Learning Outcomes
After reading this article, you will be able to describe the components of working capital, explain the cash conversion cycle, and distinguish between liquidity and profitability in financial management. You will also learn to calculate and interpret relevant ratios and discuss the trade-offs between maintaining liquidity and achieving profitability, all aligned to the ACCA FFM exam.
ACCA Foundations in Financial Management (FFM) Syllabus
For ACCA Foundations in Financial Management (FFM), you are required to understand how businesses manage their working capital. In particular, focus your revision on:
- The composition and role of working capital within a business
- Calculation and interpretation of the cash conversion cycle
- The relationship and balance between liquidity and profitability
- Key working capital ratios: current ratio, quick ratio, inventory days, receivables days, payables days
- The impact of working capital policies on business operations and financial stability
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.
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Which formula best describes the cash conversion cycle?
- Inventory days + Receivables days – Payables days
- Inventory days × Receivables days × Payables days
- Receivables days – Inventory days – Payables days
- Inventory days – Receivables days + Payables days
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What is the primary risk of holding excessive inventory?
- Higher liquidity
- Increased profitability
- Higher holding costs and potential obsolescence
- Enhanced supplier relations
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True or false? Improving profit margins always improves liquidity.
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Explain how an aggressive receivables collection policy might affect both liquidity and profitability.
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If a company shortens its payables period, what effect might this have on its cash conversion cycle and overall cash flow?
Introduction
Working capital management is essential for ensuring a business can meet its short-term obligations and operate efficiently. The balance between maintaining enough current assets to cover liabilities (liquidity) and investing efficiently to maximise profit is a core consideration for finance professionals. This article explains the key concepts, demonstrates calculation methods, and discusses policies affecting liquidity and profitability for ACCA FFM.
Key Term: working capital
The excess of current assets over current liabilities, representing the liquid resources available for day-to-day operations.
WORKING CAPITAL COMPONENTS
Working capital consists of four main elements:
- Inventory (goods held for sale and materials for production)
- Trade receivables (amounts owed by customers)
- Cash and cash equivalents
- Trade payables (amounts owed to suppliers)
Optimal working capital management ensures the business can pay its debts on time while limiting unproductive investment in current assets.
Key Term: current ratio
The ratio of current assets to current liabilities, indicating the short-term liquidity of a business.Key Term: quick ratio
The ratio of quick assets (current assets excluding inventory) to current liabilities, measuring a company’s ability to meet short-term obligations without selling inventory.
THE CASH CONVERSION CYCLE
The cash conversion cycle (CCC) measures the time, in days, between when a business pays for its inventory and when it receives cash from customers. It combines three key working capital periods:
- Inventory holding period (days)
- Receivables collection period (days)
- Payables payment period (days)
The formula is:
Cash Conversion Cycle (days) = Inventory days + Receivables days – Payables days
A shorter CCC means a business turns its investment into cash more quickly, reducing the need for external financing.
Key Term: cash conversion cycle
The time taken, in days, for a business to convert its investment in inventory back into cash by sales, after accounting for payables and receivables periods.
Worked Example 1.1
**Metro Ltd reports the following annual figures:
- Average inventory: $50,000
- Annual cost of sales: $365,000
- Average receivables: $32,000
- Annual credit sales: $400,000
- Average payables: $25,000
- Annual credit purchases: $300,000**
Calculate the cash conversion cycle.
Answer:
Inventory days = ($50,000 ÷ $365,000) × 365 = 50 days
Receivables days = ($32,000 ÷ $400,000) × 365 = 29 days
Payables days = ($25,000 ÷ $300,000) × 365 = 30 days
Cash conversion cycle = 50 + 29 – 30 = 49 days
Metro Ltd’s cash is tied up in the operating cycle for 49 days.
LIQUIDITY VS PROFITABILITY TRADE-OFF
A key objective in working capital management is balancing liquidity (ability to pay debts as they fall due) with profitability (earning returns for owners). Policies favouring liquidity often mean higher balances of cash or inventory, reducing risk but also limiting returns due to higher holding costs or tied capital. On the other hand, policies targeting profitability minimise working capital, which may increase returns but heighten the risk of running short of funds or missing payment deadlines.
Examples of trade-offs
- Loose credit terms to customers: May boost sales (profitability) but tie up funds in receivables, increasing risk of bad debts (reduced liquidity).
- Low inventory: Reduces holding costs (profitability), but risks stockouts and lost sales (reduced liquidity).
- Extended payment periods to suppliers: Improves cash flow (liquidity), but may harm supplier relationships or miss discount opportunities (profitability).
Worked Example 1.2
Oceanic Co wants to cut inventory to improve profitability. It reduces average inventory from $100,000 to $60,000. As a result, customers experience more stockouts and annual sales fall by 10%. How could this policy impact both liquidity and profitability?
Answer:
Cutting inventory frees up cash (improves liquidity) but lost sales may reduce profits, possibly more than the savings from lower inventory. Therefore, the benefit to liquidity may be offset by a bigger negative effect on profitability.
Exam Warning
Always analyse the effects of proposed working capital policy changes on both liquidity and profitability. ACCA exams frequently test your understanding of this balance.
KEY RATIOS FOR MONITORING WORKING CAPITAL
Several ratios are essential for monitoring working capital and supporting exam calculations:
- Current Ratio = Current assets / Current liabilities
- Quick Ratio = (Current assets – Inventory) / Current liabilities
- Inventory Days = (Inventory / Cost of Sales) × 365
- Receivables Days = (Receivables / Credit Sales) × 365
- Payables Days = (Payables / Credit Purchases) × 365
Interpret ratios carefully. High liquidity ratios suggest resources for bill payments are available, but ratios far above normal may signal excess inventory or slow collection, indicating inefficiency. Conversely, very low ratios may mean potential liquidity problems.
Worked Example 1.3
Delta Ltd has a current ratio of 2.5 and a quick ratio of 1.1. What does this indicate about the company's inventory management?
Answer:
Since the quick ratio is much lower than the current ratio, a significant portion of current assets is tied up in inventory. This may signal slow-moving stock or overstocking issues.
Revision Tip
Regularly practise calculating and interpreting working capital ratios. In exams, clearly show your calculations and link them to business risk and performance.
Summary
Effective working capital management ensures a business can pay its debts while investing surplus funds for profit. The cash conversion cycle is a key metric for analysing how quickly cash invested in working capital returns to the business. The trade-off between liquidity and profitability is fundamental in deciding working capital policies.
Key Point Checklist
This article has covered the following key knowledge points:
- Define working capital and list its main components
- Explain the cash conversion cycle and calculate it using given data
- Identify and interpret key working capital ratios
- Discuss liquidity vs profitability trade-offs in real business scenarios
- Recognise the impact of policy changes on business risk and returns
Key Terms and Concepts
- working capital
- current ratio
- quick ratio
- cash conversion cycle