I.

CONCEPTS AND SIGNIFICANCE OF WORKING CAPITAL MANAGEMENT

 Working capital is part of the total assets of the company. Generally, it is the difference between current
assets and current liabilities. It is the daily, weekly and monthly cash requirement for the operations of a
business. Therefore, working capital management is a process of managing short-term assets and
liabilities. It makes sure that a firm has sufficient liquidity to run its operations smoothly.
 Working capital refers to the current assets of a company that are changed from one form to another in
the ordinary course of business
 Proper management of working capital is essential to a company’s fundamental financial health and
operational success as a business. A hallmark of good business management is the ability to utilize
working capital management to maintain a solid balance between growth, profitability and liquidity.

What Is Working Capital Management?

Working capital management is a business strategy designed to ensure that a company operates
efficiently by monitoring and using its current assets and liabilities to the best effect. The primary purpose of
working capital management is to enable the company to maintain sufficient cash flow to meet its short-term
operating costs and short-term debt obligations.

Benefits of Working Capital Management

Working capital management can improve a company's earnings and profitability through efficient use of
its resources. Management of working capital includes inventory management as well as management of
accounts receivables and accounts payables.

The objectives of working capital management, in addition to ensuring that the company has enough
cash to cover its expenses and debt, are minimizing the cost of money spent on working capital, and
maximizing the return on asset investments.

There are two concepts in respect of working capital:

1. Gross Working Capital:
The sum total of all current assets of a business concern is termed as gross working
capital. So,

𝐺𝑟𝑜𝑠𝑠 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝑆𝑡𝑜𝑐𝑘 + 𝐷𝑒𝑏𝑡𝑜𝑟𝑠 + 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 + 𝐶𝑎𝑠ℎ

2. Net Working Capital:

The difference between current assets and current liabilities of a business concern is
termed as the Net working capital

𝑁𝑒𝑡 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝑆𝑡𝑜𝑐𝑘 + 𝐷𝑒𝑏𝑡𝑜𝑟𝑠 + 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 + 𝐶𝑎𝑠ℎ − 𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠 − 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠

II. FACTORS AFFECTING WORKING CAPITAL REQUIREMENTS OF THE BUSINESS

1. LENGTH OF OPERATING CYCLE

- the amount of working capital directly depends upon the length of operating cycle.
2. NATURE OF BUSINESS
- this depends on the nature of the business which an entity adapt.
3. SCALE OF OPERATION
- this involves the scope of operation of the business.
4. BUSINESS CYCLE FLUCTUATION
- it pertains to the fluctuation of demand.
5. SEASONAL FACTORS
- this refer to a company which sells seasonal goods or those products that can be sold on a seasonal
basis.
6. TECHNOLOGY AND PRODUCTION CYCLE
- in the simplest sense, this refers to the technique adapted by the entity in the conversion of their products.
7. CREDIT ALLOWED
- this refers to the average period for collection of sale proceeds.
8. CREDIT AVAIL
- it concerns to the length of credit which the supplier of the company provide.
9. AVAILABILITY OF RAW MATERIALS
- this factor is dependent on the availability of the materials needed for production.
10. LEVEL OF COMPETITION
- this depend on the level of competitiveness of the entity towards the market.
11. INFLATION
- this pertain to the increase in price of raw materials which affects the working capital requirement of the
business.
12. GROWTH PROSPECTS
- companies who expand their operations also require them to a larger amount of working capital.
 III. CASH CONVERSION CYCLE

• It is a metric that shows the amount of time it takes a company to convert its inventory into cash.
• The formula of the CCC or Cash Conversion Cycle measures the amount of time, (in days), it takes to
turn its resources into cash.
Formula:
CCC = DIO + DSO – DPO
Whereas:
DIO = Days Inventory Outstanding
DSO = Days Sales Outstanding
DPO = Days Payable Outstanding

What is “DIO” or Days Inventory Outstanding?

It is the number of days, on average, it takes a company to turn its inventory into sales.

