BUSINESS FINANCE

MODULE

Module No. 5: Week 5: First Quarter

Working Capital Management

Learning Competencies (Essential Competencies)

The learner shall be able to explain tools in managing cash, receivables, and
inventory.
Code: ABM_BF12-IIIc-d-12

Let’s Recall (Review)

My Grandiose Birthday!
You are to organize your grandiose birthday celebration this year.
1. What are the things that should be considered in planning? (List down the needed
resources that will be needed for your birthday celebration)
2. How do you feel when planning for the celebration of your birthday? Why do you feel that way?
3. Do you have enough funds to have this kind of birthday celebration?
4. What will you do to achieve this kind of birthday celebration?

Let’s Understand (Study the Concept)

To fully understand what is working capital, let us first define these two accounting
terms:
1. Current assets, such as cash and equivalents, inventory, accounts receivable, and
marketable securities, are resources a company owns that can be used up or converted into cash within
a year.
2. Current liabilities are the amount of money a company owes, such as accounts payable, short-term
loans, and accrued expenses, that are due for payment within a year.
Working capital is the difference between a company’s current assets and current liabilities. It is a
financial measure, which calculates whether a company has enough liquid assets to pay its bills that
will be due within a year. When a company has excess current assets, that amount can then be used to
spend on its day-to-day operations.
To illustrate, the working capital formula is:
Working capital = Current Assets – Current Liabilities

To further illustrate, below is an example balance sheet used to calculate working capital.
Current Assets:
Cash P20,000
Accounts Receivable 15,000
Inventories 45,000
80,000
Working Capital = Current Assets –
Current Liabilities Current Liabilities
Accounts Payable 25,000
=80,000 – 40.000
Short-term Borrowings 5,000
Accrued Interest Payable 10,000 =P40,000
40,000
Working Capital P40,000
Moreover, if the company fails in the management of these accounts, there will be no expansion to
talk about or this can lead to the closure of the company. Good management of working capital
accounts allows the company to pay maturing obligations on time. This helps in developing good
business relationships with suppliers and other vendors such as utility companies. Furthermore,
efficient management of working capital accounts can improve the earnings of the company. This
improvement in earnings can come from savings in financing costs and minimizing possible
impairment losses from inventories.
Types of Working Capital Financing Policies
1. Maturity-matching working capital financing policy
2. Aggressive working capital financing policy
3. Conservative working capital financing policy

Working capital requirements change with the volume of business operations. As the sales increase,
working capital requirements also increase.
For example, if a company needs P10 million working capital to support the annual sales of P50
million. If the sales increase to P100million, will the P10 million working capital be enough?
Most likely NO, because with P100 million sales, there will be more cash needed for the operations,
more account receivables, and more inventories especially if the company is a trading or
manufacturing company.
However, during the year, sales are not the same every month. This is why companies have slack
season and peak season. If a company has annual sales of P50 million, chances are these sales are not
generated uniformly throughout the year. Given this situation, the net working capital requirements
during the slack season are lower than those during the peak season.
The net working capital needed to support an operation during the slack season represents the
permanent working capital requirements while the additional net working capital needed during
the peak season represents the temporary working capital requirements.
Cite for instance, the company has annual sales of P50 million. The company’s lowest level of
operations is the second quarter and during this period its working capital requirement is P6 million.
Its peak season is the fourth quarter where the working capital hits P10 million.
How much is the permanent working capital requirement? How about the temporary working

capital requirement?
You are right! Given the above scenario, the permanent working capital requirement is P6
million while its additional temporary working capital requirement is P4 million. Of course,
both numbers will change as the general level of sales increase.
All of these working capital financing policies have something to do with financing permanent
working capital and temporary working capital requirements.
Maturity-Matching Working Capital Financing Policy
Based on the maturity-matching
working capital financing policy as
Financing
Short-term

shown in Chart 1.1, permanent capital

requirements should be financed by
long-term sources while temporary
working capital requirements should be
financed by short-term sources of
Financing
Long-term

financing. Examples of long-term

sources of financing are common
Financing
Short-term

stocks, preferred stocks, and bonds. On

the other hand, short-term sources Permanent Working Capital Requirements
include short-term loans from banks.

