Working capital and liquidity management

Working capital is current assets minus current liabilities. That is the technical definition; in practice it is the pool of cash and near-cash a business has available to keep running day to day.

If current assets exceed current liabilities the company has a surplus, usually sitting in bank deposits or short-term investments. If liabilities exceed assets there is a deficit, and the company is typically running on an overdraft or short-term loan. Treasury's job is to manage the pool as efficiently as possible: too little working capital and the business cannot pay its suppliers; too much and money sits idle earning nothing when it could be in productive assets.

Every company makes two decisions that together define its working capital policy: how much to hold, and how to fund it.

The investment decision asks how much safety stock and cash buffer to hold above the operating minimum.

The financing decision asks what mix of short and long-term debt funds the asset base.

The symmetry is the point: in both decisions, aggressive means higher return and higher risk together, conservative means lower of both. When the exam asks you to evaluate a policy, state both sides — a policy is never simply good or bad, it is a chosen position on that trade-off.

The operating cycle is the time between paying cash for inputs and receiving cash from sales. The cash conversion cycle (CCC) measures it precisely — and the longer it runs, the more working capital the business must fund. A company with a 90-day CCC finances 90 days of operations before its cash comes back.

Work it on the lecture's example. Zanaco Distributors Ltd holds inventory of ZMW 2,600,000, receivables of ZMW 1,700,000 and payables of ZMW 1,600,000, on annual revenue of ZMW 15,000,000 and cost of goods sold of ZMW 9,200,000.

Just over 81 days pass between paying for goods and collecting the cash, so the cash turns over 4.5 times a year. Every route to a shorter cycle attacks one component: collect debts faster through tighter credit terms or discounts, turn inventory quicker, order raw materials in smaller and more frequent lots, or negotiate longer supplier credit without damaging the relationship.

Extending credit to customers ties up cash, and the goal is the level of credit and discount terms that maximises profit — not simply the fewest days outstanding. That starts with knowing who deserves credit. The Zambian sources: bank references, trade references from existing suppliers, published accounts, the Credit Reference Bureau's cross-bank borrowing data, and for existing customers your own sales ledger's payment history.

Discount terms put a price on early payment. Terms of "2/10 net 30" mean: take a 2% discount by paying within 10 days, or pay in full by day 30. Whether to take the discount is a borrowing decision, and it has a formula.

On 2/10 net 30 with a short-term borrowing rate of 8%: the cost of forgoing the discount is [2 ÷ 98] × [365 ÷ 20] = 0.0204 × 18.25 = 37.23% per annum. Paying on day 30 instead of day 10 is borrowing from the supplier at 37.23% — so the buyer should borrow from the bank at 8% and take the discount.

Rather than managing receivables in-house, a company can outsource them. A factoring company takes on the sales ledger: it advances a percentage of invoice value immediately — typically 80–85% — and pays the remainder, less its fees, when the customer settles. Full-service factors also assess customer credit and chase overdue accounts. Non-recourse factoring means the factor absorbs the credit risk; with recourse factoring the risk stays with you.

The lecture's example prices it. Mutengo Plc invoices ZMW 300,000 a month on an average 2.5-month credit period. The factor charges a 2.5% service fee, advances 85% of invoices at 13% per annum, and saves Mutengo ZMW 95,000 a year in administration. The alternative is an overdraft at 12.5% on the same funding.

Invoice discounting provides the same finance without handing over the ledger: customers never know a third party is involved, it costs less than factoring, and the customer relationship stays entirely in your hands. The choice between them is really a choice about what you are buying — finance alone, or finance plus an outsourced credit function.