Working Capital Management

Cash Management

Characteristics of Cash:
 it is considered to be the most unproductive form of asset
 it is the beginning and end of the operating cycle of the business
 it is easily converted into other forms of assets and is easily concealed and
transported.

Motives for Handling Adequate Cash Balance:

Transaction Motive - to meet daily operating requirements such as purchases, payrolls,
ordinary expenses, taxes, etc....
Precautionary Motive - providing for cash sufficient to meet emergency and other
contingency requirements such as strikes and expected slowdown in collections.
Speculative Motive - providing for funds to take advantage of profit-making
opportunities which are typically outside the normal course of business such as drop in
securities prices, major acquisition of business and merger proposals.

Cash Management:
- this refers to the most effective way of handling cash or its equivalent, in a
manner intended to result to its most efficient use.
- this involves managing the monies of the firm in order to maximize cash
availability and income on any idle funds.

Objectives of Cash Management:

a. better synchronization of cashflows
b. prevention of pilferage or theft
c. search for more productive uses of surplus cash

A cash budget is instrumental in cash management because it provides

information on the timing and magnitude of cash availability. It serves as a foundation
for cash planning and control.

Two Important Functions of Cash Management

1. Cashflow Control - involves the maximum acceleration of collection coupled with a
disbursement prepared at the latest possible moment compatible with obtaining discount
on purchases or at least maintaining a reputation for paying obligations on schedule.
2. Cash Surplus Investment - investing idle cash for income.

Cash Management Techniques

 Float
Float refers to the funds that have been dispatched by a payer but are not yet in
the form that can be spent by the payee. Float also exists when a payee has received
funds in a spendable form but these funds have not been withdrawn from the account of
the payer. Delays in the collection-payment system resulting from the transportation and
processing of checks are responsible for float.

Components of float:
Mail Float - The delay between the time when a payer places payment in the mail and
the time when it is received by the payee.
Processing Float - The delay between the receipt of a check by the payee and the deposit
of it in the firm’s account.
Clearing float - the delay between the deposit of a check by the payee and the actual
availability of the funds. This component of float is attributable to the time required for
a check to clear the banking system.

Speeding up Collections
1. Concentration banking - a collection procedure in which payments are made to
regionally dispersed collection centers, then deposited in local banks for quick clearing.
This reduces the mail float as well as the clearing float.

Example:
Suppose ABC Co. could go to concentration banking and and reduce its
collection by period by 3 days. If the company normally carried P10,000,000.00 in
receivables and that level represented 30 days of sales, cutting 3 days from the collection
process would result in a P1,000,000 decline in receivables (3/30 X 10,000,000). Given
a 10% opportunity cost, the gross annual benefits (profits) of concentration banking
would amount to P100,000.00 (10% X 1,000,000.00). Assuming no change in risk, as
long as total annual costs - incremental administrative costs and bank service fees and the
opportunity cost of holding specified minimum bank balances - are less than the expected
benefits of P100,000.00, concentration banking would be very beneficial for the
company.

2. Lockboxes - a collection procedure in which payers send their payments to a nearby

post office box that is emptied by the firm’s bank several times daily, the bank deposits
the paym,ent checks in the firm’s account. This reduces collection float by shortening
processing float as well as mail and clearing float.

Example :
XYZ Company has annual credit sales of P6 million, which are billed at a
constant rate each day. It takes about four days to receive customers’ payments at
corporate headquarters. It takes another day for the credit department to process receipts
and deposit them in the bank. A consultant told the firm about the lockbox system which
would shorten the the mail float from 4 days to 1 1/2 days and completely eliminate the
processing float. This would cost the firm P8,000 per year. The company currently earns
12% on investments of comparable risks. The lockbox system would free P58,333.33 of
cash (P6 million /360 days X 3.5 days) that is currently tied up in mail and processing
float. The gross annual benefit is P7,000 (12% X 58,333.33). Since the annual gross
benefit of P7,000 is less than the P8,000 annual cost, the company should not use the
lockbox system.
3. Direct Send - a collection procedure in which the payee presents payment checks
directly to the banks on which they are drawn, thus reducing clearing float.

