SH1663

Working Capital Management

I. Working Capital Management
A. Holding on to cash
• Why People Hold on to Cash
o Speculation – Firms hold on to cash in case there are special opportunities for the firm
that must be acted on quickly.
o Precaution – Holding cash can serve as an emergency fund for the firm. If expected
cash inflows are not received, the cash held on as a precautionary basis could be used
to satisfy short-term obligations.
o Transaction – Firms exist to produce goods and services. This activity results to the
need for cash to buy raw materials and pay off debts.
• Liquidity
o Liquidity is the ability of the company to satisfy its short-term obligations using assets
that are readily converted to cash. Liquidity management is the ability of the company
to generate cash when and where needed.
o Liquidity management requires addressing the drags and pulls on liquidity.
 Drags on liquidity are the forces that delay the collection of cash, such as slow
payments from customers or obsolete inventory.
 Pulls on liquidity are decisions that result in paying cash too soon, such as paying
cash credit or a bank reducing its line of credit.
o Primary sources of liquidity
 Cash and cash equivalents
• Cash received from sales
• Accounts payables
 Short-term funds
• Trade credit from suppliers
• Working capital loans from banks
 Cash flow management
• The firm can also generate working capital by effectively managing its cash.

II. Managing Cash, Receivables, and Inventory

A. The Operating Cycle
• A business purchases raw materials to manufacture the products they sell. Sometimes, those
raw materials are bought on credit. Once the products are sold, the business can choose to
pay immediately or at a later date.
• Ideally, businesses want to receive payment for sales right away and then use the payment
to clear the debts. However, in reality, there is often a mismatch in the timing of cash
receipts and the cash payment for the raw materials. Therefore, it is necessary to know how
long, on the average, it takes for the business to pay its suppliers and collect its sales.
• The operating period refers to the time period between the sale of the product and receiving
the cash payment. The cycle is composed of two (2) periods: the inventory period and the
accounts receivable period. The inventory period is the time it takes for the business to sell
its product after it has purchased the raw materials, while the accounts receivable period is
the time it takes for the business to collect the sale of the finished product. A shorter
operating period is preferable for business.

06 Handout 1 *Property of STI

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 SH1663

Accounts Receivable Period

Receivables Turnover 𝑁𝑁𝑁𝑁𝑁𝑁 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
Ratio: (𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 + 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅)⁄2

Age of Receivables 365

𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇

Inventory Period
Inventory Turnover Ratio 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
(𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 + 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼)⁄2

Age of Inventory 365

𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇

Operating Cycle
𝐴𝐴𝐴𝐴𝐴𝐴 𝑜𝑜𝑜𝑜 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 + 𝐴𝐴𝐴𝐴𝐴𝐴 𝑜𝑜𝑜𝑜 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼

B. The Cash Conversion Cycle

• The cash conversion cycle, also known as the cash cycle, is the time it takes for the
business to collect its account receivables after it has paid for its raw materials. It is
calculated by subtracting the accounts payable period from the operating cycle.
• The cash conversion period may be obtained by first computing the accounts payable
period turnover. It is the time it takes for the business to pay for its raw materials from the
time they are acquired. Just like the operating cycle, a shorter cycle is preferred.

Accounts Payable Turnover 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆

𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 + 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
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Accounts Payable Period 365

𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇

Cash Conversion Cycle 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 − 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

References:
Benito, P. P., Chan Pao, T. P., & Yumang, K. (2016). Exploring small business and personal finance
in senior high. Quezon City: Phoenix Publishing House.
Lopez-Mariano, N. D. (2014). Elements of finance. Quezon City: Rex Book Store.
Maneval, E. (n.d.). Working capital management. Retrieved from Study Finance website:
http://www.studyfinance.com/lessons/workcap/?page=03
Sources of liquidity and factors affecting firm's liquidity. (2016). Retrieved from Finance Train:
http://financetrain.com/sources-of-liquidity-and-factors-affecting-firms-liquidity/

06 Handout 1 *Property of STI

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