Aggressive Working Capital Chart 1.1

Financing Policy Maturity-Matching Working Capital Financing Policy
Financing
Long-term

Based on this financing policy, some of

the permanent capital requirements should

Permanent Working Capital Requirements

Chart 1.2
Aggressive Working Capital Financing Policy
 be financed by short-term sources of financing.
Why do managers adopt this policy?
It is because long-term sources of funds have higher cost as compared to short-term sources
of financing. By financing some of the permanent working capital requirements with short-
term sources of financing, financing cost is minimized which in turn, improves net income.
But the management must keep in mind that by having this financing policy, the company is
increasing the probability that it will not be able to meet maturing obligations.
Conservative Working Capital Financing Policy
Based on this financing policy, some of the temporary working capital requirements are financed by
long-term sources of financing.
The management opts to utilize this policy

Financing
Short-term
because the top management does not
probably want to be stressed too much so
that they can concentrate their efforts on
other important concerns that will benefit
the company.
Maybe, the top management would also

Financing
Long-term
like to preserve their financial flexibility.
This means that if the company is
conservatively financed and good
investment opportunities come along the Permanent Working Capital Requirements
way, it will be easier for the company to
raise additional funds, be it in the form of
debt financing or equity financing. Chart 1.3
Conservative Working Capital Financing
KEY TAKEAWAYS Policy
 Working Capital Management requires monitoring a company's assets and liabilities to
maintain sufficient cash flow.
 The strategy involves tracking three ratios: the current ratio, the collection ratio, and the
inventory ratio.
 Keeping those three ratios at optimal levels ensures efficient working capital management.

Ratio Analysis
Working capital management commonly involves monitoring cash flow, current assets, and current
liabilities through ratio analysis of the key elements of operating expenses, including the working
capital ratio, collection ratio, and inventory turnover ratio.
Working capital management helps maintain the smooth operation of the net operating cycle, also
known as the cash conversion cycle (CCC)—the minimum amount of time required to convert net
current assets and liabilities into cash.
Types of Working Capital Management Ratios
1. CURRENT RATIO
The current ratio is calculated as current assets divided by current liabilities. It is a key indicator of a
company's financial health as it demonstrates its ability to meet its short-term financial obligations.
The formula to calculate the current ratio is as follows:

Although numbers vary by industry, a working capital ratio below 1.0 generally indicates that a
company is having trouble meeting its short-term obligations. That is, the company's debts due in the
upcoming year would not be covered by its liquid assets. In this case, the company may have to resort
to selling off assets, securing long-term debt, or using other financing options to cover its short-term
debt obligations.
2. COLLECTION RATIO (ACCOUNTS RECEIVABLE TURNOVER RATIO)
The collection ratio is a measure of how efficiently a company manages its accounts receivables. The
collection ratio calculation provides the average number of days it takes a company to receive
payment after a sales transaction on credit. If a company's billing department is effective at collections
attempts and customers pay their bills on time, the collection ratio will be lower. The lower a
company's collection ratio, the more efficient its cash flow.
To further illustrate on how to come up with the collection ratio, follow the steps below.
a. First, compute for the average accounts receivable.

b. Then, compute for the collection ratio (accounts receivable turnover ratio).

You can also compute for the days of receivable (average collection period) to measure the average
time to collect a receivable. Just follow the formula presented below.

3. INVENTORY TURNOVER RATIO

Inventory turnover is a measure of the number of times inventory is sold and replenished during a
period. Generally, the higher the ratio, the better.
To further illustrate on how to come up with the collection ratio, follow the steps below.
a. First, compute for the average inventory.

b. Then, compute for the inventory turnover ratio.

You can also compute for the days of inventory (average sale period) to measure the number of days
inventory is held before it is sold. Just follow the formula presented below.

