Corporate Finance Fundamentals: Cash Flow, Working Capital, and Liquidity Management

Cash vs. Accounting Profit: Why They Diverge

Accounting profit (net income) measures performance under accrual accounting: revenue is recognized when earned and expenses when incurred, not necessarily when cash moves. Cash, by contrast, is the company’s ability to pay bills on time. A profitable company can still fail if it cannot convert sales into cash fast enough or if it must fund large inventory and receivables.

Common reasons profit and cash differ

• Credit sales: Revenue is recorded now, but cash arrives later (accounts receivable increases).
• Inventory timing: Cash may be paid to suppliers before goods are sold (inventory increases).
• Supplier credit: Expenses may be recorded even if cash is paid later (accounts payable increases).
• Non-cash expenses: Depreciation reduces profit but does not use cash in the period.
• One-time cash items: Paying down a loan uses cash but is not an operating expense; it does not reduce operating profit.

Liquidity management focuses on ensuring the company has enough cash at the right time, even when profits look healthy.

Day-to-Day Funding Needs: What Liquidity Management Actually Does

Day-to-day funding needs come from the gap between when cash goes out (payroll, suppliers, rent, taxes) and when cash comes in (customer payments). Liquidity management is the set of routines and controls used to keep that gap from becoming a crisis.

Core routines

• Cash forecasting: A rolling view (often weekly for the next 13 weeks) of expected inflows and outflows, updated with actual collections and payments.
• Payment scheduling: Paying on agreed terms (not early by default), batching payments, and prioritizing critical vendors.
• Collections management: Ensuring invoices are accurate, sent immediately, and followed up systematically.
• Liquidity buffers: Maintaining minimum cash balances and committed credit lines to absorb surprises.

Practical step-by-step: Build a simple 13-week cash forecast

1. Start with opening cash balance (bank balance + readily available cash equivalents).
2. List expected cash inflows by week: customer collections (by invoice due date), other income (rebates, refunds).
3. List expected cash outflows by week: payroll, taxes, rent, supplier payments, interest, planned capex.
4. Compute weekly net cash flow = inflows − outflows.
5. Compute ending cash = opening cash + net cash flow.
6. Add a minimum cash threshold (for example, two weeks of payroll + critical supplier payments).
7. Flag weeks below threshold and assign actions (accelerate collections, delay non-critical spend, draw on credit line).

Operating Cash Flow Drivers: Receivables, Inventory, Payables

Operating cash flow is heavily influenced by working capital: the short-term assets and liabilities tied to operations. The key drivers are accounts receivable (AR), inventory, and accounts payable (AP). Changes in these accounts explain why cash can tighten even when sales rise.

Receivables (AR): cash tied up in customer credit

When AR increases, cash is being used because customers have not paid yet. When AR decreases, cash is released because collections exceed new credit sales.

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• Cash impact rule: AR up = cash down; AR down = cash up.
• Operational meaning: Payment terms, invoice accuracy, disputes, and collection discipline drive AR.

Inventory: cash tied up in stock

Inventory increases when the company buys or produces more than it sells in the period. That typically consumes cash (even if the expense is not fully recognized yet in profit due to cost accounting timing).

• Cash impact rule: Inventory up = cash down; Inventory down = cash up.
• Operational meaning: Forecast accuracy, reorder points, batch sizes, lead times, and product mix drive inventory.

Payables (AP): supplier financing

AP increases when the company delays paying suppliers (within agreed terms), which preserves cash. AP decreases when the company pays down supplier balances, which uses cash.

• Cash impact rule: AP up = cash up; AP down = cash down.
• Operational meaning: Negotiated terms, payment discipline, and vendor relationships drive AP.

The Cash Conversion Cycle (CCC): A Simple Liquidity Scorecard

The cash conversion cycle measures how long cash is tied up in operations from paying suppliers to collecting from customers. A shorter CCC generally means less cash trapped in working capital.

Key components

• DSO (Days Sales Outstanding): how long it takes to collect from customers.
• DIO (Days Inventory Outstanding): how long inventory sits before being sold.
• DPO (Days Payables Outstanding): how long the company takes to pay suppliers.

Formula: CCC = DSO + DIO − DPO

Interpretation: if CCC is 60 days, the business must fund about 60 days of operating activity before cash returns through collections (subject to seasonality and growth).

Practical step-by-step: Translate CCC into a cash target

1. Estimate average daily cost of operations (often COGS + operating cash expenses divided by 365, depending on your internal approach).
2. Multiply by CCC days to approximate cash tied up in the operating cycle.
3. Use this as a working capital baseline and track improvements over time.

Tactics to Improve Liquidity (and What They Trade Off)

Working capital improvements are not just accounting moves; they are operational decisions with customer, supplier, and risk implications. The goal is to free cash without damaging service levels, margins, or long-term relationships.