4. Other Techniques:
PAC- Pre-authorized check - A check written by the payee against a customer’s
checking account for a previously agreed upon amount. Because of prior legal
authorization, the check does not require the customer’s signature. The payee merely
issues and then deposits the PAC in its account. The check then clears through the
banking system just as if it were written by the customer and received and deposited by
the firm.

DTC - Depository transfer check - An unsigned check drawn on one of the

firm’s bank accounts and deposited into its account at a concentration or major
disbursement bank, thereby speeding up the transfer of funds. Once the DTC has cleared
the bank on which it is drawn, the actual transfer of funds is completed.

ACH - Automated Clearinghouse debits. - These are preauthorized electronic

withdrawals from the payer’s account. A computerized clearing facility (called an ACH)
makes a paperless transfer of funds between the payer and the payee banks.

Slowing down disbursements

1. Controlled Disbursements - involves the strategic use of mailing points and bank
accounts to lengthen mail float and clearing float, respectively. It can place payments in
the mail at locations from which it is known that they will take a considerable amount of
time to reach the supplier.
2.Playing the float - is a method of consciously anticipating the resulting float, or delay,
associated with the payment process. Firms often play the float by writing checks against
funds that are not currently in their checking accounts. Ineffective use of this practice
could however result in problems associated with “bounced checks”.
3. Staggered Funding - A way to play the float by depositing a certain proportion of a
payroll or payment into the firm’s checking account on several successive days following
the actual issuance of checks.
4. Payable-through draft - a draft drawn on the payer’s checking account, payable to a
given payee but not payable on demand; approval of the draft by the payer is required
before the bank pays the draft.

Marketable Securities

Characteristics of Marketable Securities:

1. Ready Market - the market for a security should have both breadth and depth to
minimize the amount of time required to convert it into cash. Breadth of a market is
determined by the number of participants (buyers). Depth of a market is determined by
its ability to absorb the purchase or sale of a large dollar amount of a particular security.

2. Safety of Principal (No likelihood of loss in value) - the ease of salability of a

security for close to its initial value.

Types of Marketable Securities

Security Type Issuer Initial Description

 Maturity
Treasury bills Govt. 90 to 182 Issued weekly at auction;sold at a
treasury days discount;strong secondary market
Treasury notes Govt. 1 to 10 Stated interest rate;interest paid semi-
treasury years annually;strong secondary market
Negotiable Commercial 1 month to Represent specific cash deposits in
Certificates of banks 3 years commercial banks;amounts and
deposits maturities tailored to investor
needs;large denominations;good
secondary market
Commercial Corp. w/ 3 to 270 Unsecured note of issuer; large
Paper high credit days denominations.
standing
Bankers’ Banks 30 to 180 Results from a bank guarantee of a
Acceptance days business transaction; sold at discount
from maturity value
Eurodollar Foreign 1 day to 3 deposits of currency not native to the
deposits banks years country in which the bank is located;
large denominations
Repurchase Bank or customized Bank or security dealer sells specific
Agreements security to securities to firm and agrees to
dealer purchaser’s repurchase them at a specific price and
needs time.

Estimating Cash Balances:

Management’s goal should be to maintain levels of transactional cash balances

and marketable securities investments that contribute to improving the value of the firm.

The Baumol Model:

ECQ = 2 X Conversion Cost X demand for cash

Opportunity Cost

The Baumol model is a simple approach that provides for cost-efficient

transactional cash balances by determining the optimal cash conversion quantity. It treats
cash as an inventory item whose future demand for settling transactions can be predicted
with certainty. In other words, cash inflows and cash outflows can be predicted with
certainty. A portfolio of marketable securities acts as reservoir for replenishing
transactional cash balances. The firm manages this cash inventory on the basis of the
cost of converting marketable securities into cash (conversion cost) and the cost of
holding cash rather than marketable securities (opportunity cost).

Example:
A company anticipates P1,500,000.00 in cash outlays during the coming year. A
recent study indicates that it costs P30 to convert marketable securities to cash. The
marketable securities portfolio currently earns an 8% annual rate of return. The ECQ for
this company is:

= 2 X 30 X 1,500,000 = 33,541
.08 =====
 It means that 33,541 is received each time the cash account is replenished and
there will be 45 conversions during the year to replenish the account that is,
P1,500,000/33,541.