Illustrative Example:
PAPA Company
Statement of Financial Position
As of December 31, 2019
ASSETS 2019 2018
Cash and cash equivalents 30,000 80,000
Accounts receivable, net 1,672,000 304,000
Inventory 500,000 300,000
Prepaid Assets 48,000 50,000
Total Current Assets 2,250,000 734,000
Property, Plant and Equipment 780,000 720,000
Total Noncurrent Assets 780,000 720,000
TOTAL ASSETS 3,030,000 1,454,000
LIABILITIES
Accounts Payable, net 980,000 420,000
Notes Payable (current portion) 180,000 180,000
Total Current Liabilities 1,160,000 600,000
Notes Payable (noncurrent) 180,000 360,000
Total Noncurrent Liabilities 180,000 360,000
TOTAL LIABILITIES 1,340,000 960,000
EQUITY
Papa, Capital 1,690,000 494,000
TOTAL LIABILITIES & EQUITY 3,030,000 1,454,000
Additional Information:
a. The credit sales for 2019 amounted to P3,200,000.
b. The cost of goods sold for 2019 amounted to P1,400,000.
Instructions:
1. Compute for the following ratios in 2019 using the SFP of the Papa Company:
1.1 Working Capital 1.3 Collection Ratio
1.2 Current Ratio 1.4 Inventory Turnover Ratio
2. Give interpretation for each ratio.

Solutions:
1.1 Working Capital = Current Assets – Current Liabilities
= 2,250,000 - 1,160,000
= 1,090,000
Interpretation: The business has a positive working capital (i.e., current assets is greater than the
current liabilities). A positive working capital means that the business is able to pay off its short-term
liabilities.
1.2
=
= 1.94
Interpretation: The current ratio (1.94:1) means that the business has P1.94 current assets to pay
every P1 of its current liability. Ideally, its better to have a current ratio that is higher than P1 to
secure the stability of the business.
1.3 Collection Ratio (Here, let’s follow the given steps.)
a.

= 988,000

= 3.24
Interpretation: The result above means that the business was able to generate and collect an account
receivable level of P988,000 3.24 times during the period.

= 112.65 days
Interpretation: The result above means that it takes 112.65 days to collect an account receivable.
Of course, you must keep in mind that low average collection period indicates organizations collect
payments faster. A lower average collection period is generally more favorable than a higher average
collection period. But, there is a downside to this as it may indicate its credit terms are too strict.
Customers may seek suppliers or service providers with more lenient payment terms.
1.3 Inventory Turnover Ratio (Here, let’s follow the given steps again!)

= 400,000
 = 3.5
Interpretation: The result above means that the business was able to sell and replenish an inventory
level of P400,000 3.5 times during the period.

= 104.29 days
Interpretation: The result shows that the inventory is held 104.29 days before it is sold.
Take note that a low days inventory outstanding (DIO) indicates that a company is able to more
quickly turn its inventory into sales. Therefore, a low DIO translates to an efficient business in terms
of inventory management and sales performance. However, a high days inventory outstanding
indicates that a company is not able to quickly turn its inventory into sales. This can be due to poor
sales performance or the purchase of too much inventory. Having too much idle inventory is
detrimental to a company as inventory may eventually become obsolete and unsellable. Holding
excess inventory also negatively impacts cash flow.

Let’s Try (Evaluation)

Mr. Papa is managing the working capital of SR Ice Cream. SR Ice Cream is engaged
in the selling of different ice creams. The following are the sales volume, and the
working capital needed based on the recent years:
QUARTER SALES WORKING CAPITAL
First (Jan. to March) P200,000 P120,000
Second (April to June) P900,000 P300,000
Third (July to Sept.) P750,000 P250,000
Fourth (Oct. to Dec.) P350,000 P150,000

The following banks offered the following loans:

BANK TERM (OR DURATION) AMOUNT
BPI 3 years P40,000-P90,000
BDO 5 months P25,000-P60,000
AUB 4 years P90,000-P150,000
PNB 9 months P65,000-P105,000
Based on the given information on the previous page, answer the following questions:
1. How much is the sales of SR Ice Cream during the peak season?
2. How much is its permanent working capital requirement?
3. How much is its maximum temporary working capital requirement?
4. What banks will be probably chosen by SR Ice Cream when choosing different policies?