Working Capital & Liquidity: Ratios, Management & Analysis

TAKEAWAYS:

• Working capital = Current Assets – Current Liabilities, measuring a company’s ability to pay short-term debts.
• Liquidity ratios (current, quick, cash) reveal how quickly assets can be converted to cash—critical for banks assessing loan risks.
• Operating cycle = Inventory period + Receivables period – Payables period; shorter cycles mean faster cash conversion.
• Overtrading (high sales but insufficient working capital) can bankrupt a business, as seen in Nepal’s retail shops during Dashain sales.
• Cash conversion cycle (CCC) = Inventory days + Receivables days – Payables days; negative CCC means the company is earning cash from suppliers.
• Trade-offs: Holding too much inventory (high storage costs) vs. too little (lost sales), like Kathmandu’s fashion retailers balancing stock levels.

1. Definitions: Working Capital and Liquidity

Working capital (WC) is the net amount of a company’s current assets (cash, inventory, receivables) minus its current liabilities (payables, short-term loans, taxes). It answers:

"Can the business pay its bills in the next 12 months?"

Liquidity measures how quickly assets can be converted to cash without losing value. High liquidity = safety; low liquidity = growth potential but higher risk.

Working Capital Components

pie
    title Working Capital Structure
    "Current Assets" : 60
    "Current Liabilities" : 40

• Current Assets (must convert to cash within 1 year):

  • Cash & cash equivalents (e.g., eSewa wallet balances).
  • Short-term investments (e.g., Ncell’s treasury bills).
  • Inventory (e.g., Daraz’s unsold smartphones).
  • Accounts receivable (e.g., Pathao’s unpaid ride fares).
  • Prepaid expenses (e.g., NTC’s prepaid electricity bills).

• Current Liabilities (due within 1 year):

  • Accounts payable (e.g., Kathmandu’s unpaid supplier invoices).
  • Short-term loans (e.g., bank overdrafts for small businesses).
  • Accrued expenses (e.g., unpaid employee salaries).
  • Current portion of long-term debt (e.g., NEPSE-listed companies’ maturing bonds).

2. Why Working Capital Matters: Real-World Examples

In the Real World

1. eSewa’s Liquidity Challenge

   • Idea: Cash ratio (Cash + Marketable Securities / Current Liabilities).
   • How it’s used: eSewa must maintain a minimum cash ratio of 20% to process daily transactions (Rs. 500+ crore/day in Nepal). If liquidity drops, it risks failing to refund users or pay merchants, as happened during the 2021 cyberattack when withdrawal limits were imposed.

2. Daraz’s Inventory Turnover

   • Idea: Inventory turnover ratio = COGS / Average Inventory.
   • How it’s used: Daraz aims for 8–10 turns/year for electronics. In 2023, poor turnover in "smart home" devices (low demand) led to write-offs of Rs. 150 million. Conversely, fast-moving items like mobile accessories turn 15+ times/year.

3. Khalti’s Operating Cycle

   • Idea: Operating cycle = Inventory days + Receivables days – Payables days.
   • How it’s used: Khalti’s cycle is ~5 days (near-instant payments mean no receivables; payables to banks are settled daily). Compare this to a Kathmandu grocery shop, which may take 30 days to sell inventory and 15 days to collect receivables, but pays suppliers in 7 days → net cycle = 38 days (risk of cash shortages).

4. NTC’s Cash Flow Crisis (2022)

   • Idea: Negative working capital (current liabilities > assets).
   • How it happened: NTC’s current ratio dropped to 0.8 due to:
     • Low receivables collection (customers delayed payments post-lockdown).
     • High inventory obsolescence (old telecom equipment became worthless).
     • Result: NTC had to borrow Rs. 2 billion from the central bank to meet payroll.

