LECTURE 3:

WORKING CAPITAL MANAGEMENT *

The current assets that are utilized in the company's activities and operations is called working
*

capital . This includes cash, receivables accounts, inventories and expenditures paid in advance or the
*

prepaid expenses. The discrepancy between the current assets and the current liabilities used in the
* *

company activities is referred to as net working capital . *

Current asset management and management of current liabilities are relevant as well, as these
“ * **

accounts deal with the day-to-day business transactions . * ”

Good management of working capital accounts allows business organizations to meet maturing
*

obligations on time. This helps in developing good business relationships with suppliers and other
vendors such as utility companies.

Big Idea:

“Computing the company’s working capital* is a good method to monitor the

efficiency of the company and to sustain the short-term* financial health. This is
one of the important things to compute in liquidity ratio*.”

“ The working capital ratio is computed by dividing current assets by current liabilities.
* ”

Most think a ratio of 1.2 to 2.0 implies that the working capital is adequate. It indicates that a
“

company has ample short-term assets to offset its short-term debt. Something inferior to 1 indicates
negative W / C (working capital). On the other hand, if the answer is over 2, it means the company does
not spend excess money or it does not invest the excess fund to generate more funds. ”

Interpreting Working Capital *

When the current assets of a company do not outweigh its current liabilities (which means that
current assets are not enough to be used as payment for current liabilities), then in the short term it can
run into difficulty paying back creditors. The worst possible outcome will be company's bankruptcy.

A decreasing working capital ratio over a longer period of time may also be a warning sign which
justifies further evaluation of the finances and operations of the company. It may be that the sales
volumes of the company are declining, for example, and as a result , the number of its accounts
receivable drops significantly.

Working capital also provides investors of the operating efficiency supporting the business. If the
*

fund is wrapped up in inventory or the money is still owed by consumers to the company, obviously this
cannot be used to pay off all of the company's obligations. Therefore, if a business does not run in the
most productive way because of slow or inefficient collection; it may manifest as an improvement in
working capital.
 This can be seen by comparing work capital from one time to another; slow credit collection can
indicate an underlying issue in the performance of the organization.

REMEMBER!

➢ If the ratio is less than one, then they have negative working capital which means that
“ * *

the firm cannot pay its short-term obligations using its current or short-term assets like
* *

cash. ”

➢ However, a high working capital ratio isn't always a good thing, it could indicate that they
“ *

have too much inventory or they are not investing their excess cash.
* * ”

MANAGEMENT OF WORKING CAPITAL ACCOUNTS *

▪ Managing cash
Being the most liquid asset, cash is an important account in the statement of financial position *

that may affect the liquidity , and solvency of a company. It is also the most vulnerable when it comes to
* *

theft.

A good internal control must be properly implemented to safeguard this asset:

• A basic internal control system entails the assignment of custodial function and recording
function to separate individuals, unless you are the owner. Why is this so? Imagine a cashier of
a company who is also the chief accountant. If tempted, this person can steal cash from the
company and can manipulate the records so that nobody can discover that he is stealing. If you
are the owner, you probably will not steal from yourself and adjust the records?

• Cash collections should be supported by official receipts which are summarized in a daily
collection report. The daily collection report is going to useful for the next control measure for
cash – depositing collections.

• A good internal control over cash is by depositing all collections intact. The daily collection
reports are now compared with the deposit slips to find out if all collections are indeed
deposited.

• If all collections need to be deposited, then payments must be made through a check voucher
system. There must also be two signatories in the check to provide a check and balance. If the
business is small then the entrepreneur’s signature may suffice.

• For small payments like the fare given to a messenger, a petty cash fund is used. A petty cash
*

fund which should be minimal in amount, will be issued to a petty cash fund custodian, say the
*

office administrator. The petty cash fund may be PHP10,000 or PHP20,000. Disbursements
from this petty cash funds must be backed by a petty cash voucher signed by the recipient of
* *

the petty cash . *

 When the pett y cash fund is almost depleted, the petty cash fun d custodian will get
’ ’

reimbursements. This reimbursement will go through the check voucher system where the
custodian gets a check with the petty cash vouchers as supporting documents.

