How much should a business tie up in working capital? Too much and the funds earn nothing; too little and it runs out of stock, loses customers or cannot pay on time. The answer is not a single figure but a policy, a deliberate choice about how lean or how safe to be, together with a way of turning that policy into a number for the budget.
This topic covers how the investment in working capital is measured and what it costs, the three factors that decide the level (the length of the working capital cycle, the company’s attitude to risk and the industry), how to calculate the working capital a business needs from its expected sales, costs and working capital ratios, with a full manufacturing example, and the aggressive and conservative policies with their benefits and risks.
The next topic covers working capital funding strategies.
The calculation also answers questions about cash released by a change of policy. In November Diet, 2025, Question 2(c) (3 marks) asked how much cash would be released if inventory fell by 30% and receivable and payable days changed. Read cash management models: Baumol and Miller-Orr first.
In 30 seconds
The investment in working capital = current assets (inventory, receivables, short-term investment, cash) less current liabilities (overdraft, payables, other). It has a cost: average investment × annual cost of finance. The level required depends on the length of the working capital cycle (and terms of trade), the company’s risk policy and the industry.
To estimate it, apply expected days to the forecast figures: inventory days ÷ 365 × cost, receivables days ÷ 365 × sales, payables days ÷ 365 × purchases. An aggressive policy keeps working capital low (higher profit, higher risk of stock-outs, lost customers and liquidity crises). A conservative policy keeps it high (safer, but more cost and lower profit).
The investment in working capital and its cost
The investment in working capital is the total amount an organisation has tied up in it. It must be managed so that it is neither too high nor too low. It is calculated as current assets (inventory, receivables, short-term investment, cash) less current liabilities (overdraft, payables and other current liabilities).
The investment has a cost: the interest on the finance used or the opportunity cost of other uses of the cash. Working capital is financed from long-term capital (debt or equity).
Annual cost of working capital = average investment in working capital × annual cost of finance. The amount to invest is a decision between having enough finance (but not too much) and the cost of financing it. For example, if the average investment is ₦32.2m and finance costs 14%, the annual cost is ₦4.5m.
What decides the level required
- The length of the working capital cycle. The cycle is the time from paying suppliers to receiving cash from customers. Manufacturing has a longer cycle than retailing, because a manufacturer holds raw materials, work in progress and finished goods and often sells on credit, while a retailer sells for cash and holds goods briefly. The terms of trade also affect the cycle.
- The working capital risk policy: aggressive or conservative, set by management’s risk appetite.
- The industry: normal levels of inventory and credit differ between sectors, so a company is compared with its industry.
Calculating the working capital required
The working capital ratios are used to estimate the investment needed for a coming period. Each balance is the annual figure × days ÷ 365 (or months ÷ 12). Example: a company expects sales of ₦240m and purchases of materials of ₦96m, with inventory held 40 days (on materials), receivables 45 days and payables 30 days. Inventory = 40 ÷ 365 × 96 = ₦10.52m; receivables = 45 ÷ 365 × 240 = ₦29.59m; payables = 30 ÷ 365 × 96 = ₦7.89m. Working capital required = 10.52 + 29.59 − 7.89 = ₦32.22m.
A manufacturing example: Tunde Manufacturing
Sales are ₦3,600,000 a year. Costs as a percentage of sales are: direct materials 32%, direct labour 20%, variable overheads 8%, fixed overheads 12% and selling and distribution 6%. Receivables take 2 months to pay; raw materials are held 2 months; work in progress and finished goods are each one month of production, valued at the cost of materials, labour and variable overheads.
Credit taken: materials 1.5 months, direct labour 1 week (50 working weeks), variable overheads 1 month, fixed overheads 1 month and selling and distribution half a month.
| Working | ₦ | |
|---|---|---|
| Raw materials | 2 ÷ 12 × 1,152,000 | 192,000 |
| Work in progress | 1 ÷ 12 × 2,160,000 | 180,000 |
| Finished goods | 1 ÷ 12 × 2,160,000 | 180,000 |
| Receivables | 2 ÷ 12 × 3,600,000 | 600,000 |
| Current assets | 1,152,000 | |
| Materials payable | 1.5 ÷ 12 × 1,152,000 | (144,000) |
| Labour payable | 1 ÷ 50 × 720,000 | (14,400) |
| Variable overheads payable | 1 ÷ 12 × 288,000 | (24,000) |
| Fixed overheads payable | 1 ÷ 12 × 432,000 | (36,000) |
| Selling and distribution payable | 0.5 ÷ 12 × 216,000 | (9,000) |
| Current liabilities | (227,400) | |
| Working capital required | 924,600 |
The production cost used for work in progress and finished goods is materials, labour and variable overheads: ₦1,152,000 + ₦720,000 + ₦288,000 = ₦2,160,000. Fixed overheads and selling costs are not included in inventory valuation in this example. At a financing cost of 13% the annual cost of the investment is about ₦120,000.