3. Key Ratios: Measuring Liquidity

4. How to Calculate: Step-by-Step with a Nepali Example

Scenario: Kathmandu’s "Thamel Bazaar" (a retail shop) reports the following for FY 2079:

• Current Assets:
  • Cash: Rs. 500,000
  • Inventory: Rs. 2,000,000 (clothes, jewelry, souvenirs)
  • Accounts Receivable: Rs. 800,000 (unpaid tourist bills)
  • Prepaid Rent: Rs. 200,000
• Current Liabilities:
  • Accounts Payable: Rs. 1,500,000 (unpaid suppliers)
  • Short-term Bank Loan: Rs. 800,000
  • Accrued Salaries: Rs. 300,000

Step 1: Calculate Working Capital

| **Item**               | **Amount (Rs.)** |
|------------------------|------------------|
| **Current Assets**     |                  |
| Cash                   | 500,000          |
| Inventory              | 2,000,000        |
| Accounts Receivable    | 800,000          |
| Prepaid Rent           | 200,000          |
| **Total Current Assets** | **3,500,000**    |
| **Current Liabilities**|                  |
| Accounts Payable       | 1,500,000        |
| Short-term Loan        | 800,000          |
| Accrued Salaries       | 300,000          |
| **Total Current Liabilities** | **2,600,000** |
| **Working Capital**    | **3,500,000 – 2,600,000 = 900,000** |

Interpretation:

• Positive WC (Rs. 900,000): The shop can cover its short-term debts.
• But: Inventory is 57% of current assets—high risk if unsold (e.g., post-Dashain clearance sales).

Step 2: Calculate Liquidity Ratios

| **Ratio**               | **Calculation**                          | **Result** | **Analysis**                                                                 |
|-------------------------|------------------------------------------|------------|------------------------------------------------------------------------------|
| Current Ratio          | 3,500,000 / 2,600,000                    | 1.35       | **Marginal**: Can pay debts but vulnerable if receivables aren’t collected. |
| Quick Ratio             | (3,500,000 – 2,000,000) / 2,600,000      | 0.58       | **Weak**: Without selling inventory, the shop can’t cover liabilities.      |
| Cash Ratio              | 500,000 / 2,600,000                      | 0.19       | **Critical**: Only 19% of debts are payable in cash.                          |

Actionable Insight:

• The shop should:
  1. Negotiate longer payables terms with suppliers (e.g., 60 days instead of 30).
  2. Reduce inventory by 20% (focus on fast-selling items like souvenirs).
  3. Offer discounts for early payment of receivables (e.g., 2% off if paid within 7 days).

5. Operating Cycle and Cash Conversion Cycle (CCC)

The operating cycle shows how long it takes to turn inventory into cash from sales. The CCC refines this by accounting for supplier payments.

Example: Thamel Bazaar’s Operating Cycle

flowchart TD
    A["Start: Pay Suppliers"] -->|"Rs. 1,500,000"| B["Inventory Purchased"]
    B -->|"30 days"| C["Inventory Sold"]
    C -->|"Average 15 days"| D["Collect Receivables"]
    D -->|"Rs. 2,300,000"| E["End: Cash Received"]

Calculations:

1. Inventory Period = 365 days / Inventory Turnover

   • COGS (for the year) = Rs. 4,000,000 (estimated).
   • Average Inventory = Rs. 2,000,000.
   • Turnover = 4,000,000 / 2,000,000 = 2 times/year.
   • Inventory Period = 365 / 2 = 182.5 days.

2. Receivables Period = (Accounts Receivable / Net Sales) × 365

   • Net Sales = Rs. 6,000,000 (estimated).
   • Receivables Period = (800,000 / 6,000,000) × 365 = 48.7 days.

3. Payables Period = (Accounts Payable / COGS) × 365

   • Payables Period = (1,500,000 / 4,000,000) × 365 = 137.1 days.

4. Operating Cycle = Inventory Period + Receivables Period = 182.5 + 48.7 = 231.2 days.

5. Cash Conversion Cycle (CCC) = Operating Cycle – Payables Period = 231.2 – 137.1 = 94.1 days.

Interpretation:

• CCC = 94 days: The shop ties up cash for 94 days before recovering it from sales.
• Industry Benchmark: For retail, CCC should be <60 days. Thamel Bazaar is overtrading—it’s growing too fast without enough working capital.
• Risk: If sales drop by 10%, the shop may face a cash crisis in ~3 months.

6. Working Capital Management Strategies

Trade-offs in WC Policy

| **Policy**       | **Pros**                                  | **Cons**                                  | **Best For**                     |
|------------------|-------------------------------------------|-------------------------------------------|----------------------------------|
| **Low WC**       | Higher profitability, more cash for expansion. | Risk of insolvency, lost sales.       | E-commerce (Daraz, Sastodeal).   |
| **High WC**      | Safety net, creditworthiness.             | Low returns, cash trapped in inventory. | Utilities (NTC), banks.          |
| **Balanced WC**  | Optimal efficiency.                      | Requires precise forecasting.           | Retail (Kathmandu, Big Mart).    |

7. Overtrading: The Silent Killer of SMEs

Definition: When a business grows sales faster than its ability to finance working capital needs, leading to cash flow crises.

