Course Code and Title: ACED 7 – Financial Management

Lesson Number: 11

Topic: Addressing Working Capital Policies and Management of Short-Term Assets and
Liabilities
Learning Objectives:
After studying Chapter 11, you should be able to:
1. Understand the concept of working capital management.
2. Know the importance of working capital management.
3. Identify and understand the factors affecting the firm’s working capital policy.
4. Appreciate the need of knowing how to trace cash movement through the firm’s operation.
5. Understand and calculate the operating cycle and cash conversion cycle of a business firm.
6. Know how operating cycle can be shortened.
7. Distinguish the alternative policies as to the amount of investment in current assets.
8. Identify and distinguish between the costs relevant to investment in current assets i.e. carrying
costs versus shortage costs.
9. Know the alternative policies in financing investment in current assets.
CHAPTER 11:

Pre-assessment:
Write T if the statement is true and F if the statement is false.

_____1. Working capital management is associated with long-term financial decision making.
_____2. Long-term financial decisions involve cash and outflows that occur within a year of less.
_____3. Working capital management involves finding optimal levels of cash, marketable
securities, accounts receivable, and inventory at the least cost.
_____4. Working capital management directly affects the firm’s long-term survival because
higher levels of current assets are needed to support production and sales growth.
_____5. Effective working capital management can generate considerable amounts of cash for
the firm.
 CHAPTER 11
ADDRESSING WORKING CAPITAL POLICIES AND MANAGEMENT OF SHORT-TERM
ASSETS AND LIABILITIES
INTRODUCTION
Working capital management is associated with short-term financial decision making.
Short-term financial decisions typically involve cash and outflows that occur within a year or less.
For instance, short-term financial decisions are involved when a firm orders raw materials or
merchandise, pays in cash and anticipates selling finished goods in one year for cash. In contrast,
long-term financial decisions are involved when a firm purchases a special equipment that will
reduce operating costs over; say, the next five years.
Working capital management also involves finding the optimal levels of cash, marketable
securities, accounts receivable, and inventory and then financing that working capital at the least
cost. Effective working capital management can generate considerable amounts of cash.
REASONS WHY WORKING CAPITAL MANAGEMENT IS IMPORTANT
1. Working capital comprises a large portion of the firm's total assets. Although the level of working
capital varies widely among different industries, firms in manufacturing and trading industries
more often than not, keep more than half of their assets in current assets.
2. The financial manager has considerable responsibility and control in managing the lever of
current assets and current liabilities.
3. Working capital management directly affects the firm's long-term and survival because higher
levels of current assets are needed to support production and sales growth.
4. Liquidity and profitability are likewise directly affected by working capital management. Without
sufficient liquidity, a firm may be unable to pay its liabilities as they mature. The firm's profitability
is also affected because current assets must be financed and financing involves interest expense.
FACTORS AFFECTING THE FIRM'S WORKING CAPITAL POLICY
There is no single working capital policy that is optimal for all firms or for any single firm in all
situations. The optimal working capital policy is difficult to develop in practice because not all
factors are controllable by management. The significant factors affecting a firm's working capital
position are as follows:
1. The Nature of Operations. Working capital requirements differ greatly among
manufacturing, retailing and service organizations. For example, retailing firms have a
high proportion of total assets in the current category because they earn their return from
current assets such as inventory.
2. The Volume of Sales. More current assets such as, accounts receivables and
inventories, are needed to support a higher level of sales.
3. The Variation of Cash Flows. The greater the fluctuations in the firm's cash inflows and
outflows, the greater the level of net working capital required.
4. The Operating Cycle Period. The operating cycle is the length of time cash is tied up in
a firm's operating process. For example, the operating cycle of a manufacturing firm is the
length of time required to purchase raw materials on credit, produce and sell a product,
collect the sales receipts and repay the credit. Shortening the operating cycle reduces the
 amount of time funds are tied up in working capital and thus lowers the level of Working
capital required.
Some questions that will fall under the general heading of working capital management are:
1. What is a reasonable level of cash to keep on hand and in a bank to pay bills?
2. How much credit should the firm extend to customers?
3. How much inventory should the company hold?
4. How much should the firm borrow in the short-term?
Working capital management has become particularly difficult in the declining economic
environment following the recent financial crisis. Some companies have been stuck with unused
inventory while others refrain front purchasing additional inventory until they see sufficient
evidence that consumers would start spending again. Also, some companies have relied more on
trade credit from their suppliers as a substitute form of financing rather than obtaining short-term
loans from financial institutions. Suppliers on the other hand worry that because of weak
economy, customers will not be able to pay them back on time.
Working capital management involves risk-return tradeoffs because the level composition and
financing of working capital always affect both a firm's risk and its profitability.
TRACING CASH AND NET WORKING CAPITAL
To trace cash movement through the firm's operation, we must measure the operating cycle as
well as the firm's cash conversion cycle.
Understanding the following time periods is necessary in monitoring the working capital
movement.
1. Operating Cycle. The length of time in which the firm purchases or produce inventory,
sell it and receive cash.
2. Cash Conversion Cycle. The length of time funds are tied up in working capital or the
length of time between paying for working capital and collecting cash from the sale of
inventory
• Inventory Conversion Period. The average time required to purchase merchandise
or to purchase raw materials and convert them into finished goods and then sell
them.
• Average Collection Period. The average length of time required to convert the
firm's receivables into cash, that is, to collect cash following a sale.
• Payables Deferral Period. The average length of time between the purchase of
materials and labor or merchandise and the payment
Figure 11-1 shows the relationship between operating and cash conversion cycle.
THE OPERATING CYCLE
The operating cycle of a company consists of the time period between the procurement of
inventory of raw materials and turn them into finished good (for manufacturing concerns), sell
them and receive payment for them. To ensure the firm’s operating cycle, the following formula
can be used.