Aggressive and conservative policies
An organisation with a lower level of working capital than its competitors has an aggressive working capital policy: it keeps current assets (inventory, receivables) low and uses current liabilities (payables) as much as possible. It gives higher profitability and higher risk.
Typically it means low finished goods (risking lost sales), low raw material inventory (risking stock-outs, idle time and costly replacement), a short receivables period through tight credit control (risking loss of customers) and a long payables period (risking suppliers cancelling orders). The benefits are improved liquidity, efficiency and profitability; the risks are stock-outs, damaged supplier relationships, liquidity crises if short-term finance is withdrawn, and less flexibility.
A conservative working capital policy puts liquidity first and minimises risk by holding high levels of cash, inventory and receivables and using little short-term finance. It means large cash reserves, high inventory, lenient credit terms and a stress on long-term relationships. The benefits are lower risk of a liquidity crisis, flexibility and better relationships; the risks are opportunity cost on idle funds, higher storage and handling costs and lower profitability.
Example: two companies have sales of ₦600m, non-current assets of ₦300m and operating profit before the cost of working capital of ₦90m. The aggressive company holds working capital of ₦60m and the conservative one ₦150m, and finance costs 15%.
Finance costs are ₦9.0m and ₦22.5m. The aggressive company risks stock-outs: if 3% of sales (₦18m) are lost at a contribution of 30%, profit falls by ₦5.4m to ₦84.6m, a return of 84.6 ÷ 360 = 23.5% on capital employed of ₦360m, against 90 ÷ 450 = 20.0% for the conservative company. The aggressive policy still pays here, but the margin is thinner than it first appears, and a bigger loss of sales would reverse it.
The ideas in more depth
Why each balance uses a different annual figure
Receivables are valued at selling price, so they are based on sales; inventory and payables are valued at cost, so they are based on cost of sales or purchases. Using sales for all three overstates the investment in inventory and payables, which is a common error.
Why a policy is not chosen in isolation
The level of working capital is tied to the choice of funding: an aggressive investment policy is often paired with short-term funding, which is cheaper but riskier. The next topic considers the two decisions together.
Sources and references
- No accounting standard governs the policy. Inventory is valued under International Accounting Standard (IAS) 2 Inventories, and the same ratios are used in the earlier topics on the cash operating cycle.
These points are stated as at 5 November 2026.
Worked examples
Example 1: receivables. Expected sales ₦240m; receivables 45 days. Required: the investment in receivables.
- Receivables.
45 ÷ 365 × ₦240m = ₦29.59m.
Example 2: working capital required. Inventory ₦10.52m, receivables ₦29.59m, payables ₦7.89m. Required: the investment and its cost at 14%.
- Investment.
10.52 + 29.59 − 7.89 = ₦32.22m. - Cost.
14% × ₦32.22m = ₦4.51m.
Example 3: a stock-out. Sales lost are ₦18m at a contribution of 30%. Required: the lost contribution.
- Lost.
30% × ₦18m = ₦5.4m.
How to answer in the exam
- Use the right base for each balance: sales for receivables, cost or purchases for inventory and payables.
- Tabulate current assets and liabilities and total them, with each working shown.
- Compute the annual cost of the investment at the cost of finance.
- Discuss the policy with both sides: the saving in finance cost against the risk of stock-outs, lost sales and supplier problems.
Common mistakes in the exam
- Basing inventory and payables on sales.
- Mixing months and days in one table.
- Valuing work in progress at selling price.
- Forgetting to deduct current liabilities.
- Calling an aggressive policy riskless because it is cheap.
- Ignoring the industry when judging whether the level is right.
Quick revision
- Investment = current assets − current liabilities; cost = investment × finance rate.
- Level depends on cycle length, risk policy and industry.
- Inventory and payables on cost; receivables on sales.
- Aggressive: low, profitable, risky. Conservative: high, safe, costly.
Practice questions
These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.
