivables or inventory as collateral. Short-term debt is cheaper but riskier than long-term financing because it must be refinanced frequently.

Total Inventory Cost and EOQ Logic

The two costs EOQ balances move in opposite directions as order size changes. Ordering larger quantities means fewer orders (lower total ordering cost) but more average inventory on hand (higher holding cost). EOQ is exactly the order size where total annual ordering cost equals total annual holding cost, minimizing their sum.

• Total ordering cost = (D / Q) x S
• Total holding cost = (Q / 2) x H
• At EOQ, these two are equal

Notice EOQ is not sensitive to small input errors because of the square root: doubling demand raises EOQ by only about 41%, not 100%.

Maturity Matching

A core financing principle is maturity matching: finance long-lived (permanent) assets with long-term capital and short-lived (temporary, seasonal) assets with short-term financing. Financing a permanent asset with short-term debt creates rollover risk; financing a seasonal need with long-term debt leaves idle, costly capital. The maturity-matching (hedging) approach aligns the life of the asset with the life of its financing.

Liquidity vs. Profitability Trade-Off

Every working-capital decision sits on this trade-off. Holding more cash, receivables, and inventory raises liquidity and service levels but lowers return on assets because those funds earn little. Holding less boosts return but raises the risk of stockouts, lost sales, and missed payments. The cash conversion cycle (DSO + days inventory - days payables) is the single best summary metric: shortening it frees cash, while lengthening it ties cash up in operations.