The Miller- Orr Model

This model is generally more realistic and appropriate than the Baumol model. It
provides for cost-efficient transactional cash balance by determining an upper limit and a
return point for them. The return point represents the level at which the cash balance is
set, either when the cash is converted to marketable securities or vice-versa. Cash
balance is allowed to fluctuate between the upper limit and zero balance.

Return Point = 3 3 X Conversion Cost X variance of daily net cash flows

4 X daily opportunity cost

Upper limit = 3 X return point

When the cash balance reaches the upper limit, an amount equal to the upper limit
minus the return point is converted to marketable securities. When the cash balance falls
to zero, the amount converted from marketable securities to cash is the amount
represented by the return point.

Example :

Continuing with the example above, suppose the variance of daily net cash flow
is P27,000.00, the daily opportunity cost is (8% / 360) .0222% daily. Working on the
Miller-Orr equation, the return point is P1,399.00 and the upper limit is P 4,197.00 So
the firm’s cash balance is allowed to vary between 0 to 4,197.00. When the upper limit
is reached, 2,798 (4,197-1,399) is converted to marketable securities. When the cash
balance is zero, 1,399 is converted from marketable securities to cash.

Mtgumban

Management of Accounts Receivable

Objectives:

1. to achieve a balance which will result in a combination of turnover and profit rates
that will maximize the over-all return on investment in a business entity.

2. to maintain an effective credit and collection policy to maximize the value of the firm.

Changing Credit Standards

A firm’s credit standards reflect the minimum level of creditworthiness for which
it would extend credit to a customer. The concern of the financial manager is to
determine the restrictiveness of a firm’s overall policy. The key variables to be
considered in evaluating proposed changes in credit standards are:
1. sales volume
2. the investment in accounts receivable
3. bad debt expenses

To decide whether the firm should relax its credit standards, the additional profit
contribution from sales must be compared to the sum of the cost of the marginal
investment in accounts receivable and the cost of marginal bad debts. If the additional
profit contribution is greater than the marginal costs, credit standards should be relaxed.

Example:
A manufacturing company is currently selling a product for P10 per unit.
Sales(all on credit) for last year were 60,000 units. The variable cost per unit is P6.00.
The firm’s total fixed costs are P 120,000.00. The firm is currently contemplating a
relaxation of credit standards expected to result in a 5% increase in unit sales to 63,000
units, an increase in the average collection period from its current level of 30 days to 45
days, and an increase in bad debt expenses from the current level of 1 percent of sales to
2%. The firm’s required rate of return on equal-risk investments, which is the
opportunity cost of tying up funds in accounts receivable is 15 %.

Additional profit contribution from sales (3,000 units X [10-6]) 12,000

Cost of marginal investment in Accts. Receivable:
A/R balance per proposal:
(6 X 63,000)/ 8 = 378,000 / 8 47,250
A/R balance under present standards:
(6 X 60,000)/ 12 = 360,000/ 12 30,000
Marginal Investment in Accounts Receivable 17,250
Cost of Marginal Investment in A/R (17,250 X 15%) (2,588)
Cost of Marginal Bad Debts:
Bad Debts per proposal(2% X 10 X 63,000) 12,600
Bad Debts under present standards: (1% X 10 X 60,000) 6,000
Cost of Marginal bad debts (6,600)
Net profit from implementation of proposed plan. 2,812
=====
As seen from the computation above, the firm should relax its credit standards
because it is able to raise income.

The cost of marginal investment in accounts receivable is based only on the total variable
cost of annual sales since the analysis is focused only on the relevant cost, that is ,
variable cost in this analysis.

Changing Credit Terms:

 A firm’s credit terms specify the repayment terms required of all its credit
customers. Credit terms cover three things:
1. cash discount
2. the cash discount period
3. the credit period.

Changes in any aspect of the firm’s credit terms may have an effect on its overall
profitability.

Cash Discount

Example:
Suppose in the preceding example, the company offered a 2% cash discount to
customers paying prior to day 10 after a purchase. The firm expects that this move will
increase sales by 5% to 63,000 units. The discount takers will be 60% of this sales;
average collection period will be will drop to 15 days;bad debt expenses will also drop
by 1/2 of the present 1% of sales. The firm is having the same required rate of return of
15%.