Recall check: multiple choice
Question 1. The investment in working capital is:
- Total assets
- Non-current assets
- Current assets less current liabilities
- Equity
Show the answer
C. It is the net current assets.
Question 2. The annual cost of working capital is:
- Sales × profit margin
- Average investment × annual cost of finance
- Inventory × days
- Payables ÷ sales
Show the answer
B. The interest or opportunity cost of the funds.
Question 3. The required level of working capital depends on:
- The length of the cycle, the risk policy and the industry
- The share price
- The tax rate
- The dividend
Show the answer
A. These three factors set the level.
Question 4. Compared with manufacturing, retailing usually has:
- A longer cycle
- The same cycle
- No inventory
- A shorter cycle
Show the answer
D. It sells mainly for cash and holds goods briefly.
Question 5. An aggressive policy means:
- High inventory
- Low working capital, higher profit and higher risk
- High cash reserves
- Lenient credit
Show the answer
B. It minimises the investment.
Question 6. A conservative policy means:
- High cash, inventory and receivables, with lower risk and lower profit
- Low inventory
- Tight credit
- Long supplier credit
Show the answer
A. Liquidity comes first.
Question 7. A risk of an aggressive policy is:
- Idle cash
- Higher storage cost
- Stock-outs and damaged supplier relationships
- Lenient credit
Show the answer
C. Also liquidity crises if finance is withdrawn.
Question 8. The investment in payables is estimated as:
- Sales × days
- Profit ÷ 365
- Inventory ÷ sales
- Payables days ÷ 365 × purchases
Show the answer
D. Purchases are the base for payables.
Question 9. A cost of a conservative policy is:
- Stock-outs
- Supplier cancellation
- Opportunity cost of idle funds and storage cost
- Loss of liquidity
Show the answer
C. Funds could earn more elsewhere.
Question 10. Work in progress in a working capital estimate is valued at:
- Cost of materials, labour and variable overheads in production
- Selling price
- Fixed overheads only
- Nil
Show the answer
A. As an inventory item at cost.
Section B style: written questions
Question 11 (10 marks). (a) State the formula for the investment in working capital and its annual cost. (3 marks) (b) State the three factors that decide the level of working capital. (3 marks) (c) Compare an aggressive and a conservative policy. (4 marks)
Question 12 (15 marks). A company expects sales of ₦300m and purchases of ₦120m. Inventory is held for 30 days (on purchases), receivables are 50 days and payables 40 days. The cost of finance is 13%. (a) Calculate inventory, receivables and payables. (6 marks) (b) Calculate the working capital required. (3 marks) (c) Calculate its annual cost. (3 marks) (d) State why inventory and payables use purchases and not sales. (3 marks)
A further written question
Question 13 (20 marks). Two policies are considered. Sales are ₦800m, non-current assets ₦400m and operating profit before the cost of working capital ₦120m. The aggressive policy needs working capital of ₦50m but loses 2% of sales through stock-outs at a contribution of 25%. The conservative policy needs ₦130m. Finance costs 14%.
(a) Calculate the cost of financing each. (4 marks) (b) Calculate the contribution lost under the aggressive policy. (4 marks) (c) Calculate the profit after financing cost under each. (6 marks) (d) Recommend, and state TWO risks of the aggressive policy. (6 marks)
Model answers
Show the model answer to Question 11
(a) Investment = current assets − current liabilities (1.5); annual cost = average investment × annual cost of finance (1.5).
(b) The length of the working capital cycle; the risk management policy; the industry (1 each).
(c) Aggressive: low working capital, higher profit and higher risk (2). Conservative: high working capital, lower risk and lower profit (2).
Show the model answer to Question 12
(a)
- Inventory 30 ÷ 365 × ₦120m = ₦9.86m (2)
- receivables 50 ÷ 365 × ₦300m = ₦41.10m (2)
- payables 40 ÷ 365 × ₦120m = ₦13.15m (2).
(b) 9.86 + 41.10 − 13.15 = ₦37.81m (3).
(c) 13% × ₦37.81m = ₦4.92m (3).
(d) Inventory and payables are valued at cost, so cost or purchases is the correct base; receivables are valued at selling price, so sales is used (3).
Show the model answer to Question 13
(a)
- Aggressive 14% × ₦50m = ₦7.0m
- conservative 14% × ₦130m = ₦18.2m (4).
(b)
- Lost sales 2% × ₦800m = ₦16m
- contribution lost 25% × ₦16m = ₦4.0m (4).
(c)
- Aggressive.
120 − 4 − 7 = ₦109.0m (3). - Conservative.
120 − 18.2 = ₦101.8m (3).
(d) The aggressive policy gives ₦7.2m more profit, so it is preferred on these figures (2). Risks: stock-outs and loss of customers beyond the 2% assumed; damaged supplier relationships; a liquidity crisis if short-term finance is withdrawn (any two, 2 each).
Pathfinder on Working capital investment policy and determining needs
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
Part (c) asks for the cash released if the new inventory and credit policies are implemented: inventory cut by 30%, receivables to 40 days and payables to 50 days (3 marks).
Revise first: Calculating the working capital required
Source: ICAN Pathfinder, Financial Management. Diets covered: Every diet in the Pathfinder, November Diet, 2025 and May Diet, 2026, was reviewed here. The diets listed above test this topic directly..
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