Signs of Overtrading

• Current ratio < 1.0.
• Inventory turnover declining (old stock piling up).
• Receivables collection period increasing.
• Bank overdrafts rising (e.g., a shop borrowing Rs. 500,000/month to pay suppliers).

Example: Nepal’s Post-Lockdown Retail Crash (2021)

• Cause: Restaurants and shops increased orders 30% pre-Dashain but didn’t secure supplier credit.
• Result:
  • Inventory write-offs: Rs. 800 million in unsold goods.
  • Bankruptcies: 12% of small shops in Thamel closed within 6 months.
  • Lesson: Match sales growth to working capital, not the other way around.

8. Financial Statements and Working Capital

Working capital is reflected in three key statements:

1. Balance Sheet (Snapshot of WC)

| **Assets**               | **Liabilities & Equity**          |
|--------------------------|-----------------------------------|
| **Current Assets**       | **Current Liabilities**           |
| Cash: 500,000            | Accounts Payable: 1,500,000       |
| Inventory: 2,000,000     | Short-term Loan: 800,000          |
| Receivables: 800,000     | Accrued Salaries: 300,000         |
| Prepaid Rent: 200,000    | **Total Current Liabilities**     | **2,600,000** |
| **Total Current Assets** | **3,500,000**                    | **Working Capital** = 900,000       |

2. Income Statement (Affects WC)

• COGS (higher = more inventory used = lower WC).
• Sales on credit (higher receivables = higher WC).
• Example: If Thamel Bazaar’s COGS rises by 20%, inventory may drop to Rs. 1,600,000 → WC = 500,000 (risky).

3. Cash Flow Statement (WC in Action)

| **Cash Flow Activity**   | **Amount (Rs.)** |
|--------------------------|------------------|
| **Operating**            |                  |
| Cash from Customers      | +2,300,000       |
| Paid to Suppliers        | -1,500,000       |
| Paid Salaries            | -300,000         |
| **Net Operating Cash**   | **+500,000**     |
| **Investing**            |                  |
| Bought New Shelves       | -200,000         |
| **Financing**            |                  |
| Repaid Short-term Loan   | -400,000         |
| **Net Change in Cash**   | **-100,000**     |

Implication: The shop’s cash dropped by Rs. 100,000 despite profits. This signals WC mismanagement.

9. Exam Tip: How to Score Full Marks

1. Always define terms clearly:

   • "Working capital is the difference between current assets and current liabilities, representing a firm’s short-term financial health." (2 marks)

2. Show calculations with tables:

   • Use Dr/Cr columns for adjustments (e.g., if inventory is written down).
   • Label every step (e.g., "Step 1: Calculate Current Ratio").

3. Interpret ratios with real-world context:

   • "A current ratio of 0.8 for a retail shop like Kathmandu’s Thamel Bazaar indicates liquidity risk, as it cannot cover short-term debts without selling inventory at a loss." (3 marks)

4. Compare policies:

   • "While aggressive WC policies maximize profits (e.g., Daraz’s low inventory), conservative policies reduce risk (e.g., NTC’s high cash reserves)." (2 marks)

5. Flag red flags:

   • "Negative working capital in a service business (e.g., a restaurant) is normal, but in a retail shop like Big Mart, it signals overtrading." (2 marks)

6. Use Nepali examples:

   • Tie answers to eSewa’s liquidity, Daraz’s inventory, or NTC’s cash flow to show practical understanding. (1 extra mark for relevance)

10. Common Mistakes to Avoid

• Ignoring prepaid expenses: They are current assets and boost WC.
• Mixing current and non-current items: E.g., classifying a 5-year loan as current liability.
• Assuming all inventory is liquid: Jewelry sells faster than clothes—adjust ratios accordingly.
• Forgetting the operating cycle: Always calculate CCC if inventory/receivables data is given.
• Overlooking seasonality: A Kathmandu shop’s WC needs peak in Dashain, not just annual averages.

11. Quick Revision Checklist