Calculation of Operating Cycle

Suppose that Mermaid Industries has annual sales of P1 million, cost of goods sold of
P650,000, average inventories of P116,000, and average accounts receivable of P150,000.
Assuming that all Mermaid Industries sales are on credit, what will be the firm’s operating cycle?
Solution:

So it will take Mermaid Industries almost 120 days from the time they receive raw materials, to
produce, market, sell and collect the cash for their finished goods.
THE CASH CONVERSION CYCLE
The firm’s cash conversion cycle is determined by subtracting the average payment
period from the operating cycle.
Calculation of Cash Conversion Cycle
Using the data from the previous example Mermaid Industries and assuming that the average
accounts payable balance is P120,000, what will be the firm’s cash conversion cycle?
Solution:

The cash conversion cycle (CCC) may also be calculated as follows:

Discussion:
On Day J, Mermaid buys merchandise and expects to sell the goods and thus convert
them to accounts receivable in 65 days. It should take 55 days to collect the receivables, making
a total of 120 days between receiving merchandise and collecting cash. However, Mermaid is
able to defer its own payments for only 67 days.
Although Mermaid must pay its suppliers after 67 days, it will not receive any cash until
120 days into the cycle. Therefore, it may have to borrow from its bank on day 67 and it will not
be able to repay the loan until it collects from customers on Day 120. Thus, for 53 days which is
the cash conversion cycle (CCC), it will owe the bank and will be paying interest on this debt.
Thus, the shorter the cash conversion cycle, the better because that will lower interest charges.
Therefore, if Mermaid could (a) sell the goods faster, (b) collect receivables faster, or (c)
defer its payables longer without hurting sales or increasing operating costs, its cash conversion
cycle would decline, its interest charges would be reduced, and its profits and stock price would
be improved.
HOW CAN OPERATING CYCLE BE REDUCED
The aim of every management should be to reduce the length of operating cycle or the
number of operating cycles in a year in order to reduce the need for working capital It is therefore
necessary that the financial managers be able to identify the reasons for prolonged operation
cycle and how it could be reduced.
The following could be the reasons for longer operating cycle period:
1. Defective purchasing policy and practices that could lead to
 • Purchase of raw materials or merchandise in excess/short of requirements
• Buying inferior, defective materials thus lengthening the production time
• Failure to get credit from suppliers
• Failure to get trade/cash discount, and o Inability to purchase goods due to seasonal
swings
2. Lack of proper production planning, coordination and control that could result to protracted
manufacturing cycle
3. Defective inventory policy
4. Use of outdated machinery, technology as well, poor maintenance and upkeep of plant,
equipment and infrastructure facilities
5. Defective credit policy and receivable collection procedure
6. Lack of proper monitoring of external environment
Remedies that may be adopted to reduce the length of operating cycle period are as follows:
1. Production Management
There should be proper production planning and coordination at all levels of activity. Also,
a continuing assessment of the manufacturing cycle, proper maintenance of plant,
equipment and infrastructure facilities and improvement of manufacturing system,
technology would help shorten manufacturing cycle thus shortening the operating cycle.
2. Purchasing Management
The purchasing manager should ensure the availability of the right type, quantity and
quality of materials/merchandise obtained at the right price, time and • place through
proper logistics management. Further, efforts exerted towards lengthening the credit
period of the suppliers, increasing the rates of trade discount and cash discount would
certainly bring favorable outcome to the company's deferral payment period.
3. Marketing Management
The sale and production policies should be synchronized. Production of quality products
at lower costs enhances their marketability and sale ability. Storage costs would likewise
be minimized. The marketing people should strive to continually develop effective
advertisement, sales promotion activities, effective salesmanship and appropriate
distribution channels
4. Credit and Collections Policies
Sound credit and collection policies will enable the finance manager to minimize
investment in working capital particularly on inventory and receivables.
5. External Environment
The length of operating cycle is equally influenced by external environment. The financial
manager should be aware and sensitive to fluctuations in demand, entrants of new
competitors, government fiscal and monetary policies, price fluctuations, etc. to be able to
anticipate and minimize any adverse impact of the changes to the company.
SOME ASPECTS OF SHORT-TERM FINANCIAL POLICY
The working capital or short-term financial policy that a firm adopts involves answering two basic
questions.
1. What is the appropriate size of the firm's investment in current assets?
2. How should the current assets be financed?
ALTERNATIVE POLICIES AS TO THE SIZE OF INVESTMENT IN CURRENT ASSETS
There are at least three alternative policies regarding the total amount of current assets carried:
1. Relaxed Current Asset Investment Policy
This is a policy under which relatively large amounts of cash, marketable securities and
