FIN 103 - V. Working Capital Management

ATENEO - J.G.
SCHOOL OF MANAGEMENT FINANCE 103: PRINCIPLES OF FINANCE

Finance & Accounting Department V. - Working Capital Management
Instructor : Alice Ann M. Parlan, MBA, RFP SY 2017 – 2018 2nd Semester
WORKING CAPITAL MANAGEMENT / Part 1: Managing Current Assets

Alternative working capital policies
Cash management
Inventory management
Accounts receivable management
WORKING CAPITAL TERMINOLOGY
Gross Working Capital – total current assets
Net Working Capital – current assets minus non-interest bearing current liabilities
Working Capital Policy – deciding the level of each type of current asset to hold, and
how to finance current assets
Working Capital Management – controlling cash, inventories, and A/R, plus short-term
liability management.
GIVEN: SELECTED RATIOS OF SKI, INC.

Industry
SKI Average
Current Ratio 1.75x 2.25x
Debt/Assets 58.76% 50.00%
Turnover of Cash & Securities 16.67x 22.22x
Day Sales Outstanding (days) 45.63 32.00
Inventory Turnover 4.82x 7.00x
Fixed Asset Turnover 11.35x 12.00x
Total Asset Turnover 2.08x 3.00x
Profit Margin 2.07% 3.50%
Return on Equity 10.45% 21.00%
HOW DOES SKI’s WORKING CAPITAL POLICY COMPARE WITH ITS INDUSTRY?
SKI appears to have large amounts of working capital given its level of sales.
Working Capital Policy is reflected in current ratio, turnover of cash and securities,
inventory turnover, and DSO.
These ratios indicate SKI has large amounts of working capital relative to its level of
sales. SKI is either very conservative or inefficient.
IS SKI INEFFICIENT OR JUST CONSERVATIVE?
A conservative (relaxed) policy may be appropriate if it leads to greater profitability.
However, SKI is not as profitable as the average firm in the industry. This suggests the
company has excessive working capital.
Sources: Brigham and Houston: Essentials of Financial Management, 13th Ed., Cengage Learning Asia 2013; 1
Keown, Martin, Petty: Foundations of Finance, 7th Ed., Pearson Education, Inc. / Prentice Hall 2011
ATENEO - J.G. SCHOOL OF MANAGEMENT FINANCE 103: PRINCIPLES OF FINANCE
CASH CONVERSION CYCLE (CCC)
The cash conversion model focuses on the length of time between when a company
makes payments to its creditors and when a company receives payments from its
customers.
SKI’s CCC = __Days per Year__ + Day Sales - Payables Deferral Period
Inventory Turnover Outstanding
= (365 / 4.82) + 45.63 - 30 = 92 days
CASH CONVERSION CYCLE: AN ILLUSTRATION
CASH DOESN’T EARN A PROFIT, SO WHY HOLD IT?
Transactions – must have some cash to operate
Precaution – “safety stock”, which is reduced by line of credit and marketable securities
Compensating Balances – for loans and/or services provided
Speculation – to take advantage of bargains and to take discounts, which is reduced by

credit lines and marketable securities
GOAL OF CASH MANAGEMENT
To meet above objectives, especially to have cash for transactions, yet not to have any
excess cash
To minimize transactions balances in particular, and also needs for cash to meet other
objectives
CASH GENERATION AND DISPOSITION PROCESS
WAYS TO MINIZE CASH HOLDINGS
Use a lockbox
Insist on wire transfers from customers
Synchronize inflows and outflows
Use a remote disbursement account
Increase forecast accuracy to reduce need for “safety stock” of cash
Hold marketable securities (also reduces need for “safety stock”)
Negotiate a line of credit (also reduces need for “safety stock”)
WHAT IS “FLOAT”? HOW IS IT AFFECTED BY THE FIRM’S CASH MANAGER?
Float is the difference between cash as shown on the firm’s books and on its bank’s
books.
If SKI collects checks in 2 days but those to whom SKI writes checks don’t process them
for 6 days, then SKI will have 4 days of net float.
If a firm with 4 days of net float writes and receives $1 million of checks per day, it would
be able to operate with $4 million less capital than if it had zero net float.
CASH BUDGET: THE PRIMARY CASH MANAGEMENT TOOL
Purpose: Forecasts cash inflows, outflows, and ending cash balances. Used to plan
loans needed or funds available to invest.
Timing: Daily, weekly, or monthly, depending upon purpose of forecast. Monthly for
annual planning, daily for actual cash management.
GIVEN: SKI’S CASH RECEIPTS & PAYMENTS FOR JAN – FEB
Net Cash Inflows