• The check must also be cross-checked by drawing two lines on the payee section of the check.
This cross-checking requires depositing of a check. It cannot be encashed. This makes it more
difficult for somebody who stole a check to get the money.

▪ Accounts Receivable Management

An excellent business proposition is to generate sales without offering a credit facility to
customers. However, this concept is theoretically sound, but not sustainable.

Consider a real estate company which sells condominium units at PHP5 million per unit. How
many units can the property developer sell if he sells the units only on cash basis? Do you think he can
sell a lot? Probably not as many as compared to providing instalment payments. Providing credit terms
to customers is one way of generating sales.

Credit management strategically defines the quality of account receivables collection.

The credit department of a firm is tasked to ensure the guidelines for extending credit are in place.
They are also responsible for monitoring the payment (including default) of customers. The credit
department performs the following functions:

1. Compiling information about the credit scores of customers before they are granted credit
lines.
2. Collection of receivables.
3. Determine ways by which aging receivables (overdue) are collected such that they do not
become bad debts (uncollected debt)

• Possible sources of credit information about customers:

1. Information provided by the customers in the customer information sheet
2. References provided by the customers
3. Reports published by the credit bureau or credit reporting companies
4. Names of the customers’ banking institutions or other financial institutions as asked for in
information sheet

• Information sheet generally contains the following information:

1. Name of Applicant
2. Current residence/ Legal address and former address if any
3. Occupation or business (and other sources of income)
4. Business address
5. Bank where the applicant maintains account
6. Types of account
7. Properties owned
 8. References (at least three credit references)
9. Financial statements (if the applicant for credit is a company)
10. At least two valid IDs (government issued)

The collectability of accounts receivables depends largely on the quality of customers. The quality
of customers depends on the standards or credit policies set up and used by an organization. Credit
policies are an integral part of the credit evaluation and there are 5C’s used in credit evaluation. These
are:

✓ Character – The borrower 's ability and enthusiasm to pay back the loan
✓ Capacity – a customer’s ability to generate cash flows
✓ Collateral – security pledged for payment of the loan
✓ Capital – The customer’s assets which can be the sources of his or her funds
✓ Condition – current situation of the market, economy, and even politics
* *

▪ Inventory Management
Managing inventory comprises developing and implementing plans and strategies to meet
production and merchandising requirements effectively and satisfactorily, and reducing inventory related
costs.

Effective inventory management becomes critical when the nature of the products are either
perishable (e.g. fruits, vegetables), fragile (e.g. glasses), or toxic (e.g. bleaching agent).

Proper inventory management involves the determination of reasonable levels of inventories

considering the size and nature of business. Maintaining too much inventories has costs such as carrying
or holding costs, possible obsolescence or spoilage. On the other hand, too low inventory can result to
stockout, and eventually lost sales.

Inventory In A Manufacturing Company

• In a manufacturing company, there are 3 kinds of inventory :

* * **

- Raw materials – these are purchased materials not yet put into production .
* *

- Work in process – these are goods and labor put into production but not yet finished .
* * *

- Finished goods – these are goods put into production and finished. These are ready to be sold.
*

The ABC Analysis

One way to control inventory is to classify inventory into a system called ABC Analysis. Under
this system, all items in the warehouse are classified into the following classification: A, B and C are
*
Items that are categorized from the most important to the least important. The objective is for the one in
charge of managing inventory to focus on the most important inventories in terms of value.

Example:

o Inventories classified as “A” are high valued items which should be safeguarded the most.
o B items, on the other hand, are average-cost items that should be safeguarded more than C
items but not as much as A items.
o While C items have low cost and is the least safeguarded.

Summary in handling inventory classes using ABC Analysis:

INVENTORY CLASS

A B C

Money Value High Medium Low

Quality of Control Very Strict Strict Not Too Strict

Inventory Slow Relatively Fast Fast

Movement