24 Working capital and liquidity management

Need to know

A business which sells goods typically has to pay creditors for the purchase of stock before it generates revenue and cash from the sale of that stock. The timing of cash payments and receipts is critical to working capital management.

Why is this important?

Effective working capital management requires every company to understand its working capital (or cash conversion) cycle. This cycle identifies the number of days it takes to convert current assets into cash. Comparing this to when payments to creditors are due enables a company to identify whether it has a working capital (cash) requirement.

The longer it takes for a business to generate cash from the sale of stock, the longer it is tying up cash, or working ‘capital’. A business with a long working capital cycle may find that it does not have the cash to pay its creditors because it cannot generate cash from sales quickly enough.

Understanding the working capital cycle is therefore key to identifying the likelihood of a business suffering cash flow difficulties.

Companies that invest heavily in stock or those that offer their customers extended payment periods heighten the risk of cash flow difficulties, which in turn increase the risk of insolvency (see Chapter 25 Insolvency and going concern risk).

Working capital ‘ties up’ cash. It represents a net investment by the business, which needs to be financed.

Example – ABC Ltd

ABC Ltd is a reseller of branded paints to trade customers only. The company buys paint from specialist manufacturers on strict 30-day credit terms and offers identical (30-day) terms to trade customers although experience shows that the reseller’s customers typically pay after 35 days. The company has a full range of paints in stock, which are held for 22 days (on average) before sale. Suppliers must be paid after 30 days to maintain supply lines.

The company buys stock on day 1 (on 30 days credit), takes on average 22 days to sell the stock and a further 35 days for the customers to settle in cash. It must, however, pay its creditors after 30 days. In this example, the business has a short-term financing (cash) requirement of £58, 000 to pay creditors. It requires this financing for a period of 27 days until cash is received from customers.

In this example, unless ABC can come to an agreement with its creditors to delay payment, it would need an alternative source of finance, such as utilising an overdraft facility. Delaying payment, while always an option, may have adverse repercussions with suppliers such as renegotiated terms of supply or cancellation of supply contracts.

Failure to pay suppliers also runs the risk of legal action being taken by creditors for recovery of debts. Such action could lead to insolvency (see Chapter 25 Insolvency and going concern risk).

When is this important?

Fast-growing (ambitious) companies are often at highest risk of insolvency because they reinvest surplus cash generated from sales into buying more stock to drive sales growth. Directors may not pay sufficient attention to cash tied up in stock and the importance of collecting cash from debtors on a timely basis. The result is that they can quickly ‘grow the company out of money’. This is known as overtrading.

Managing the working capital cycle should be an operational priority in any business to avoid the risk of cash shortage and insolvency.

Management of working capital

Techniques to manage/improve working capital include:

• ■Optimising stock holding. ‘Just in time’ (JIT) ordering and delivery of stock ensures cash is not tied up in stock (see Chapter 11 Stock). Supermarkets also use JIT to optimise the physical space set aside to hold stock while also avoiding stock-outs.
• ■Faster debtor collection. Enforcing credit terms reduces the risk of non-recovery. Early payment incentives coupled with strong credit control can improve timing of cash receipts. Businesses short of cash may choose to factor their debts. Factoring involves selling debts at a discount to third parties in return for immediate cash (see Chapter 12 Debtors and creditors).
• ■Negotiation with suppliers. It can be mutually beneficial for suppliers to support the growth of their customers with favourable payment terms. Supplier credit can be negotiated although success often depends on the relative size and power of each party (see In practice below).
• ■Cash flow forecasting. This can help to identify the cost of holding excessive cash balances as well as short-term funding gaps. A treasury function is responsible for this activity in larger organisations (see Chapter 2 Finance personnel and systems).

In addition to freeing up cash (or minimising borrowing requirements) by shortening the working capital cycle, a well-managed business should also have in place alternative sources of short-term finance (see Chapter 30 Debt finance). An overdraft facility is a common source of short-term finance, although the benefits of having an overdraft must be balanced carefully against the costs of borrowing and maintaining the facility.

Excessive working capital tied up in a business can also be an indicator of management inefficiency. For example, having a high multiple of current assets to current liabilities can indicate that management is unnecessarily tying up money in stock or not recovering debtors quickly enough. It might also indicate that the company is offering excessively generous credit terms to its customers.

In practice

Some businesses delay payments to creditors as a policy or tactic to fund working capital needs. Each day payment is delayed is a day that the creditor is in effect financing the working capital of the business. While not illegal, the morality of this practice is questionable (especially with small suppliers who are most likely to suffer the effects of payment delays from larger companies).

Large companies are encouraged to publish average time taken to pay creditors and this is used by some companies to distinguish themselves from competitors, by displaying their fair-trading policy credentials. Large businesses are advised to sign up to the Prompt Payment Code, a government initiative designed to set the gold standard in payment terms and bring about a culture change in payment practices.

The business model of a company influences its working capital cycle. For example, cash-based retailers such as Tesco operate with a negative working capital cycle. This is because stock purchased on credit is typically sold quickly for cash. At the same time generous credit terms are received from suppliers. This enables Tesco, in effect, to use suppliers to finance its working capital requirements. At 2 January 2021, for example, Tesco reported that it was operating with £4.8 billion of negative working capital.

There is no ‘right’ level of working capital. Each business is unique and will face its own challenges or opportunities, including the risk of payment default by customers. A business should aim to manage its working capital to ensure it is sufficient yet not excessive for its operating needs. Sufficient in this sense means having access to necessary liquid sources to enable the business to meet identified short-term working capital requirements as well as bad debts or customer refunds.