Jan Feb
Collections $67,651.95 $62,755.40
Purchases 44,603.75 36,472.65
Wages 6,690.56 5,470.90
Rent 2,500.00 2,500.00
Total Payments $53,794.31 $44,443.55
Net CF $13,857.64 $18,311.85
THEREFORE, SKI’S CASH BUGET:

Net Cash Inflows
Jan Feb
Cash at start,
If no borrowing $ 3,000.00 $16,857.64
Net CF 13,857.64 18,311.85
Cumulative Cash 16,857.64 35,169.49
Less: Target Cash 1,500.00 1,500.00
Surplus $15,357.64 $33,669.49
SHOULD DEPRECIATION BE EXPLICITLY INCLUDED IN THE CASH BUDGET?
No. Depreciation is a non-cash charge. Only cash payments and receipts appear on
cash budget.
However, depreciation does affect taxes, which appear in the cash budget.
WHAT ARE SOME OTHER POTENTIAL CASH INFLOWS BESIDES COLLECTIONS?
Proceeds from the Sale of Fixed Assets
Proceeds from Stock and Bond Sales
Interest Earned
Court Settlements
HOW COULD BAD DEBTS BE WORKED INTO THE CASH BUDGET?
Collections would be reduced by the amount of the bad debt losses.
For example, if the firm had 3% bad debt losses, collections would total only 97% of
sales.
Lower collections would lead to higher borrowing requirements.
ANALYZE SKI’S FORECASTED CASH BUDGET
Cash holdings will exceed the target balance for each month
Cash budget indicates the company is holding too much cash.
SKI could improve its EVA by either investing cash in more productive assets, or by
returning cash to its shareholders.
A REVIEW: ECONOMIC VALUE ADDED (EVA)
WHY MIGHT SKI WANT TO MAINTAIN RELATIVELY HIGH AMOUNTS OF CASH?
If sales turn out to be considerably less than expected, SKI could face a cash shortfall.
A company may choose to hold large amounts of cash if it does not have much faith in
its sales forecast, or if it is very conservative.
The cash may be used, in part, to fund future investments.
TYPES OF INVENTORY COSTS
Carrying Costs – storage and handling costs, insurance, property taxes, depreciation,
and obsolescence.
Ordering Costs – cost of placing orders, shipping, and handling costs.
Costs of Running Short – loss of sales or customer goodwill, and the disruption of
production schedules.
Reducing the average amount of inventory generally reduces carrying costs, increases
ordering costs, and may increase the costs of running short.
INVENTORY MANAGEMENT
Economic Order Quantity (EOQ) Model –

attempts to determine the order size for
an inventory item, given its usage,
ordering costs, and carrying costs, that
will minimize total inventory costs
TOTAL INVENTORY COSTS AND EOQ DETERMINATION
IS SKI HOLDING TOO MUCH INVENTORY?
SKI’s inventory turnover (4.82) is considerably lower than the industry average (7.00).
The firm is carrying a lot of inventory per dollar of sales.
By holding excessive inventory, the firm is increasing its costs, which reduces its ROE.
Moreover, this additional working capital must be financed, so EVA is also lowered.
IF SKI REDUCES ITS INVENTORY, WITHOUT ADVERSELY AFFECTING SALES,

WHAT EFFECT WILL THIS HAVE ON THE CASH POSITION?
Short Run: Cash will increase as inventory purchases decline.
Long Run: Company is likely to take steps to reduce its cash holdings and increase its
EVA.
DO SKI’S CUSTOMER PAY MORE OR LESS PROMPTLY THAN THOSE OF ITS