Additional profit from sales [3,000 units X 4] 12,000

Cost of Marginal Investment in Accounts Receivable:
Per proposal: (6 X 63,000) / 24 = 15,750
Per status quo: (6 X 60 )/12 = 30,000
Marginal Investment in A/R (14,250)
Cost of marginal investment in A/R ( 15% X -14,250) 2,138

Cost of Marginal Bad Debts:

Bad Debts per proposal
(.5% X 10 X 63,000) 3,150
Bad Debts per status quo:
(1% X 10 X 60,000) 6,000
Cost of marginal Bad Debts
2,850
Cost of Cash Discount (2% X 60% X 10 X 63,000) (7,560)
Net profit from implementation of cash discount 9,428
=====
Cash Discount period

Effects of increasing the discount period:

Variable Direction of Effect on Profits

change
Sales Volume Increase Positive
Investment in A/R due to nondiscount takers Decrease Positive
paying earlier
Investment in A/R due to discount takers still Increase Negative
getting cash discount but paying later
Investment in A/R due to new customers Increase Negative
Bad Debt Expenses Decrease Positive
Profit per unit Decrease Negative

Credit period

Effects of increasing the length of the credit period:

 Variable Direction of Effect on Profits
change
Sales Volume Increase Positive
Investment in Accounts Receivable Increase Negative
Bad Debt Expenses Increase Negative

MTGUMBAN

Management of Inventory

This refers to the development and administration of of inventory

policies,systems and procedures necessary for efficiently and satisfactorily meeting
inventory requirements at the minimum cost possible.
Basic Objective:
To maintain a satisfactory balance between satisfying customer requirements
while reducing inventory costs and investment.

Uses of Inventories:
1. Pipeline Inventory - refers to the inventory requirements to fill the supply pipelines
between stages of the entire production distribution system.
2. Safety Stock - (buffer stock) - is intended to prevent or at least minimize the
occurrence of stockout when the actual demand exceed the expected demand.
3. Seasonal stock - also known as anticipated stock. It is intended to meet the
increasing demand during the period when it is anticipated.
4. Decoupling function - is primarily intended to provide a certain degree of
independence in each link in the production distribution chain.

The EOQ Model

This is an inventory management technique for determining an item’s optimal

order quantity, which is the one that minimizes the total of its order and carrying costs.

Mathematical Approach:

EOQ = 2 X S X O
C

S = usage in units per period

O = order cost per order
C = carrying cost per unit per period
Q = order quantity in units

Example :
Assume that a company uses 1,600 units of an item annually. Its order cost is
P50 per per order, and carrying cost is P1 per unit per year. Using the equation above
and substituting the values, the EOQ for this company is equal to 400 units.

This economic order quantity represents the quantity that should be maintained by
a firm to minimize the total cost for maintaining an inventory. This level also represents
the level at which the total ordering cost is equal to the total carrying cost.

The Reorder Point

The firm has also to determine when to place the order for an inventory. This is
called the reorder point. In the graph below, this level is shown by the broken line. This
is equivalent to the lead time usage if there is no safety stock.

Q
Q/2

Reorder
point

p r
time

Formula for the reorder point :

Reorder point = lead time in days X daily usage

if there is a safety stock, this should be equal to

Reorder point = lead time usage + safety stock

Safety Stock:

This refers to the additional quantity of goods that must be on hand at the time an
order is placed to take care of unforeseeable delays and usage above normal while
awaiting delivery of the goods. The optimal safety stock level must also be determined
by considering the relevant costs which are the stockout cost as well as the carrying cost.

Example :
A company has an annual usage of 15,000 units and an EOQ of 1,000 units.
Normal usage during lead time or reorder period is 100 units. Usages exceeding normal
lead time usage have been as follows:

Usage Probability
120 20%
130 15%
140 7%
150 3%
Stockout and carrying cost per unit are P12 and P90, respectively.

ROP Stockout cost Safety stock carrying cost Total relevant cost
100 192 X 12 = 2,304 0 2,304
120 57 X 12 = 684 20 X 90 = 1,800 2,484
130 19.5 X 12 = 234 30 X 90 = 2,700 2,934
140 4.5 X 12 = 54 40 X 90 = 3,600 3,654
150 NONE 50 X 90 = 4,500 4,500

MTGUMBAN