Formula:

For example, Company A reported a $1,000 beginning inventory and $3,000 ending inventory for the fiscal year
ended 2018 with $40,000 cost of goods sold. The DIO for Company A would be:

Therefore, it takes this company approximately 18 days to turn its inventory into sales.

What is “DSO” or Days Sales Outstanding?

It is the number of days, on average, it takes a company to collect its receivables.

Formula:

For example, Company A reported a $4,000 beginning accounts receivable and $6,000 ending accounts
receivable for the fiscal year ended 2018 with credit sales of $120,000. The DSO for Company A would be:

Therefore, it takes this company approximately 15 days to collect a typical invoice.

What is “DPO” or Days Payable Outstanding?

It is the number of days, on average, it takes a company to pay back its payables.

Formula:

For example, Company A posted a $1,000 beginning accounts payable and $2,000 ending accounts payable
for the fiscal year ended 2018 with $40,000 cost of goods sold. The DSO for Company A would be:

Therefore, it takes this company approximately 13 days to pay for its invoices.

Putting it all together: CCC = DIO + DSO – DPO

CCC = 18.25 + 15.20 -13.69 = 19.76

Therefore, it takes Company A approximately 20 days to turn its initial cash investment in inventory back into
cash.

IV. WORKING CAPITAL INVESTMENT POLICIES

1. Relaxed Current Asset Investment Policy
- Relative large amount of cash, marketable securities and inventories are carried and under which
sales are stimulated by granting liberal credit terms resulting in high level of receivables.
- Marginal carrying cost of Current Assets will increase while marginal shortage cost will decrease.
2. Restricted Current Asset Investment Policy
 - Holdings of cash, securities, inventories and receivables are minimized.
- Marginal carrying cost of current assets will decrease while marginal shortage cost will increase
3. Moderate Current Asset Investment Policy
- Policy between the relaxed and restricted policies
- Dictates that the firm will have just enough current assets so that marginal carrying cost and marginal
shortage cost are equal, thereby minimizing cost.

Cost relevant to Investment in Current Asset

 Carrying Cost- cost associated with having current assets.

o Opportunity Cost- cost associated with having capital tied up in current asset instead of more
productive fixed cost
o Explicit Cost- cost necessary to maintain the value of current assets (storage cost)
 Shortage Cost- cost associated with not having current assets
o Opportunity Cost- sales lost due to not having enough inventory on hand
o Explicit Transactions Fees- paid to replenish the particular type of asset (extra shipping cost,
interest expense for money borrowed)

V. WORKING CAPITAL FINANCING POLICIES

a. Long-term/Permanent Assets
-Consist of property, plant and equipment, long-term investments and the portion of a firm’s current
assets that remains unchanged over the year.
b. Fluctuating/Seasonal Assets
-Current assets that vary over the year due to seasonal or cyclical needs

1. Maturity Hedging
- Attempt to match the maturities of assets and liabilities.
- Finance inventories with short-term bank loans and long-term assets with long-term financing
- Firms tend to avoid financing long-lived assets with short term borrowing
2. Cash Reserve/ Flexible Financing Policy
- Implies surplus cash and a little short-term borrowing.
- Reduces probability that a firm will experience financial distress
3. Aggressive Policy
- Greatest risk
- Greatest opportunity for profitability
- Long term funds will finance temporary capital any remaining permanent working capital
- A business must minimize its current assets or the amount of debt it owed
- Followed by companies looking for brisk growth
4. Conservative Policy
- Low risk
- Low potential for funding rapid growth
- Credit limits are pre-set to a specific amount
- Companies will have longer term loans with higher interest rates

VI. MANAGEMENT OF CASH & MARKETABLE SECURITIES

MANAGEMENT OF CASH

- To meet all the disbursement needs of the company

- To minimize funds committed to transaction and precautionary balances
- To avoid misappropriation and mishandling of funds / cash

The main objective of cash management is an optimal cash balance; minimizing the sum of fixed cost of
transactions and the opportunity cost of holding cash balance. Optimal balance here means a position
when the cash balance amount is on the most ideal proportion so that the company has the ability to invest
the excess cash for a return [profit] and at the same time have sufficient liquidity for future needs.