COMPETITORS?
SKI’s DSO (45.6 days) is well above the industry average (32 days).
SKI’s customers are paying less promptly.
SKI should consider tightening its credit policy in order to reduce its DSO.
ELEMENTS OF CREDIT POLICY
Credit Period – How long to pay? Shorter period reduces DSO and average A/R, but it
may discourage sales.
Cash Discounts – Lowers price. Attracts new customers and reduces DSO.
Credit Standards – Tighter standards tend to reduce sales, but reduce bad debt
expense. Fewer bad debts reduce DSO.
Collection Policy – How tough? Tougher policy will reduce DSO but may damage
customer relationships.
DETERMINANTS OF INVESTMENT IN ACCOUNTS RECEIVABLES
DOES SKI FACE ANY RISK IF IT TIGHTENS ITS CREDIT POLICY?
Yes, a tighter credit policy may discourage sales. Some customers may choose to go
elsewhere if they are pressured to pay their bills sooner.
IF SKI SUCCEEDS IN REDUCING DSO WITHOUT ADVERSELY AFFECTING SALES,

WHAT EFFECT WOULD THIS HAVE ON ITS CASH POSITION?
Short Run: If customers pay sooner, this increases cash holdings.
Long Run: Over time, the company would hopefully invest the cash in more productive
assets, or pay it out to shareholders. Both of these actions would increase EVA.
WORKING CAPITAL MANAGEMENT / Part 2: Financing Current Assets

Working Capital Financing Policies
Accounts Payable (Trade Credit)
Commercial Paper
Short-Term Bank Loans
WORKING CAPITAL FINANCING POLICIES
Moderate – Match the maturity of the assets with the maturity of the financing.
Aggressive – Use short-term financing to finance permanent assets.
Conservative – Use permanent capital for permanent assets and temporary assets.
MODERATE APPROACH (MATURITY MATCHING)
RELATIVELY AGGRESSIVE APPROACH
CONSERVATIVE APPROACH
SHORT-TERM CREDIT
Any debt scheduled for repayment within one year.
Major Sources of Short-Term Credit:

o Accounts Payable (Trade Credit)
o Bank Loans
o Commercial Loans
o Accruals
From the firm’s perspective, short-term credit is more risky than long-term debt.
o Always a required payment around the corner.
o May have trouble rolling over loans.
ADVANTAGES AND DISADVANTAGES OF USING SHORT-TERM FINANCING
Advantages
o Speed
o Flexibility
o Lower cost than long-term debt
Disadvantages
o Fluctuating interest expense
o Firm may be at risk of default as a result of temporary economic conditions
ACCRUED LIABILITIES
Continually recurring short-term liabilities, such as accrued wages or taxes.
Is there a cost to accrued liabilities?

They are free in the sense that no explicit interest is charged.
However, firms have little control over the level of accrued liabilities.
WHAT IS TRADE CREDIT ?
Trade credit is credit furnished by a firm’s suppliers.
Trade credit is often the largest source of short-term credit, especially for small firms.
Spontaneous, easy to get, but cost can be high.
THE COST OF TRADE CREDIT
A firm buys $3,000,000 net ($3,030,303 gross) on terms of 1/10, net 30.
The firm can forego discounts and pay on Day 40, without penalty.
Net Daily Purchases = $3,000,000 / 365

= $8,219.18
NET AND GROSS EXPENDITURES: BREAKING IT DOWN
Firm buys goods worth $3,000,000. That’s the cash price.
They must pay $30,303 more if they don’t take discounts.
Think of the extra $30,303 as a financing cost similar to the interest on a loan.
Want to compare that cost with the cost of a bank loan.
BREAKING DOWN TRADE CREDIT
Payables level, if the firm takes discounts:
Payables = $8,219.18 (10) = $82,192
Payables level, if the firm takes no discounts:
Payables = $8,219.18 (40) = $328,767
Credit Breakdown:
Total Trade Credit $328,767
Free Trade Credit - 82,192
Costly Trade Credit $246,575
NOMINAL COST OF COSTLY TRADE CREDIT
The firm loses 0.01($3,030,303)

