Title LM04 Working Capital and Liquidity IFT Notes.pdf ✅

LM04 Working Capital and Liquidity 2025 Level I Notes © IFT. All rights reserved 1 LM04 Working Capital and Liquidity 1. Introduction ........................................................................................................................................................... 2 2. Cash Conversion Cycle ....................................................................................................................................... 2 3. Liquidity .................................................................................................................................................................. 7 4. Managing Working Capital and Liquidity................................................................................................10 Summary ...................................................................................................................................................................13 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM04 Working Capital and Liquidity 2025 Level I Notes © IFT. All rights reserved 2 1. Introduction This learning module covers:  Cash conversion cycle  Primary and secondary sources of liquidity; evaluating a company’s liquidity position  Working capital approaches and their impact on the funding needs of a company 2. Cash Conversion Cycle The business operations of a company are typically made up of several sequential steps such as: acquiring raw materials, producing inventory, selling products to customers, and collecting cash. These activities are known as the issuer’s operating cycle, and they can occur once or several times per year. Exhibit 1 from the curriculum illustrates an operating cycle. These activities generate cash outflows and inflows that do not always occur at the same time as the activity. For example, raw materials may be purchased on credit and a payment made to the vendor later. Finished goods can be sold and delivered to customers but payment collected later. Inventory may take time to produce and be ready for sale. Future cash inflows from operating activities are recorded as short-term assets, while future cash outflows are recorded as short-term liabilities. Exhibit 2 from the curriculum defines a few short-term assets and liabilities that are of
LM04 Working Capital and Liquidity 2025 Level I Notes © IFT. All rights reserved 3 interest to analysts. Short-Term Asset Meaning Accounts receivable Amounts to be collected from customers for products or services sold Inventory Cost of products produced or purchased for sale Short-Term Liability Meaning Accounts payable Amounts owed to suppliers for products or services received Exhibit 3 from the curriculum demonstrates when these short-term assets and liabilities are recognized and de-recognized on the balance sheet. Short-Term Asset Recognized When . . . Derecognized When . . . Accounts receivable Product or service is sold to customer on credit Cash is received from customer Inventory Issuer takes ownership of materials, goods, supplies, etc. Product is sold to customer Short-Term Liability Recognized When . . . Derecognized When . . . Accounts payable Product or service is received, and issuer defers payment to supplier Cash is paid to supplier The amounts of time that accounts payable, inventory, and accounts receivable are outstanding on the balance sheet are known, respectively, as days payable outstanding (DPO), days of inventory on hand (DOH), and days sales outstanding (DSO). Instructor’s Note: The calculation of these amounts will be covered in a later learning module. Cash Conversion Cycle: A company’s cash conversion cycle is the amount of time between an issuer paying its suppliers and receiving cash from customers. (i.e., the time between derecognition of accounts payable and derecognition of accounts receivable) Cash conversion cycle = Days of inventory on hand + Days sales outstanding – Days payable outstanding. Exhibit 4 form the curriculum illustrates a cash conversion cycle graphically.
LM04 Working Capital and Liquidity 2025 Level I Notes © IFT. All rights reserved 4 Generally, the shorter the cycle the better. A short cash conversion cycle means that a company converts its inventory investment into cash quickly, whereas a long cash conversion cycle means that a company converts its inventory investment into cash slowly. The longer the cycle the higher the amount of working capital a company will need. Some companies can also have a negative cash conversion cycle – they receive cash from customers well before suppliers are paid. Example: Cash Conversion for US Retailers (This is based on Example 2 from the curriculum.) The following information is provided for five large US discount retailers Walmart Inc., Target Corporation, Costco Wholesale Corporation, The TJX Companies, and Ross Stores for the 2021 calendar year. Walmart Target Costco TJX Ross Days sales outstanding 5 2 3 7 2 Days of inventory on hand 48 68 29 63 61 Days payable outstanding 47 75 34 47 63 Which company has the shortest cash conversion cycle? Solution: Cash conversion cycle = DSO + DOH − DPO Cash conversion cycle for Walmart = 5 days + 48 days − 47 days = 6 days Cash conversion cycle for Target = 2 days + 68 days −75 days = −5 days Cash conversion cycle for Costco = 3 days + 29 days − 34 days = −2 days Cash conversion cycle for TJX = 7 days + 63 days − 47 days = 23 days Cash conversion cycle for Ross = 2 days + 61 days − 63 days = 0 days Target has the shortest cash conversion cycle of the five companies.