(The basic objective in cash management is to keep the investment in cash as low as possible while still
keeping the firm operating efficiently and effectively.)

Reasons for holding cash balances:

a) TRANSACTION MOTIVE
- involves the use of cash for day-to-day transactions (supplies, payrolls, taxes, interests, etc.)
b) PRECAUTIONARY MOTIVE
- inflows and outflows are not usually perfectly synchronized therefore it will need to keep enough cash for
emergency purposes
c) SPECULATIVE MOTIVE
 - ready cash to use in case of opportunities at unexpected moments and which are typically outside the
normal course of business.
d) CONTRACTUAL / COMPENSATING MOTIVE
- maintain compensating balance as a part of contract

Determining the Target Cash Balance

Baumol Cash Management Model - derived from EOQ formula

Optimal Level of Cash of the Company

- Level of cash at optimum but not risk of bankruptcy

- Cost of holding is at its minimum

𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑠ℎ = 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 + 𝑇𝑟𝑎𝑛𝑠𝑎𝑐𝑡𝑖𝑜𝑛 𝐶𝑜𝑠𝑡

𝑇𝐶𝐶 = 𝐶𝐶 + 𝑇𝐶

𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑎𝑠ℎ 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 × 𝑂𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝐶𝑜𝑠𝑡

𝐶
𝐶𝐶 = (𝐾)
2
𝑇𝑟𝑎𝑛𝑠𝑎𝑐𝑡𝑖𝑜𝑛 𝐶𝑜𝑠𝑡 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑇𝑟𝑎𝑛𝑠𝑎𝑐𝑡𝑖𝑜𝑛𝑠 × 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑡𝑟𝑎𝑛𝑠𝑎𝑐𝑡𝑖𝑜𝑛

𝑇
𝑇𝐶 = (𝐹)
𝐶
Optimal Cash Balance Formula

2 × 𝐶𝑎𝑠ℎ 𝑛𝑒𝑒𝑑𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 × 𝑇𝐶

𝐶∗ = √
𝑂𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝐶𝑜𝑠𝑡

2 ×𝑇 ×𝐹
𝐶∗ = √
𝐾

Opportunity Cost – income of the rejected alternative

Accelerating Cash Collections

Once the credit sales have been effected, there should be a built-in mechanism for timely recovery from
the debtors such as:

1. Prompt billing and periodic statements prepared to show the outstanding bills.
 Computerized billing, invoices are faxed, invoices included with shipment
2. Incentives such as trade and cash discounts offered to the customers for early/prompt
payments.
3. Direct deposit to firm’s bank account. Customers may be advised to deposit their checks
or cash directly to the bank.

Slowing Disbursements

1. Centralized processing of payables. This permits the finance manager to evaluate the
payments coming due for the entire firm and to schedule the availability of funds to meet
these needs on a company-wide basis.
 2. Zero balance accounts (ZBA). A corporate checking account in which a zero balance is
maintained. The account requires a master (parent) account from which funds are drawn to
cover negative balances or to which excess balances are sent.
3. Delaying payment. If one is not going to take advantage of any offered discount for early
payment, pay on the last day of the credit period.
4. Less frequent payroll. Instead of paying the workers weekly, they may just be paid semi-
monthly.

MANAGEMENT OF MARKETABLE SECURITIES

VII. MANAGEMENT OF RECEIVABLES

Overview of Accounts Receivable Management

 Seek to identify the impact of decisions on accounts receivable and how to determine the optimal credit and
collection policies.
 Establishment of a credit policy
 Is the company prepared to offer a credit?

Accounts Receivable
-Accounts receivable refer to amounts owed to the firm by customers who bought its goods or enjoyed its
services on credits.
-it is a component of current assets and as such a working capital.
- it is also referred to as trade debtors or simply receivables

Two Forms:
Trade or commercial credit
- credit which the firm extends to other firms
-short-term credit provided by suppliers of goods or services to other business
Consumer or retail credit
- credit which the firms extents to its final customers
-credit extended to individuals by suppliers of goods and services, or by financial institutions
through credit cards

Credit Policy
- refers to a suppliers policy on whether credit will be offered to customers.
- is a set of guidelines for extending credit to customers.