= $30,303 of discounts to obtain $246,575 in extra trade credit:
kNOM = $30,303 / $246,575

= 0.1229 = 12.29%
The $30,303 is paid throughout the year, so the effective cost of costly trade credit is
higher.
NOMINAL TRADE CREDIT COST FORMULA
Discount % 365 days

k NOM
1 - Discount % Days taken - Disc. period
1 365
99 40 - 10
0.1229
12.29%
EFFECTIVE COST OF TRADE CREDIT
Periodic Rate = 0.01 / 0.99 = 1.01%
Periods/Year = 365 / (40-10) = 12.1667
Effective Cost of Trade Credit:
EAR = (1 + periodic rate)n – 1
= (1.0101)12.1667 – 1 = 13.01%
COMMERCIAL PAPER (CP)
Short-term notes issued by large, strong companies. SKI couldn’t issue CP--it’s too
small.
CP trades in the market at rates just above T-bill rate.
CP is bought with surplus cash by banks and other companies, then held as a
marketable security for liquidity purposes.
BANK LOANS
The firm can borrow $100,000 for 1 year at an 8% nominal rate.
Interest may be set under one of the following scenarios:

o Simple annual interest
o Discount interest
o Discount interest with 10% compensating balance
o Installment loan, add-on, 12 months
USE THE APPROPRIATE EARs TO EVALUATE THE ALTERNATIVE LOAN TERMS
Nominal (quoted) rate = 8% in all cases.
We want to compare loan cost rates and choose lowest cost loan.
We must make comparison on EAR = Equivalent (or Effective) Annual Rate basis.
SIMPLE ANNUAL INTEREST
“Simple Interest” means no discount or add-on.
Interest = 0.08($100,000) = $8,000
kNOM = EAR = $8,000 / $100,000 = 8.0%
For a 1-year simple interest loan, kNOM = EAR
DISCOUNT INTEREST
Deductible Interest = 0.08 ($100,000)

= $8,000
Usable Funds = $100,000 - $8,000

= $92,000
RAISING NECESSARY FUNDS WITH A DISCOUNT INTEREST LOAN
Under the current scenario, $100,000 is borrowed but $8,000 is forfeited because it is a
discount interest loan. Therefore, only $92,000 is available to the firm.
If $100,000 of funds are required, then the amount of the loan should be:
Amount Borrowed = Amount Needed / (1 – Discount)

= $100,000 / 0.92 = $108,696
DISCOUNT INTEREST LOAN WITH A 10% COMPENSATING BALANCE
Amount needed
Amount borrowed
1 - discount - comp. balance
$100,000
$121,951
1 - 0.08 - 0.1
Interest = 0.08 ($121,951) = $9,756
Effective Cost = $9,756 / $100,000 = 9.756%
ADD-ON INTEREST ON A 12-MONTH INSTALLMENT LOAN
Interest = 0.08 ($100,000) = $8,000
Face Amount = $100,000 + $8,000 = $108,000
Monthly Payment = $108,000/12 = $9,000
Average Loan Outstanding = $100,000/2 = $50,000
Approximate Cost = $8,000/$50,000 = 16.0%
To find the appropriate effective rate, recognize that the firm receives $100,000 and
must make monthly payments of $9,000. This constitutes an annuity.
INSTALLMENT LOAN
From the financial calculator output below, we have:
kNOM = 12 (0.012043)
= 0.1445 = 14.45%
EAR = (1.012043)12 – 1 = 15.45%
WHAT IS A SECURED LOAN ?
In a secured loan, the borrower pledges assets as collateral for the loan.
For short-term loans, the most commonly pledged assets are receivables and
inventories.
Securities are great collateral, but generally not available.
For long-term loans, the most commonly pledged assets are real estate properties,
plant and equipment.
COMPARISON OF EFFECTIVE RATES

Assume Php 100,000 Loan for 1-Year Period at 8% Nominal Interest Rate

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ATENEO - J.G.

