ACCA Applied Skills · Financial Management

The nature, elements and importance of working capital: formula sheet

Full chapter guide

Key formulas

Working capital (net current assets): Working capital = Current assets − Current liabilities; Current assets are inventory, receivables and cash. Current liabilities are payables, overdraft, tax payable and other short-term amounts. Use the items the question tells you to include.
Trade working capital (operating items): Trade working capital = Inventory + Trade receivables − Trade payables; Excludes cash and overdraft. Useful when a question asks about the investment in the operating cycle only.
Current ratio: Current ratio = Current assets ÷ Current liabilities; A liquidity measure. Show it as a ratio, such as 1.5 : 1. It has no single correct level, as it depends on the industry.
Quick (acid test) ratio: Quick ratio = (Current assets − Inventory) ÷ Current liabilities; Removes inventory because it may be slow to convert to cash.
Working capital: Working capital = Current assets − Current liabilities; A positive figure means current assets exceed current liabilities. It is not by itself a measure of 'good' or 'bad'.
Current ratio: Current ratio = Current assets ÷ Current liabilities; A liquidity measure. Interpret against the industry and the firm's own trend, not a fixed target.
Quick (acid test) ratio: Quick ratio = (Current assets − Inventory) ÷ Current liabilities; Excludes inventory because it may be slow to turn into cash.
Cost of tying up funds: Annual financing cost = Extra working capital × Cost of finance; Use to show the profitability cost of holding more inventory or receivables.
Current assets to sales ratio: Current assets ÷ Revenue; A higher ratio suggests a more conservative investment policy; a lower ratio suggests a more aggressive one. Compare with a similar business or the industry.
Total funding of current assets: Permanent current assets + Fluctuating current assets = Total current assets; Permanent is the minimum level always held. Fluctuating is the variable part above it.
Matching financing policy: Long-term finance = Non-current assets + Permanent current assets; Short-term finance = Fluctuating current assets; This is the benchmark against which conservative and aggressive financing are described.
Conservative financing: Long-term finance > Non-current assets + Permanent current assets; Some fluctuating current assets are also funded long term. Lower risk, higher cost, possible surplus cash in quiet periods.
Aggressive financing: Long-term finance < Non-current assets + Permanent current assets; Some permanent current assets are funded short term. Higher risk, lower cost.
Current ratio: Current assets ÷ Current liabilities; Falls in overtrading. A very high figure may signal over-investment.
Quick (acid test) ratio: (Current assets − Inventory) ÷ Current liabilities; Often falls sharply in overtrading.
Receivables days: Trade receivables ÷ Credit sales × 365; Often rises if credit is loosened to chase sales.
Inventory days: Inventory ÷ Cost of sales × 365; Rising days suggests over-investment. Low days with stock-outs suggests under-investment.
Payables days: Trade payables ÷ Credit purchases × 365; Lengthening payables days may show reliance on suppliers as free finance.
Cash operating cycle: Inventory days + Receivables days − Payables days; A longer cycle needs more funding.
Gearing (debt to equity): Debt ÷ Equity; Rising gearing and overdraft reliance support an overtrading diagnosis.
Inventory days: Inventory days = (Inventory ÷ Cost of sales) × 365; Use average inventory only if the question says so. For a manufacturer, raw materials, work in progress and finished goods may be calculated separately.
Receivable days: Receivable days = (Trade receivables ÷ Credit sales) × 365; Use credit sales if given. If not, use total revenue and state the assumption.
Payable days: Payable days = (Trade payables ÷ Credit purchases) × 365; If purchases are not given, use cost of sales and state the assumption.
Cash operating cycle: Cycle = Inventory days + Receivable days − Payable days; Answer is in days. A lower figure is generally better, other things equal.
Current ratio: Current ratio = Current assets ÷ Current liabilities; Often expressed as x : 1. Do not treat 2 : 1 as a rule for every business.
Quick ratio (acid test): Quick ratio = (Current assets − Inventory) ÷ Current liabilities; Removes inventory because it may be slow to turn into cash.

Quick revision

Working capital = inventory + receivables + cash − payables (and other current liabilities), which is current assets − current liabilities.
Main elements: inventory, trade receivables, cash and trade payables.
Objective: balance liquidity against profitability.
Too little working capital risks illiquidity; too much reduces returns.
Conservative investment policy holds high levels of current assets; aggressive holds low levels.
Matching funds permanent assets with long-term finance and fluctuating assets with short-term finance.
Short-term finance is usually cheaper but riskier (refinancing and interest rate risk) than long-term finance, though this depends on the yield curve.
Overtrading means growing faster than working capital funding allows.
Cycle = inventory days + receivable days − payable days.
Inventory days = inventory ÷ cost of sales × 365; receivable days = receivables ÷ credit sales × 365; payable days = payables ÷ credit purchases (or cost of sales) × 365.
Current ratio = current assets ÷ current liabilities; quick ratio = (current assets − inventory) ÷ current liabilities.
A longer cycle needs more funding; shortening it releases cash.

Common mistakes

Including non-current assets or long-term loans in working capital. Fix: Only include items due or realised within one year or the normal operating cycle. Ignore long-term items.
Treating payables as part of current assets. Fix: Payables are a current liability. They reduce working capital because they are a source of finance, not an investment.
Saying the objective is to maximise working capital or to minimise it. Fix: Always state that the aim is the optimal level that balances liquidity and profitability.
Treating a high current ratio as automatically good. Fix: Point out it may mean idle cash, excess inventory or slow-paying customers, which reduces profitability.
Mixing up investment policy and financing policy. Fix: Ask two questions: how much is held (investment) and how it is paid for (financing). Answer only the one asked, and label it.
Saying a conservative policy gives higher profit. Fix: Remember: conservative means lower risk and lower return. Aggressive means higher risk and higher return.
Saying overtrading means the business is making losses. Fix: Stress that profit may be strong. The problem is cash and liquidity.
Mixing up overtrading and overcapitalisation. Fix: Overtrading means too little capital for the activity. Overcapitalisation means too much capital tied up.
Using revenue for inventory days. Fix: Inventory is held at cost, so divide by cost of sales.
Adding payable days instead of subtracting. Fix: Payables are a source of finance. Subtract them from the cycle.

Exam tips

In objective tests, watch the wording. Questions often ask which item is not an element of working capital, so know that non-current assets and long-term debt are excluded.
Remember that payables are a source of finance. If a question asks how to reduce the working capital investment, longer payment terms to suppliers is a valid answer.
In written answers, always mention the liquidity versus profitability trade-off. It earns marks in discussion parts.
Show your totals for current assets and current liabilities separately. Even if the final figure is wrong, you can still earn method marks.
Do not quote an ideal current ratio such as 2 : 1 as a rule. Compare with the industry or prior years.
In Section C, always name both objectives and show the conflict between them before giving an opinion.
In objective test questions, avoid options saying 'maximise' or 'minimise' working capital. The correct idea is usually balance.
Use the scenario's numbers: ratios, days and finance costs earn marks that generic points do not.