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IFT Notes for Level I CFA® Program
IFT Notes for Level I CFA® Program

R35 Working Capital Management

Part 2

4.  Investing Short-Term Funds

Short-term funds are a temporary store of surplus funds that are not necessarily needed in a company’s daily transactions. If a significant part of a company’s working capital portfolio is not needed for daily/short-term transactions, then the money can be invested in a longer-term portfolio. Short-term working capital portfolios consist of securities that are highly liquid, less risky and shorter in maturity than other types of investment portfolios.

Generally working capital portfolios consist of short term government securities, and short term bank and corporate obligations. These are investments that can be converted into cash within 2-3 working days.

Yield on Short-term Investment

The yields on short-term investments are measured by:

Discount-basis yield = \frac{F-P}{F} \times \frac{360}{T}

Money market yield = \frac{F-P}{P}*\frac{360}{T} = Holding period yield x \frac{360}{t}

Bond equivalent yield = \frac{F-P}{P}*\frac{365}{T} = Holding period yield x \frac{365}{t}


F = face value

P = purchase price

T = number of days to maturity

Instructor’s tip: We have covered these yield measures in quantitative methods. The formula for bond equivalent yield below is different than the one we have seen in Quant which was BEY = 2 * semi-annual yield.


A 90-day $100,000 U.S. T-bill was purchased at a discount rate of 4%. Calculate the money market yield and bond equivalent yield.


Face value = $100,000; T = 90; discount rate = 4%

Using Equation 3:

\frac{F\ -\ P}{F}*\frac{360}{T} = \frac{100,000\ -\ P}{100,000}*\frac{360}{90} = 0.04

Solving for P, we get P = 99,000

Money market yield = \frac{F\ -\ P}{P}*\frac{360}{T} = \frac{100,000\ -\ 99,000}{99,000}*\frac{360}{90} = 4.04%

Bond equivalent yield = \frac{F\ -\ P}{P}*\frac{365}{T} = \frac{100,000\ -\ 99,000}{99,000}*\frac{365}{90} = 4.097%

Strategies and Evaluation

The objective of investing in short-term funds is to earn a reasonable return while taking on limited credit and liquidity risk.

Companies must create an investment policy statement to achieve this objective. An IPS usually has the following structure:

  • Purpose: Describes the purpose of the portfolio, strategy to be followed, and acceptable instruments.
  • Authorities: Names the executives who will oversee the portfolio managers responsible for making investments.
  • Limitations: Lists the generic types of investments that can be included in the portfolio, and any restrictions on the amount of each security.
  • Quality: To ensure funds are safe, references to credit ratings from agencies such as Moody’s or S&P are made.

Short term investing strategies can be either active or passive. Passive strategies focus on rules; safety and liquidity are prioritized. Active strategies are more aggressive and require constant monitoring. The different types of active strategies are as follows:

  • Matching strategy: A conservative strategy that uses many of the same instruments as in passive strategy. In this strategy, the maturity of the current assets matches the maturity of the current liabilities.
  • Mismatching strategy: This is riskier than matching strategy as it requires accurate and reliable cash forecasts. Invests in liquid securities that can be sold if need arises. Maturity of the current liabilities does not match with the maturity of current assets.
  • Laddering StrategyInvolves purchasing bonds with multiple maturities that are spread out equally over the term of the ladder. Reduces interest rate and reinvestment risk. It can be an effective short-term strategy.

When evaluating a company’s short-term investment policy, one must see if the policy strategy meets the goals of the investment and if the credit ratings are neither restrictive nor liberal.

5.  Managing Accounts Receivable

Accounts receivable gets recorded when a company sells a good or service to its customers on credit, i.e., customers do not pay for it at the time of sale. There is a trade-off between increasing sales by granting credit and uncollectible accounts (when the amount owed by customers is never paid back). If the credit terms are strict, then it hurts sales.

Three primary activities in accounts receivable management are:

  • Establishing credit terms: granting credit and processing transactions. A company can offer multiple terms. An example of a credit term is 2/10 net 45. This means a customer must pay back within 45 days, but he will get a 2 percent discount if the entire amount is paid within 10 days.
  • Monitoring credit balances.
  • Measuring performance of the credit function.

