WORKING CAPITAL MANAGEMENT

WORKING CAPITAL
➢ Management of CURRENT ASSETS and LIABILITIES
➢ To achieve a balance between profitability and risk that contributes positively to the firm’s
value.
➢ Formula: Net working capital = Current assets – Current liabilities
OPERATING CYCLE
➢ The length of time in which the firm purchase inventories, sell it, then receive cash from
sale.
➢ Formula: Operating Cycle = Days of inventory + Days accounts receivable

Purchase inventories Sell inventories Collecting cash

DAYS INVENTORY / DAYS ACCOUNTS

AVERAGE CONVERSION RECEIVABLE / AVERAGE
OR SALE PERIOD COLLECTION PERIOD

CASH CONVERSION CYCLE

➢ The length of time between paying for working capital and collecting cash from sale of
inventory.
➢ This is the basis for how much the company should invest in working capital.
➢ Formula: Operating cycle – Days accounts payable

Payment for
Purchase inventories Collecting cash
purchases

DAYS ACCOUNTS CASH CONVERSION

PAYABLE / AVERAGE CYCLE
PAYMENT PERIOD

GOAL OF THE COMPANY:

✓ To shorten the cash conversion cycle (↓ CCC = ↓ Investment in Working Capital)
Ways to shorten the CCC:
↓ Days Inventory or Days Accounts Receivable
↓ CCC
↑ Days Accounts Payable
Illustration (OP & CCC)
Roque-Agamata & Co., a leading producer of erasable pens, turns out 3,000 erasable pens a day
at a cost of P250. It takes the firm 20 days to convert raw materials into erasable pens. The firm
allows its customers 25 days in which to pay for the items, and it pays the suppliers on a 15-day
basis.
Requirements:
1. How long Roque-Agamata & Co.’s operating cycle and cash conversion cycle,
respectively?
2. Assuming that the production of erasable pens is steady, what amount of working capital
must the firm finance?

WORKING CAPITAL POLICY

1. INVESTMENT POLICY
* Answers the question: Where to invest?

Types of Policy CONSERVATIVE AGGRESSIVE

Description Relaxed Restricted

Profitability Low High

Default Risk Low High

Liquidity High Low

Investments Current Assets Noncurrent Assets

2. FINANCING POLICY
➢ Assets are classified as temporary and permanent.
• Permanent Assets – are CURRENT and FIXED assets that remains
unchanged over the year.
• Temporary or Seasonal Assets – are CURRENT assets that vary over
the year.
Illustration (Working Capital Policy)
Roque-Agamata & Co. is currently in the process of preparing its financial plan for next year. The
Following estimation are related to the said financial plan: (amounts in millions PHP)
Roque-Agamata & Co. fixed assets is expected to be constant over the year amounting to P 35
million.
Requirements:
1. Determine the amount of temporary and permanent assets.
2. Determine the amount of short-term and long-term amount of financing assuming working
capital policy requires that 50% of temporary assets be finance with permanent financing.
Month CA Month CA Month CA
January 10.8 May 21.2 September 25.6
February 18.2 June 22.1 October 18,7
March 12.5 July 19.8 November 24.9
April 17.6 August 10 December 15.2

RELEVANT COSTS
1. Carrying Costs – costs associated with having current assets. (e.g. opportunity cost and
storage cost)
2. Shortage Costs – costs associated with not having current assets. (e.g. transaction cost
and stock-out costs)
CASH MANAGEMENT

OBJECTIVE
To invest cash for a return while retaining some for liquidity and to satisfy future needs.

MOTIVES OF HOLDING CASH

1. Transaction Motive
-A company maintains sufficient cash to pay its operating expenses. It serves as an
assurance to maintain a smooth operation of the company.
2. Precautionary Motive
-Cash balances are maintained to serve as buffer against unexpected demands of
cash.
3. Contractual Motive
-Cash balances are maintained to satisfy a contractual agreement.
4. Speculative Motive
-Cash balances are maintained to take advantage of future business opportunities.

CONCEPT OF FLOAT
Float is the time between cash payment and the point that the cash is in the hands of the
payee already available for his disposal. It arises from time delays in mailing, processing, and
clearing checks through the banking system.
Types of Float:

Book Balance < Bank Balance = Disbursement Float or Positive Float

Book Balance > Bank Balance = Collection Float or Negative Float

The attitude of management towards an efficient operating cash flows is to speed up collections
and maximize timing of cash payments.

