Managing Liquidity Case Study

Managing Liquidity

I. Learning Objectives

1. Define net working capital, discuss the importance of working capital management

2. Define the operating and cash conversion cycles, explain how are they used, and compute their values for a firm.

3. Discuss the relative advantages and disadvantages of pursuing (1) flexible and (2) restrictive current asset management strategies.

4. Explain how accounts receivable are created and managed, and compute the cost of trade credit.

5. Explain the trade-off between carrying costs and reorder costs, and compute the economic order quantity for a firm’s inventory orders.

6. Compute the economic costs and benefits of a lockbox

II. Working capital

A working capital encompasses both a firm’s current assents

The management of working capital involves managing inventories, accounts receivable and payable, and cash. (Study Finance: Working Capital Management)

II.1 Importance of Working Capital Management

Current assets are a major financial position statement item and especially significant to smaller firms. Mismanagement of working capital is therefore a common cause of business failure, e.g.:

- inability to meet bills as they fall due

- demands on cash during periods of growth being too great (overtrading)

- overstocking

II.2 Profitability vs. Liquidity

The decision regarding the level of overall investment in working capital is a cost/benefit trade-off - liquidity versus profitability. Unprofitable companies can survive if they have liquidity. Profitable companies can fail if they run out of cash to pay their liabilities. Liquidity in the context of working capital management means having enough cash or ready access to cash to meet all payment obligations when these fall due. The main sources of liquidity are