Working Capital Strategy

This entry is part 1 of 3 in the series Working Capital


Passion is inversely proportional to the amount of real information available. See Benford’s law of controversy.

The annual “REL1 /CFO Working Capital Survey” made its debut in 1997 in the CFO Magazine. The magazine identifies working capital management as one of the key issues facing financial executives in the 21st century (Filbeck, Krueger, & Preece, 2007).

The 2010 Working Capital scorecard (Katz, 2010) and its accompanying data2 gives us an opportunity to look at working capital management3; that is the effect of working capital management on the return on capital employed (ROCE):

ROCE = EBIT/{Capital~Employed}   or,

ROCE = EBIT/(Operating fixed assets + net operating working capital)

From the last formula we can see that – all else kept constant – a reduction in net operating working capital should imply an increased return on capital employed.

Gross and Net Operating Working Capital

A firm’s gross working capital comprises its total current assets. One part of it will consist of financial current assets held for various reasons other than operational, and the other part of receivables from operations and the inventory and cash necessary to run these operations. It is this last part that interests us.

The firm’s operations will have been long term financed by equity from owners and by loans from lenders. Firms usually also have short term financing from banks (short term credit + overdraft facilities/ credit lines) and most always from suppliers by trade credit. The rest of the current liabilities; current tax and dividends will not be considered as parts of operating current liabilities, since they comprises only non recurrent payments.

Net working capital is defined as the difference between current assets and current liabilities (see figure below). It can be both positive and negative depending on the firm’s strategic position in the market.

However usually a positive net working capital is required to ensure that the firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses.  In the following we assume that any positive net working capital is held as cash and that all excess cash is held as marketable securities.

By removing from both current assets and liabilities all items not directly related to and necessary for the operations, we arrive at net operating working capital as the difference between operating current assets and operating current liabilities:

Net operating working capital = Operating current assets – Operating current liabilities

Since the needed amount of working capital will differ between industries and be dependent on company size it will be easier to base comparisons on the cash conversion cycle.

Working Capital Management

Working capital management is the administration of current assets as well as current liabilities. It is the main part of a firm’s short-term financial planning since it involves the management of cash, inventory and accounts receivable. Therefore, working capital management will reflect the firm’s short-term financial performance.

Current assets often account for more than half of a company’s total assets and hence, represent a major investment for small firms as they can not be avoided in the same way as investments in fixed assets can – by renting or leasing. A large inventory will tie up capital but it prevents the company from lost sales or production stoppages due to stock-out. A high level of current assets hence means less risk to the company but also lower earnings due to higher capital tie-up – the risk-return trade-offs (Weston & Copeland, 1986).

Since the needed amount of working capital will differ between industries and also will be dependent on company size it will be easier to base comparisons of working capital management between companies and industries on their cash conversion cycle (CCC).

The Cash Conversion Cycle

The term “cash conversion cycle” (CCC) refers to the time span between a firm’s disbursing and collecting cash and will thus be ‘unrelated’ to the firm’s size, but be dependent on the firm’s type of business (see figure below).

Companies that have high inventory turnover and do business on a cash basis – usually have a low or negative CCC and hence needs very little working capital.

For companies that make investment products the situation is a completely different. As these types of businesses are selling expensive items on a long-term payment basis, they will tend to have a high CCC and must keep enough working capital on hand to get through any unforeseen difficulties.

The CCC cannot be directly observed in the cash flows, because these are also influenced by investment and financing activities and must be derived from the firm’s balance sheet:

+ Inventory conversion period (DSI)
+ Receivables conversion period (DSO)
–  Payable conversion period (DPO)
= Cash Conversion Cycle (days)


DSI  = Days sales of inventory, DSO = Days sales outstanding,  DPO = Days payable outstanding, WIP = Work in progress, Period = Accounting period and COGS = Cost of goods sold4 or:

+ Average inventory+WIP / [COGS/days in period]
+ Average Accounts Receivable / [Revenue / days in period]
+ Average Accounts Payable / [(Inventory increase + COGS)/ days in period]
= Cash Conversion Cycle (days)

The Observations

Even if not all of the working capital is determined by the cash conversion cycle, there should be a tendency for higher return on operating capital with lower CCC. However the data from the annual survey (Katz, 2010) does not support this5:

The scatter graph shows no direct relation between return on operating capital and the cash conversion cycle. A closer inspection of the data for the surveys different industries confirms this.

Since the total amount of capital invested in the CCC is:

Cap(CCC) = CCC * Sales * (1 + VAT)/{days~pr~period}

and is thus a function of sales. The company size will then certainly play a role when we only look at the yearly data. The survey however also gives the change from 2008 to 2009 for all the companies so we are able to remove the size effect by looking at the changes (%) in ROCE by a change in CCC:

The graph still shows no obvious relation between change (%) in CCC and change (%) in ROCE.  Now, we know that the shorter this cycle, the fewer resources the company needs to lock-up; reduced debtor levels (DSO), decreased inventory levels (DSI) and/or increased creditor levels (DPO) must have an effect on the ROCE – but will it be lost in the clutter of all the other company operations effects on the ROCE?

Cash Management

Net operating working capital is the cash plus cash equivalents needed to pay for the day-to-day operation of the business. This will include; demand deposits, money market accounts, currency holdings and highly liquid short-term investments such as marketable securities6; portfolios of highly liquid, near-cash assets which serves as a backup to the cash account.