Credit policy generally covers the following variables:

Credit Standards
- Refers to the minimum financial strength of an acceptable credit customer and the amount
available to different a customer.
Delinquency and Default
- Whatever the credit policy of a business firm may adopt, there will be customers who will delay
and others who will default entirely, thereby increasing the total accounts receivable
Credit Terms
- Involves both the length of the credit period and the discount given.
 Credit Period – is the length of time buyers are given to pay for their purchases.
 Discounts – are price reductions for early payment. The discount specifies what the
percentage reduction is and when payment must be made to be eligible for discount.
Collection Policy
- Refers to the procedures the firm follows to collect past-due accounts.
5 C’s of Credit
Character - willingness to meet financial obligations
Capacity – ability to met financial obligations out of operating cash flow
Capital – financial reserves
Collateral – asset pledge as security
Conditions – general economic conditions related to customers business

Costs Associated with Investment in Accounts Receivable.

1. Credit analysis, accounting and collection costs.
2. Capital Costs
3. Delinquency Costs
4. Default Costs (Bad Debts)

Marginal analysis is performed in terms of systematic comparison of the incremental returns and the
incremental costs resulting from a change in the firm’s credit policy.
Rules in determining the need to change credit policy:
If:
1) Incremental Profit contribution > Incremental Cost ; then accept the change in credit policy
2) Incremental Profit contribution < Incremental Cost ; then reject the change in credit policy
3) Incremental Profit contribution = Incremental Cost ; then be indifferent to the change in credit policy.

VIII. MANAGEMENT OF INVENTORY

-Inventories are essential part of virtually all business operations and must be acquired ahead of sales.

The main classifications of inventories are:

Raw Materials
Goods in process
Finished Goods
Factory supplies
Merchandise

Functions of Inventories
1.) Pipeline or transit inventories
-These are inventories which are being moved or transported from one location to another and they fill
the supply pipelines between stages of the entire production-distribution system.
2.) Organizational or decoupling inventories
-These are inventories that are maintained to provide each link in the production-distribution chain a
certain degree of independence from the others.
3.) Seasonal or anticipation stock
-These are build up in anticipation of the heavy selling season or in anticipation of price increase or as
part of promotional sales campaign.
4.) Batch or lot-size
-These are inventories that are maintained whenever the user makes or buys material in larger lots tan
are needed for his immediate purposes.
5.) Safety or buffer stock
-These inventories are maintained to protect the company from uncertainties such as unexpected
customer demand, delays in delivery of goods ordered, etc.

Inventory planning

EOQ

Level monitoring and inventory Control system

1. Fixed order quantity system
This is an inventory system that controls the level of inventory by determining how much to order (the level
of replenishment), and when to order.
 Reorder point = average demand during lead time + buffer sotck

2. Fixed Reorder cycle system

- also known as the periodic review or replacement system where orders are made after a review of inventory
levels has been done at regular intervals.
Replenishment level is computed by the following formula:
M = B + D(R + L)
Where:
M = replenishment level in units
B = buffer stock in units
D = average demand per day
R = time interval in days, between reviews
L = lead time in days

3. Optional Replenishment System

- this system represents a combination of the important control mechanism of the other two systems describe.
Replenishment level is computed by the following formula:
P = B + D(L + R/2)
Where:
P = reorder point in units
B = buffer stock in units
D = average daily demand in units
L = lead time in days
R =time between review in days

4. ABC Classification System

Divide inventory into three classes based on Consumption Value
 Class A - High Consumption Value
 Class B - Medium Consumption Value
 Class C - Low Consumption Value

IX. SOURCES OF SHORT-TERM FUNDS & ESTIMATING COST OF SHORT-TERM FUNDS

Short-Term Sources for Working Capital Management

Short-term Financing

- the debt originally scheduled for repayment within one year.

- used to finance all or part of the firm’s working capital requirements and sometimes to meet permanent
financing needs.

