CPAR CPA REVIEW SCHOOL OF THE PHILIPPINES meres MAS 8708 MANAGEMENT ADVISORY SERVICES. WORKING CAPITAL MANAGEMENT AND FINANCIAL STATEMENTS ANALYSIS WORKING CAPITAL MANAGEMENT - refers to the administration and control of current assets and current liabilities to maximize the firm's value by achieving a balance between Profitability and risk WORKING CAPITAL FINANCING POLICIES 1. Matching Policy (also called self-liguidsting policy or hedging policy)~ matching the maturity of a financing source with an asset's useful life + short-term assets are financed with short-term liabilities. ‘+ long-term assets are funded by long-term financing sources 2. Conservative (Relaxed) Policy operations are conducted with too much working capital; Involves financing almost all asset investments with long-term capital 3. Aggressive (Restricted) Policy - operations are conducted on a minimum amount of working capital; uses short-term liabilities to finance, not only temporary, but also part or all of the permanent current asset requirement 4. Balanced Policy — balances the trade-off between risk and profitability in a manner consistent with its attitude toward bearing risk. WAYS OF MINIMIZING WORKING CAPITAL REQUIREMENT Managing cash and raw materials efficient. Having efficiency in making collections and In the manufacturing operations. Implementing effective credit and collection policies. Reducing the t me lag between completion and delivety of finished goods. Seeking favoraole terms from suppliers and other creditors. FORECASTING FINANCIAL STATEMENT VARIABLES ‘ASSUMPTIONS: 1. All variables are tied directly with sales 2. The current levels of most balance sheet items are optimal for the current sales level. ‘STEPS: 1. Identify assets and tlabilities that vary spontaneously with sales 2. Estimate the amount of net income that will be retained. 3. Compute the ariount of External Financing Needed (EFN) by subtracting increase in spontaneous liabilities and income retained from increase in total financing requlred (increase in assets due to increase in sales). EFN = AS x (SA/So) --AS x (SL/So) ~ ( x <1 - Payout%>) Where: SA/So = percentage relationship of spontaneous assets (variable assets) to sales at period 0. ‘SL/So = percentage relationship of spontaneous liabilities (variable liabilities) to sales at period 0, (CASH MANAGEMENT CASH MANAGEMENT - Involves the maintenance of the appropriate level of cash and investment in ‘marketable securities to meet the firm's cash requirements and to maximize Income on Idle funds,MAS 8708 WORKING CAPITAL MANAGEMENT AND FINANCIAL STATEMENTS ANALYSIS —_Page 2 of 12 REASONS FOR HOLDING CASH 4. Transaction Purposes ~ firms maintain cash balances that they can use to conduct the ordinary business transactions; cash balances are needed to meet cash outflow requirements for operational or financial obligations. 2. Compensating Balance Requirements ~ a certain amount of cash that a firm must leave in its checking account at all times as part of a loan agreement. These balances give banks ‘additional compensation because they can be relent or used to satisfy reserve requirements. 3. Precautionary Reserves ~ firms hold cash balance in order to handle unexpected ‘problems or Contingencies due to the uncertain pattern of cash inflows and outflows. 4 Potential Investment Opportunities - excess cash reserved are allowed to build up in anticipation of a future investment opportunity such as a major capital expenditure project. 5. Speculation - firms delay purchases and store up cash for use later to take advantage of possible changes in prices of materials, equipment, and securities, as well as changes in ‘currency exchange rates, THE CONCEPT OF FLOAT IN CASH MANAGEMENT Float ~ difference between the bank's balance for a firm’s account and the balance that the firm shows ‘on its own books, ‘TVPES OF Font: 1. Mail Float peso amount of customers’ payments that have been mailed by a customer but not yet received by the seller. 2. Processing Fioat— peso amount of customers’ payments that have been received by the seller but not yet deposited. 3. Clearing Float - peso amount of customers’ checks that have been deposited but not yet cleared. CASH MANAGEMENT STRATEGIES. 1. accelerate cash collections - reduce negative (mail and processing) float 2. control (slow down) disbursements 3. reduce the need for precautionary cash balance Operating Cycle - The amount of time that elapses from the point when the firm inputs materials and labor into the production process to the point when cash is collected from the sale of the finished goods. Its two components are: average age of inventories and average collection period of receivables. When the average age of accounts payable is subtracted fro the operating cycle, the result 1s called cash conversion cycle. Economic Conversion Quantity (Optimal Transaction Size) ~ the amount of marketable securities that must be converted to cash (or vice versa), considering the conversion costs and opportunity costs involved. fx conversion cost x annual demand for cash cq.