1) Payment terms and billing mechanics (AR tactics)

• Set clear terms by customer risk: shorter terms for higher-risk customers; incentives for early payment where it makes economic sense.
• Invoice immediately and accurately: delays and errors create disputes that extend DSO.
• Use milestone billing: for projects, bill at defined deliverables instead of waiting until completion.
• Automate reminders and escalation: a structured dunning process reduces “forgotten” invoices.

Trade-offs: tighter terms may reduce sales conversion or strain customer relationships; incentives reduce margin but may be worth it if cash is scarce or expensive.

2) Inventory policies (inventory tactics)

• Segment inventory: apply stricter controls to slow-moving items; protect availability for high-velocity SKUs.
• Set reorder points and safety stock scientifically: based on demand variability and lead times.
• Reduce batch sizes and lead times: smaller, more frequent replenishment can lower average inventory.
• Dispose of obsolete stock: write-downs hurt profit, but holding dead inventory quietly drains cash and space.

Trade-offs: too little inventory increases stockouts, lost sales, and expedited shipping costs; too much inventory ties up cash and raises obsolescence risk.

3) Supplier terms and payment discipline (AP tactics)

• Negotiate longer terms where feasible: especially when the company has strong purchasing power or stable demand.
• Pay on time, not early: unless early payment discounts exceed the company’s cost of capital and liquidity needs.
• Consolidate suppliers: higher volumes can support better terms, but concentration risk must be managed.

Trade-offs: stretching payables beyond agreed terms can damage supply reliability, pricing, and reputation; it can also trigger tighter terms or supply interruptions.

4) Credit control: reducing bad-debt and surprise cash gaps

• Credit approval workflow: set limits, require deposits for new/high-risk customers, and review exposures regularly.
• Monitor aging reports: focus on overdue buckets (e.g., 1–30, 31–60, 61–90, 90+ days).
• Dispute management: assign ownership and resolution deadlines; unresolved disputes are “hidden AR.”

Trade-offs: stricter credit may reduce revenue growth; looser credit may boost sales but increases cash volatility and default risk.

Risk and Opportunity: Why Working Capital Management Matters

Risk: running out of cash

• Growth can consume cash: rising sales often increase AR and inventory faster than AP, creating a funding gap.
• Shocks hit liquidity first: a delayed customer payment, supply disruption, or unexpected tax bill can push cash below minimum levels.
• Covenant and stakeholder pressure: low liquidity can trigger lender concerns, supplier tightening, or missed payroll.

Opportunity: freeing cash for investment

• Self-funding growth: reducing CCC can fund expansion without new debt or equity.
• Better negotiating position: strong liquidity enables bulk purchasing, strategic hires, or opportunistic acquisitions.
• Lower financing costs: less reliance on short-term borrowing reduces interest expense and refinancing risk.

Case Exercise: Calculate Working Capital Changes and Interpret Cash Impact

Scenario: You are analyzing the quarter’s cash performance. The company reports higher sales, but cash is tight. Below are selected balance sheet items (end of Q1 vs. end of Q2). Assume these are operating working capital accounts.

Step 1: Compute changes

• ΔAR = 1,450,000 − 1,200,000 = +250,000
• ΔInventory = 820,000 − 900,000 = −80,000
• ΔAP = 760,000 − 700,000 = +60,000

Step 2: Convert changes into cash impact

Use the operating cash impact rules:

• AR up uses cash: cash impact = −250,000
• Inventory down releases cash: cash impact = +80,000
• AP up provides cash: cash impact = +60,000

Net working capital cash impact = (−250,000) + 80,000 + 60,000 = −110,000

Interpretation: working capital changes reduced operating cash flow by $110,000 in Q2.

Step 3: Diagnose what happened operationally

• Receivables increased materially (+$250k): collections likely lagged sales, terms may have loosened, invoicing may be delayed, or disputes increased.
• Inventory decreased (−$80k): the company sold down stock or improved replenishment; this helped cash.
• Payables increased (+$60k): the company used more supplier credit (or delayed payments within terms), which helped cash.

Step 4: Choose targeted actions for next quarter

Based on the diagnosis, prioritize actions that address the biggest cash drag (AR):

1. Run an AR aging review and identify top overdue accounts by dollars.
2. Fix root causes: invoice errors, missing purchase orders, unapproved milestones, unresolved disputes.
3. Implement a collections cadence: reminders before due date, follow-up on day 1 overdue, escalation at day 15/30.
4. Adjust credit terms for repeat late payers: deposits, shorter terms, or credit limits.
5. Track weekly KPIs: DSO, % current AR, disputes count/value, and cash collected vs. forecast.