5.1.     Key Elements of the Trade Credit Granting Process  

Credit terms offered by a company depend on the type of customer, the customer’s creditworthiness, and credit terms offered by competitors. A customer’s creditworthiness is usually determined using a credit scoring model based on different factors such as prior late payments, ready cash, history of bankruptcy, etc. A company’s credit policy defines what types of credit to offer to what kind of customers.

The different types of credit terms available to customers include:

  • Ordinary terms: Terms are set forth using formats such as net t or d/t1 net t2 where t is the time before which the customer must pay the invoice, t1 is the time before which if the invoice is paid, a discount is applicable, and t2 is the same as t. For example, 1/10 net 30 means the customer gets a 1 percent discount if the invoice is paid within 10 days or else the entire invoice must be paid within 30 days.
  • Cash before delivery: Invoice must be paid before shipment is made.
  • Cash on delivery: Payment must be made at the time of delivery.
  • Bill-to-bill: The previous bill must be paid before any new shipment.
  • Monthly billing: Payments to be made on a monthly basis. For example, 1/10 net 30 means the customer gets a 1 percent discount if the invoice is paid within 10 days of the next month or else the entire invoice must be paid within 30 days of the next month.

5.2.     Managing Customers’ Receipts

This section addresses the different ways in which customers make payments.

  • Electronic funds transfer: Money is transferred electronically from a customer’s account to the company’s bank account through a network. An electronic collection network is fast and efficient in terms of collecting payments and information about the customer. Forms of electronic payment include debit/credit card, or electronic checks.
  • Lockbox: This is used when payments cannot be converted to electronic payments. Customers mail payments to a post office box and the bank collects this several times a day and deposits the payment into the company’s accounts.
  • Float factor is a good measure for check deposits. It measures the time between checks deposited by customers and when funds are available for use by the company. A high float factor indicates there is a lot of money in transition.

5.3.     Evaluating Accounts Receivable Management

There are several ways of measuring accounts receivable performance; most deal with how effectively outstanding receivables can be converted into cash. A simple measure is number of days of receivables, but this does not consider the age distribution within the outstanding balance.

Earlier in this reading, we saw that receivables turnover = credit sales/average receivables and days of receivables = 365/receivables turnover. The problem with this approach is it does not indicate how much of receivables has been outstanding for how long, i.e., age distribution. For example, a company may have 50 percent of accounts receivable outstanding for 30-60 days while the other 50 percent may be outstanding for more than 90 days.

A common report used to monitor accounts receivable is the aging schedule. An aging schedule is a method of breaking down accounts receivable into different time periods for which they have been outstanding. That is, it lists accounts receivable into various groups of days outstanding like < 31 days, between 31 and 60 days, more than 60 days, and so on.

The advantage of this technique is that it helps the company in estimating how much of the receivables is potentially going to turn into bad debt, and for each time period how much money will not be collected at all. The longer a receivable is due, the higher the probability that it will never be collected.

The table below shows the aging schedule of accounts receivable for a company for three months: January to March. In part a), it is expressed in absolute terms and in part b), it is expressed as a percentage.

a)     Aging schedule (in $ millions) b)    Aging expressed as a percentage
Days outstanding Jan Feb Mar Days outstanding Jan Feb Mar
< 31 days 2000 2120 1950 < 31 days 40% 39% 40%
31-60 days 1500 1650 1400 31-60 days 30% 31% 28%
61-90 days 1000 900 920 61-90 days 20% 17% 19%
> 90 days 500 700 660 > 90 days 10% 13% 13%

The table below calculates the weighted average collection days for January given the average collection days for each grouping. The number of average collection days is multiplied by the weight to get the overall days for each grouping.

Weighted Average Collection Period
Days outstanding Avg. collection days % weight Days x weight
< 31 days 15 40% 6
31-60 days 45 30% 13.5
61-90 days 75 20% 15
> 90 days 120 10% 12

Weighted average collection period for Jan = ∑ days * weight = 46.5. Remember that in the above table, data for average collection days under each grouping must be given in order to calculate the weighted average collection period. The challenge is that it is often not readily available.

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