= PX eenversion cost x annual demand for cash cg ‘Opportunity Cost ‘Conversion Cost ~- the cost of converting marketable securities to cash Opportunity Cost ~ the cost of holding cash rather than marketable securities (rate of interest that can be earned on marketable securities).MAS 8708 WORKING CAPITAL MANAGEMENT AND FINANCIAL STATEMENTS ANALYSIS —_—Page 3 of 12 MARKETABLE SECURITIES MARKETABLE SECURITIES ~ short-term money market instruments that can easily be converted to cash REASONS FOR HOLDING MARKETABLE SECURITIES (MS): 1. MS serve as substitute for cash (transactions, precautionary, and speculative) balances. 2. MS serve as a temporary investment that ylelds return while funds are idle. 3. Cash Is invested in MS to meet known financial obligations such as tax payments and loan amortizations. RECEIVABLE MANAGEMENT ‘ACCOUNTS RECEIVABLE MANAGEMENT — formulation and administration of plans and policies related to sales on account and ensuring the maintenance of receivables at 2 predetermined level and their collectibilty as planned, WAYS OF ACCELERATING COLLECTION OF RECEIVABLES 1 1. Shorten credit terms. 2. Offer special discounts to customers who pay their accounts within a specified period. 3. Speed up the mailing time of payments from customers to the firm. 4. Minimize float, that is, reduce the time during which payments recelved by the firm remain Uncollected funds. | AIDS IN ANALYZING RECEIVABLES 1. Ratio of receivables to net credit sales 3. Average collection period 2. Receivable turnover 4. Aging of accounts | j) INVENTORY MANAGEMENT INVENTORY MANAGEMENT - formulation and administration of plans and policies to efficiently and satisfactorily meet production and merchandising requirements and minimize costs relative to inventories. INVENTORY MODELS A basic INVENTORY MODEL exists to assist in two Inventory questions: 1. How many units should be ordered? 2. When should the units be ordered? Economic Order Quantity - the quantity to be ordered, which minimizes the sum of the ordering and carrying costs. * Economic Order Quantity may be computed as follows: where: a - cost of placing one order (or ‘ordering cost) £cq -[e D ~ annual demand in units k= annual costs of carrying one unit in inventory for one year ‘Assumptions of the EOQ Model 1. Demand occurs at a constant rate throughout the year. 2. Lead time on the receipt of the orders is constant. 3. The entire quantity ordered is reveived at one time. 4, The unit costs of the items ordered are constant; thus, there can be no quantity discounts. ‘5. There are no limitations on the size of the inventory. > When applied to manufacturing operations, the EQ formula may be used to compute the Economic Lot Size (ELS)MAS 8708 WORKING CAPITAL MANAGEMENT AND FINANCIAL STATEMENTS ANALYSIS — Page 4 of 12 where: a - set-up cost es. D = annual production requirement k = annual costs of carrying one > When the E0Q figure is available, the averagltihVRARUAP I dofRDaRe wAMoliows: Average Inventory = a > When to Reorder: When to reorder Is a stock-out problem. l.e., the objective is to order at @ point in time so as not to run out of stock before receiving the Inventory ordered but not so early that an excessive quantity of safety stock 's maintained Lead time — period between the time the order is placed and received Normal time usage = Normal lead time x Average usage Safety stock = (Maximum lead time - Normal lead time) x Average usage Reorder point if there is NO safety stock required = Normal lead time usage Safety stock + Normal lead time usage Reorder point if there is safety stock required or Maximum lead time x Average usage SHORT TERM FINANCING 1, ACCOUNTS PAYABLE - the major source of unsecured short-term financing. ‘a. Credit terms: credit period, cash discount, cash discount period b. Analysis of credit terms: «Taking the cash discount ~ IF cash discount Is to be taken, a firm should pay on the last day of the discount period. « Giving up cash discount — If the firm has to give up the cash discount, it should pay on the last day of the credit period. «© Cost of giving up cash discount = (CD/(100% - CD)] x (360/N) Where: CD = cash discount percentage N = number of days payment can be delayed by giving up the cash discount The above formula assumes that a firm gives up only one discount during the year. If 2 firm continually gives up the discount during the year, the annualized cost is calculated as follows: ‘Annualized cost of giving up cash discount = [1 + (CD/(100% - CD)}""— 1] Stretching Accounts Payable: A firm should pay the bills as late as possible without damaging its ‘credit rating. When @ firm can stretch the payment of accounts payable, the cost of foregoing the discount is reduced. 2. Bank Loans a. Single-payment notes ~ Ifthe interest Is payable upon maturity, the effective interest rate Is equal to the nominal rate. b. Discounted Note - The effective interest rate is higher than the nominal rate, Interest Effective et nperest rate Principal amount-Discounted Interest Ifthe term is less than a year, the interest rate is annualized.