Factors in the Selection of Short-term Funds

1. effective cost,
2. availability of credit;
3. influence; and
4. additional covenants.

Sources of Short-term Funds

1. Unsecured Credit
- an obligation without specific assets pledged as collateral
2. Secured Loans
- involves the pledge of a specific asset as a collateral in the event the borrower defaults in
payment of the principal or interest

The aforementioned sources can either be:

(a) Spontaneous Short-term Financing

(b) Nonspontaneous/Negotiated Short-term Financing

Spontaneous Short-term Financing

- sources that arise automatically from ordinary business transaction e.g. accounts payable and accruals.
a. Trade Credit – one of the most flexible sources of financing available to the firm.

Nonspontaneous/Negotiated Short-term Financing

 - sources that require special effort or negotiation e.g. bank loans, commercial paper, and accounts
receivable/inventory.
a. Short-term Bank Loans – commercial banks are second in importance as a source of fund.
- most common type is the commercial bank loan that is for a specific purpose, short-term and
self-liquidating.
b. Line of Credit – an informal arrangement in which a bank agrees to lend up to a specified
maximum amount of funds during a designated period.
- can also be a Revolving Credit Agreement, in which it is a legal commitment by the bank to
extend credit up to some maximum amount for a few months or several years.
c. Commercial Paper – an unsecure short-term promissory note sold in the money market by
highly credit-worthy firms.

(Cont. Nonspontaneous Short-term Financing…)

 Pledging or Assignment of Accounts Receivable

- the borrower simply pledges or assigns A/R as security for a loan.
- amount is stated at a percent of the face value of the receivables pledged
 Factoring of Accounts Receivable
- it involves the outright sale of the firms A/R to the finance company.
 Inventory Loans with:
1. Blanket Inventory Lien – this gives the lender a general lien or claim against the inventory of the
borrower
2. Trust Receipts/Chattel Mortgage Agreement – is an instrument acknowledging that the borrower
holds the inventory and proceeds from sales in trust for the lender.
3. Warehousing – goods are physically identified, segregated an stored under the direction of an
independent warehousing company

References
Concepts & Significance of WCM
• https://www.investopedia.com/terms/w/workingcapital.asp
• https://www.investopedia.com/terms/w/workingcapitalmanagement.asp
• https://www.investopedia.com/ask/answers/100715/why-working-capital-management-important-company.asp
• https://efinancemanagement.com/working-capital-financing/importance-of-working-capital-management
• http://www.yourarticlelibrary.com/financial-management/working-capital/working-capital-meaning-concept-nature-
explained/44081
Working Capital Financing Policies
• https://www.eaglebusinesscredit.com/blog/3-strategies-of-working-capital-financing/?fbclid=IwAR2tzfS6esLt-
jKV4r9JiZfXQDkjF9HFVVjRwoffpvBk-M9i8vISsfBEx2A
Working Capital Investing Policies
• https://www.bajajfinserv.in/what-are-the-types-of-working-capital-
policies?fbclid=IwAR1FS6j8fdp9DSBLZLorDVea0xbwHP2EUfQo7-Oxn3MBUync8yyzcnN87CM
Cash Conversion Cycle
 https://corporatefinanceinstitute.com/resources/knowledge/accounting/cash-conversion-cycle/
Cash Management
• Cabrera, G.A.B. & Cabrera, M.E.B. (2019). Financial Management Comprehensive Volume. Manila, Philippines:
GIC Enterprises & Co., INC.
• http://accounting-financial-tax.com/2009/08/using-cash-models-to-determine-the-optimal-cash-balance/
Marketable Securities
• https://efinancemanagement.com/investment-decisions/marketable-securities
Receivables & Inventory
• https://www.scribd.com/doc/133778715/Lecture-12-Accounts-Receivable-and-Inventory-Management-pdf
• https://www.slideshare.net/mobile/KuldeepUttam/inventory-management-27668547
• https://specialties.bayt.com/en/specialties/q/190080/what-are-the-advantages-of-fixed-order-quantity-system/
Sources of Short-Term Funds & Estimating Cost of Short-Term Funds