Working Capital & Liquidity
Refresher reading access
Introduction
Working capital (also called net working capital) is defined simply as current assets minus current liabilities:
(Net) Working capital = Current assets – Current liabilities
It includes both operating assets and liabilities, such as accounts receivable, accounts payable, and inventory, as well as financial assets and liabilities, such as short-term investments and short-term debt. Working capital management is the management of a firm’s short-term assets and liabilities and an important aspect of a firm’s operations. The goal of working capital management is to ensure the company has adequate, ready access to funds necessary for day-to-day operations, while avoiding excess reserves that can be a costly drag on the business’ profitability and returns. Having excess levels of working capital can have a harmful effect on shareholder returns. At the same time, insufficient levels of working capital can harm a company if it cannot meet its short-term obligations, leading to product shortages, sales slowdowns, and, in the extreme, bankruptcy.
An analyst should carefully evaluate the working capital position of the firm to make an informed decision about the firm’s ability to meet its short-term needs as it works to implement its long-term plans. To assess whether a firm is operating at an optimal level of working capital, financed at the lowest possible cost, an analyst should begin by asking two fundamental questions:
- What are the required investments in working capital for the firm?
- How should those investments be financed?
Understanding this provides the analyst with a basis for sound valuation analysis.
Learning Outcomes
- compare methods to finance working capital;
- explain expected relations between working capital, liquidity, and short-term funding needs;
- describe sources of primary and secondary liquidity and factors affecting a company’s liquidity position;
- compare a company’s liquidity position with that of peers; and
- evaluate short-term funding choices available to a company.
Summary
We consider key aspects of short-term financial management: the choices available to fund a company’s working capital needs and effective liquidity management. Both are critical in ensuring a company’s day-to-day operations and ability to remain in business. Key points of coverage included the following:
- Internal and external sources available to finance working capital needs and considerations in their selection.
- Working capital approaches, their considerations, and their impact on the funding needs of the company.
- Primary and secondary sources of liquidity and factors that can enhance a company’s liquidity position.
- The evaluation of a company’s liquidity position and comparison to peers.
- The evaluation of short-term financing choices based on their characteristics and effective costs.
1.25 PL Credit
If you are a CFA Institute member don’t forget to record Professional Learning (PL) credit from reading this article.