SCHOOL OF MANAGEMENT FINANCE 103: PRINCIPLES OF FINANCE

WORKING CAPITAL MANAGEMENT / Part 1: Managing Current Assets

WORKING CAPITAL TERMINOLOGY

Gross Working Capital – total current assets

GIVEN: SELECTED RATIOS OF SKI, INC.

IS SKI INEFFICIENT OR JUST CONSERVATIVE?

A conservative (relaxed) policy may be appropriate if it leads to greater profitability.

CASH CONVERSION CYCLE (CCC)

= (365 / 4.82) + 45.63 - 30 = 92 days

CASH CONVERSION CYCLE: AN ILLUSTRATION

CASH DOESN’T EARN A PROFIT, SO WHY HOLD IT?

Transactions – must have some cash to operate

Compensating Balances – for loans and/or services provided

Speculation – to take advantage of bargains and to take discounts, which is reduced by

GOAL OF CASH MANAGEMENT

CASH GENERATION AND DISPOSITION PROCESS

WAYS TO MINIZE CASH HOLDINGS

Insist on wire transfers from customers

Synchronize inflows and outflows

Use a remote disbursement account

Increase forecast accuracy to reduce need for “safety stock” of cash

Hold marketable securities (also reduces need for “safety stock”)

Negotiate a line of credit (also reduces need for “safety stock”)

WHAT IS “FLOAT”? HOW IS IT AFFECTED BY THE FIRM’S CASH MANAGER?

CASH BUDGET: THE PRIMARY CASH MANAGEMENT TOOL

GIVEN: SKI’S CASH RECEIPTS & PAYMENTS FOR JAN – FEB

Net Cash Inflows

THEREFORE, SKI’S CASH BUGET:

SHOULD DEPRECIATION BE EXPLICITLY INCLUDED IN THE CASH BUDGET?

WHAT ARE SOME OTHER POTENTIAL CASH INFLOWS BESIDES COLLECTIONS?

Proceeds from the Sale of Fixed Assets

Proceeds from Stock and Bond Sales

HOW COULD BAD DEBTS BE WORKED INTO THE CASH BUDGET?

Collections would be reduced by the amount of the bad debt losses.

Lower collections would lead to higher borrowing requirements.

ANALYZE SKI’S FORECASTED CASH BUDGET

Cash budget indicates the company is holding too much cash.

A REVIEW: ECONOMIC VALUE ADDED (EVA)

WHY MIGHT SKI WANT TO MAINTAIN RELATIVELY HIGH AMOUNTS OF CASH?

The cash may be used, in part, to fund future investments.

TYPES OF INVENTORY COSTS

Ordering Costs – cost of placing orders, shipping, and handling costs.

Economic Order Quantity (EOQ) Model –

TOTAL INVENTORY COSTS AND EOQ DETERMINATION

IS SKI HOLDING TOO MUCH INVENTORY?

IF SKI REDUCES ITS INVENTORY, WITHOUT ADVERSELY AFFECTING SALES,

Short Run: Cash will increase as inventory purchases decline.

DO SKI’S CUSTOMER PAY MORE OR LESS PROMPTLY THAN THOSE OF ITS

SKI’s customers are paying less promptly.

ELEMENTS OF CREDIT POLICY

DETERMINANTS OF INVESTMENT IN ACCOUNTS RECEIVABLES

DOES SKI FACE ANY RISK IF IT TIGHTENS ITS CREDIT POLICY?

IF SKI SUCCEEDS IN REDUCING DSO WITHOUT ADVERSELY AFFECTING SALES,

Short Run: If customers pay sooner, this increases cash holdings.

WORKING CAPITAL MANAGEMENT / Part 2: Financing Current Assets

WORKING CAPITAL FINANCING POLICIES

Aggressive – Use short-term financing to finance permanent assets.

MODERATE APPROACH (MATURITY MATCHING)

RELATIVELY AGGRESSIVE APPROACH

Any debt scheduled for repayment within one year.

Major Sources of Short-Term Credit:

ADVANTAGES AND DISADVANTAGES OF USING SHORT-TERM FINANCING