inventories are carried and under which sales are stimulated by granting liberal credit
terms resulting in a high level of receivables. In this policy, marginal carrying costs of
current assets will increase while marginal shortage costs will decrease.
2. Restricted Current Asset Investment Policy
This is a policy under which holdings of cash, securities, inventories and receivables are
minimized. Marginal carrying costs of current assets will decrease while marginal shortage
costs will increase.
3. Moderate Current Asset Investment Policy
This is a policy that is between the relaxed and restricted policies. This policy dictates that
the firm will have just enough current assets so that the marginal carrying costs and
marginal shortage costs are equal, thereby minimizing total cost.
Figure 11-3 shows three alternative policies regarding the total amount of current assets carried
in relation to sales.
COSTS RELEVANT TO INVESTMENT IN CURRENT ASSETS
Carrying costs are the cost associated with having current assets. Generally, they consist
of (a) opportunity costs associated with having capital tied up in current assets instead of more
productive fixed assets and (b) explicit costs which are costs necessary to maintain the value of
the current assets (e.g., storage costs).
Shortage costs are the costs associated with not having current assets and can include
(a) opportunity costs such as, sales lost due to not having enough inventory on hand and (b)
explicit transaction fees paid (e.g., extra shipping costs, interest expense for money borrowed) to
replenish the particular type of current asset.
Figures 11-4, 11-5 and 11-6 show the behavior and trade off between carrying costs and
shortage costs in relation to amount of current assets. On the vertical axis, have costs measured
in pesos and on the horizontal axis, we have the amount of current assets.
ALTERNATIVE STRATEGIES IN FINANCING WORKING CAPITAL
In previous section, we looked at the basic determinants of the level of investment in
current assets. Now we turn to the financing side of the question.
 Effective working capital management requires a set of strategies to manage the level,
composition and financing of a firm's current assets. Decisions should be based on the
simultaneous analysis of their joint impact on return and risk.
In addition, consideration should be given on the broad categories of assets. These are:
1. Long-Term/Permanent Assets. These consist of property, plant and equipment, long-
term investments and the portion of a firm's current assets that remain unchanged over
the year.
2. Fluctuating or Seasonal Assets. These are current assets that vary over the year due
to seasonal or cyclical needs.
Figure 11-7 shows the Total Assets Requirement over Time.

Figures 11-8, 11-9, and 11-10 show the different policies for financing current assets.
Discussion:
Policy I Flexible Financing Policy (Figure 11-8). This involves the decision to finance the peaks
of asset requirement with long-term debt and equity. It provides the firm with a large investment
surplus in cash and marketable securities most of the time
For example, for a school supplies firm, the peaks might represent inventory building prior to the
opening of classes. The valleys would come about because of lower off-season inventories. The
firm could keep a relatively large pool of cash and marketable securities. As the need for inventory
and other current assets began to rise, the firm would sell off marketable securities and use the
cash to purchase whatever was needed. Once the inventory was sold and inventory holdings
began to decline, the firm would reinvest in marketable securities. Here, the firm essentially uses
a pool of marketable securities as a buffer against changing current asset needs and never does
any short-term borrowing except in unusually very high peak asset demand.
Policy Il Restricted Financing Policy (Figure 11-9). This involves a decision to finance the
valleys or troughs of asset, with long-term debt and equity but will have to seek short-term
financing for all peak demand fluctuations for current assets as well as for in between demand
situations. This policy is considered the most "conservative" but the least convenient because it
involves seeking some level of short-term financing 41most all of the time.
Policy Ill Compromise Financing Policy (Figure 11-10). This involves a firm financing the
seasonally adjusted average level of asset demand with long-term debt and equity. It uses both
short-term financing and short-term investing as needed. With this compromise approach, the
firm borrows in the shon-term to cover peak financing needs but it maintains a cash reserve in
the form of marketable securities during slow period. As current assets build up, the firm draws
down this reserve before doing any short-term borrowing. This allows for some run-up in current
assets before the firm has to resort to short-term borrowing.
WHICH FINANCING POLICY SHOULD BE CHOSEN
On the question as to what is the most appropriate financing working capital strategy? There is
no definitive answer.
However, the following should be considered in analyzing the advantages/disadvantages of the
alternative financing policy for working capital.
1. Maturity Hedging. Most firms attempt to match the maturities of assets and liabilities.
They 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. This
type of maturity mismatching would necessitate frequent refinancing and is inherently risky
because short-term interest rates are more volatile than longer-term rates.