There are many reasons why holding cash is important; to act as a buffer when daily cash flows do not match cash out flows (Transaction motive), as a safety stock to face forecast errors and unforeseen expenses (Precautionary motive) or to be able to react immediately when opportunities can be taken (Speculative motive). If the cash level is too low and unexpected outflows occurs, the firm will have to either borrow funds or in the case of an investment – forgo the opportunity.

Such short-term borrowing of funds can be costly as can a lost opportunity by the lost returns of rejected investments. Holding cash however also induces opportunity costs due to loss of interest.

Cash management therefore aim at optimizing cash availability and interest income on any idle funds. Cash budgeting – as a part of the firm’s of short-term planning – constitutes the starting-point for all cash management activities as it represents the forecast of cash in- and outflows and therefore reflects the firm’s expected availability and need for cash.

Working Capital Strategy

We will in the following look closer at working capital management using balance simulation7. The data is from a company with large fixed assets in infrastructure. The demand for its services is highly seasonal as schematic depicted in the figure below:

A company like this will need a flexible working capital strategy with a low level of working capital in the off-seasons and high levels in the high seasons. As the company wants to maximize its equity value it is looking for working capital strategies that can do just that.

The company has been working on its cash conversion cycle, and succeeded in that with on average of only 11,1 days 1M (standard deviation 0,2 days) (across seasons) for turning supplied goods and services into cash:

All the same, even then a substantial amount, on average €4,1M (standard deviation €1,8M) of the company’s resources, is invested in the cash conversion cycle:

In addition the company needs a fair amount of cash to meet its other obligations. Its first strategy was to keep cash instead of using short term financing in the high seasons. In the off-seasons this strategy gives a large portfolio of marketable securities – giving a low return and thereby a low contribution to the ROCE.  This strategy can be described as being close to the red line in the seasonal graph above.

When we now plot the two hundred observed (simulated) values of working capital and the corresponding ROE (from now we use return on equity (ROE) since this of more interest to the owners), we get a picture as below:

This lax strategy shows little relation between the amount of working capital and the ROE and – from just looking at the graph it would be easy to conclude that working capital management is a waste of time and effort.

Now we turn to a stricter strategy: keeping a low level of cash through all seasons, using short term financing in the high seasons and always have cash closely connected to expected sales. Again plotting the two hundred observed values we get the graph below:

From this graph we can clearly see that if we can reduce the working capital we will increase the ROE – even if we live in a stochastic environment. By removing some of the randomness in the amount of working capital by keeping it close to what is absolutely needed – we get a much clearer picture of the effect. This strategy is best described as being close to the green line in the seasonal graph.

Since we use pseudo-random8 simulation we have replicated the first simulation (blue line), for the stricter strategy (green line).

This means that the same events happened for both strategies; changes in sale, prices, costs, interest and exchange rates etc. The effects for the amount of working capital are shown in the graph below:

The lax strategy (blue line) will have an average working capital of €4,8M with a standard deviation of €3.0M, while the strict strategy (green line) will have an average working capital of €1,4M with a standard deviation of €3.3M.

Even if the stricter strategy seems to associate lower amounts of working capital with higher return to equity (se figure) and that the amount of working capital always is lower than under the laxer strategy, we have not yet established that it is a better strategy.

To do this we need to simulate the strategies over a number of years and compare the differences in equity value under the two strategies. Doing this we get the probability distribution for difference in equity value as shown below:

The expected value of the strict strategy over the lax strategy is €3,4 M width a standard deviation of €6,1 M. The distribution is skewed to the right, so there is also a possible additional upside. From this we can conclude that the stricter strategy is stochastic dominant to the laxer strategy. However there might be other strategies that can prove to be better.

This brings us to the question: does an optimal working capital strategy exist? What we do know that there will be strategies that are stochastic dominant, but proving one to be optimal might be difficult.  Given the uncertainty in any firm’s future operations, you will probably first have to establish a set of strategies that can be applied depending on the set of events that can be experienced by the firm.


Filbeck, G, Krueger, T, & Preece, D. (2007). Cfo magazine’s “working capital survey”: do selected firms work for shareholders?. Quarterly Journal of Business and Economics , (March), Retrieved from

Katz, D.M.K. (2010). Working it out: The 2010 Working Capital Scorecard. CFO Magazine, June, Retrieved from

Weston, J. & Copeland, T. (1986). Managerial finance, Eighth Edition, Hinsdale, The Dryden Press


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  1. REL Consultancy. (2010). Wikipedia. Retrieved October 10, 2010, from []
  2. []
  3. Data from 1,000 of the largest U.S. public companies []
  4. COGS = Opening inventory + Purchase of goods – Closing inventory []
  5. Data used with permission from REL/CFO. Twenty of the one thousand observations have been removed as outliers, to give a better picture of the relation []
  6. Marketable securities with a maturity of less than three months are referred to as ‘cash equivalents’ on the balance sheet, those with a longer maturity as ‘short-term investments’ []
  7. In the Monte Carlo simulation we have used 200 runs, as that was sufficient to give a good enough approximation of the distributions []
  8. Pseudo random number generator (PRNG), also known as a deterministic random bit generator, is an algorithm for generating a sequence of numbers that approximates the properties of random numbers. The sequence is not truly random in that it is completely determined by a set of initial values, called the seed number []


About the Author

S@R develops models for support of decision making under uncertainty. Taking advantage of recognized financial and economic theory, we customize simulation models to fit specific industries, situations and needs.

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