Nice to know

Working capital days

Working capital days ratios are useful efficiency performance measures.

Using the earlier example of ABC Ltd as an illustration, stock, debtor and creditor ‘days’ can be calculated as follows (assume that sales are £1m and cost of sales £700,000):

These ratios identify the number of days used to derive the working capital cycle (see above). They help to identify the period over which any associated funding gap needs financing (see ABC example above).

Working capital cycle

Investors look closely at a company’s working capital cycle because it gives an indication of management’s effectiveness at managing balance sheet assets and generating cash flows. They may also look at the level of working capital as a percentage of sales, as this can be benchmarked against other organisations.

$\text{Working Capital to Sales Ratio}=\frac{\text{Working Capital}}{\text{Sales}}$

For example, company A and company B both have the same working capital of £100,000. However, company A deploys its working capital to generate sales of £1m, while company B uses the same amount of working capital to generate £2m in sales. It is clear that company B is more efficient as it is using the same amount of working capital to generate higher sales. In effect company B is using the same funds over and over again. Assuming that higher sales result in higher profits then the company with the lower working capital to sales ratio is not only more efficient but also more profitable.

An investor or acquirer will assess the need to inject additional working capital to maintain a company’s operations, or to help fund expansion. For example, to expand ABC’s business above will require cash to meet existing obligations as well as additional sums if the business is to grow. Effective working capital management strategies can be implemented to reduce the working capital cycle, which can reduce the cash needs of the business.

Some investors do not invest in companies in sectors that operate with a ‘positive’ working capital cycle because they believe such businesses are not sustainable, as they will always require cash to maintain and grow operations.

Optional detail

Liquidity ratio

The adequacy of working capital is typically benchmarked using a working capital ratio, known as the ‘liquidity ratio’.

The liquidity ratio is calculated as follows:

$\frac{\text{Current assets}}{\text{Current liabilities}}$

Where current assets equal current liabilities the ratio is 1.

Anything below 1 indicates negative working capital, as current liabilities will exceed current assets.

A number above 1 indicates that a company has enough short-term assets to cover its short-term obligations, although note the earlier comments around timing. A number of around 2 is considered healthy.

A number above 2 might be an indication of management inefficiency, i.e. that the company is not making best use of the excess working capital at its disposal. However, equally, a high number does not of itself guarantee that a business will be able to meet its liabilities as they fall due. As explained previously, the timing of receipts and payments must be looked at carefully, typically by preparing a detailed cash flow forecast, to establish whether the business requires short-term financing to meet its working capital needs.

Consider again the example of ABC. The working capital ratio, which is calculated as below, suggests the business is liquid.

$\text{Working capital (Liquidity) ratio}:\frac{\text{Current assets}}{\text{Current liabilities}}\frac{\pounds \text{138,000}}{\pounds 5\text{8,000}}=2.4$

As stated previously, a number more than 2 is considered to be a healthy level of liquidity (see below). Despite ABC’s high liquidity ratio, however, the company nevertheless had a working capital requirement as it was unable to convert current assets quickly enough to meet the short-term debts (see earlier). Ratios, such as the liquidity ratio, should never be interpreted in isolation. In this example, calculating the working capital cycle is necessary to appreciate the liquidity position of the business.

Acid test ratio

An alternative measure of liquidity is the ‘acid test’ (or ‘quick’ ratio). This measure is similar to the liquidity ratio but excludes stock. This ratio highlights the company’s ability to pay liabilities from liquid assets (i.e. those that are cash or near-cash, namely debtors). Stock is considered ‘illiquid’ as it has first to be converted into a sale (and there is typically no guarantee that this will happen) before any resulting debtor may convert into cash.

In the case of ABC Ltd, the ratio is calculated as follows.

$\frac{\text{Current assets less stock}}{\text{Current liabilities}}\frac{\pounds \text{96,000}}{\pounds 5\text{8,000}}=1.7$

Reflect and embed your understanding

• 1Reflect on why every business should focus on its working capital cycle.
• 2If a growing business manages to maintain the length of its working capital cycle (i.e. the same stock, debtor and creditor days) does it still need to finance additional working capital?
• 3What strategies can be pursued to improve a company’s working capital cycle?
• 4Reflect on the merits and drawbacks of a business maintaining an overdraft facility.
• 5Explain why an organisation that has a high liquidity ratio may still require funding to meet its working capital needs.

For the authors’ reflections on these questions, please go to financebook.co.uk

Where to spot in company accounts

Current assets are shown as stock, debtors and cash on the face of the balance sheet.

Trade creditors are typically aggregated with other payables on the face of the balance sheet with a breakdown disclosed in the notes.

Extract from Greggs plc 2020 financial statements Appendix p. 446

Consolidate and apply

To see how the concepts covered in this chapter have been applied within Greggs plc, review Chapter 36, p. 415.

Watch out for in practice

• →Companies showing significant year-on-year increases in stock holding but with no growth in sales. This could suggest difficulties in selling stock.
• →Companies with unusually low stock balances. This could indicate supply problems, indicating missed revenue opportunities.
• →Growing debtor days. Late-paying customers tie up working capital. This could indicate recoverability problems.
• →Increasing creditor days. This could indicate increasing reliance on creditors to finance growth or difficulties in repayment. If debtor days and stock days are increasing at the same time, this could indicate difficulties in converting working capital into cash to pay creditors.
• →Excessive working capital.
• →Negative working capital.
• →Working capital to sales. As sales grow, a rising ratio indicates less effective management of working capital.