2. Cash Reserves. The flexible financing policy implies surplus cash and a little short-term
borrowing. This policy reduces the probability that a firm will experience financial distress.
Firms may not have to worry as much about meeting recurring, short-run obligations.
However, investments in cash and marketable securities are zero net present value
investments at best.

3. Relative Interest Rates. Short-term interest rates are usually lower than long-term rates.
This implies that it is, on the average, more costly to rely on long-term borrowing as
compared to short-term borrowing. If we expect rates to rise in the future, the firm may
want to lock in fixed rates for a longer time by shifting towards a flexible financing policy.
With falling rates, the opposite would of course hold true.
 4. Availability and Costs of Alternative Financing. Firms with easy and sustained access
to alternative sources Wii} want to shift toward more restricted policy.

5. Impact on Future Sales. A more restricted short-term financial policy probably could
reduce future sales to level that would be achieved under flexible policy. It is also possible
that prices can be charged to customers under flexible working capital policy. Customers
may be willing to pay higher prices for the quick delivery service and more liberal credit
terms implicit in flexible policy.

Activity:
Write T if the statement is true and F if the statement is false.

_____1. The financial manager has considerable responsibility and control in managing the
lever of current assets and current liabilities.
_____2. Liquidity and profitability are indirectly affected by working capital management.
_____3. There is a no fixed financing working capital strategy for every firm/company for all
situations.
_____4. All factors affecting a firm’s working capital position can be controlled by management.
_____5. Not all firms dealing the same problems/hurdles as with other firms when it becomes to
formulating a working capital policy.

Reinforcement:
Choose the letter of the correct answer:

1. Statement 1: Not all factors affecting a firm’s working capital position can be controlled
by management.
Statement 2: All firms have the same working capital policy.
a. Statement 1 is True, Statement 2 is False
b. Statement 1 is False, Statement 2 is True
c. Both statements are True
d. Both statements are False
2. One is a factor affecting the firms’ working capital policy, except for one:
a. Volume of sales
b. Variation of cash flows
c. Nature of the environment
d. Operating cycle period
3. Statement 1: Working capital requirements differ greatly among different industries.
Statement 2: More current assets, such as accounts receivable and inventories, are
needed to support a higher level of sales.
a. Statement 1 is True, Statement 2 is False
b. Statement 1 is False, Statement 2 is True
c. Both statements are True
d. Both statements are False
4. Statement 1: The greater the fluctuations in the firm’s cash inflows and outflows, the
lower the level of net working capital required.
Statement 2: The operating cycle of the length of time cash is tied of in a firm’s operating
process.
a. Statement 1 is True, Statement 2 is False
 b. Statement 1 is False, Statement 2 is True
c. Both statements are True
d. Both statements are False
5. The following are questions that will fall under the general heading of working capital
management, except for one.
a. What is the reasonable level of cash to keep on hand and in a bank to pay bills?
b. How much inventory should the firm hold?
c. How much credit should the firm extend to customers?
d. How many people should separate from the company to maintain its working capital?
6. Statement 1: Firms have different approaches in working capital management due to the
current state of the economy due to the pandemic.
Statement 2: Working capital management involves risk-return tradeoffs because the
level composition and financing of working capital always effect both firm’s risk and
profitability.
a. Statement 1 is True, Statement 2 is False
b. Statement 1 is False, Statement 2 is True
c. Both statements are True
d. Both statements are False
7. Statement 1: Operating cycle is the length time funds are tied up in working capital.
Statement 2: Cash Conversion cycle is the length of time which the firm purchases or
produce inventory, sell it and receive cash.
a. Statement 1 is True, Statement 2 is False
b. Statement 1 is False, Statement 2 is True
c. Both statements are True
d. Both statements are False
8. The following are components of operating and cash conversion cycles, except for one.
a. Waste disposal period
b. Inventory conversion period
c. Payable deferral period
d. Average collection period.
9. The following are remedies to reduce the length of operating cycle period, except f or
one:
a. Production Management
b. Purchasing management
c. Human Management
d. Marketing Management
10. The following are alternative policies that can be applied to working capital management,
except for one:
a. Restricted Current Asset Investment Policy
b. Moderate Non-Current Asset Investment Policy
c. Relaxed Current Asset Investment Policy
d. Moderate Current Asset Investment Policy