CASH MANAGEMENT STRATEGIES

Accelerate Collections: Control or Slow Down Disbursement:

• Prompt Billing • Stretching Payables

• Offering Discounts • Less Frequent Payroll
• Online Banking • Pay Through Checks or Drafts
• Lockbox System • Zero Balance Accounts (ZBA)

Lockbox System

Is a bank-operated mailing address to which a company directs its customers to send their
payments. The bank opens the incoming mail, deposits all received funds in the company’s bank
accounts, and scans the payments and any remittance information. The scanned images are
posted to secure a website, where the company’s staff can access the images to apply payments
to outstanding accounts receivable.

Formula:
Benefit (↓ AR - ↑ Cash x % of return) xx
Cost of Lockbox system (xx)
Net benefit xx

Optimal Cash Balance

Managing cash is a treasurer’s domain. Cash balance should be at its optimum and cash
flows (i.e., inflows and outflows) should be synchronized.

Baumol Model

Used when:
1. Cash needs
2. Converting securities or investments

Formula: Optimum cash balance = √2 x annual cash demand x cost per transaction)
Carrying cost rate
Illustration (Optimum Cash Size)

Pure Gold Corporation expects to make even monthly cash payments of 160,000 during
the year. The average return on money market placements is 8% per annum and it expects to
pay P250 per cash transfer. Using the Baumol model, determine the following:
1. Optimum cash size transaction.
2. Average cash balance.
3. Number of cash transfer per year
4. Total relevant costs at the optimum cash size.
5. Total relevant cash costs at the following cash transfers:
a. P50,000
b. P400,00

Solutions/Discussions:
Where: AD = Annual Demand
OCB = Optimal cash balance

1. AD = P160K x 12 = P1,920,000
OCS = √(2 x P1,920,000 x P250) =P109,544
8%

2. Ave. Cash Bal. = OCS/2

= P109,544/2
=P54,772

3. No. of cash transfers = AD/OCS

=P1,920,000/P109,544
=P17.53 times

4. Total relevant costs at the optimum cash balance:

Transaction costs = No. of transaction x Cost per transaction
Opportunity costs = Ave. cash bal. x Carrying cost rate

By application, we have:
Transaction costs = 17.53 x P250 P4,382
Opportunity costs = 54,772 x 8% 4,382
Total cash costs P8,764

5. Total relevant cash costs at the following cash transfers shall be:
P50K P400K
Transaction costs (P1.920k/P50k) x P250 P9,600 P1,200 (P1.920k /P400k) x 250
Carrying costs (P50k/2) x 8% 2,000 16,000 (P400k/2) x 8%
Total cash costs P11,600 P17,200

Carrying cost is also referred to as the holding cost or opportunity cost

 RECEIVABLES MANAGEMENT

Credit standards are the minimum requirements for extending credit to a

customer. A company should determine the nature of the credit risk based on prior
collection records, financial capacity and stability, current net worth and other factors
necessary before extending credit. Receivables Management Strategy, extend credit if
incremental revenues are greater than incremental costs (Cost benefit analysis), or
extend credit sales at the point where marginal cost is equal to marginal revenue (Profit
Maximization).

THE FIVE Cs OF CREDIT

The 5 Cs of credit are used in evaluating the credit worthiness of a borrower. This is
the basis of a lender on approving a borrower’s application for credit. The following
are:

Character – refers to the customer’s payment habits and attitude

Capacity- is the customer’s ability to pay as reflected in his cash flows. A review
of Liquidity and Debt ratios will determine capacity.
Conditions- refers to the current business and economic conditions that affect
either party to the credit transaction.
Capital- refers to the net worth positions of the customer. A review of Profitability
and Equity ratios will determine capital.
Collateral- refers to any asset that is pledged against the debt. A review of the
valuation of the property, and liens against the property will validate the
collateral.

CONSEQUENCES OF RELAXING CREDIT TERMS

The most common credit term is 2/10; n/30. Relaxing the credit terms is a strategy
used to increase profits. The following is a summary of the effects of relaxing the credit
terms.

- increase in Credit sales

- increase in Accounts Receivable
- increase in Bad debts
- increase in Collection cost
- increase in Opportunity cost on incremental investment in receivables
- increase in Sales discounts

CREDIT TERMS
Credit terms specify the repayment terms required of a firm’s credit customers. It is
composed of three major factors 1) the discount period, 2) the cash discount, and 3)
the credit period.
The following tables summarizes the possible effects of changing credit terms:

Table 1: Increase in Credit Period

Variable Direction of Change Effect on Profits
Sales volume Increase Increase
Accounts receivable Increase Decrease
Bad debts expense Increase Decrease

Table 2: Increase in Discount Period

Variable Direction of Change Effect on Profits
Sales volume Increase Increase
Non-discount receivable-takers taking discounts
Decrease Increase
Discount-taking receivables paying later
Increase Decrease
Bad debts expense Decrease Increase

Table 3: Increase in Cash Discount

Variable Direction of Change Effect on Profits
Sales volume Increase Increase
Non-discount receivable-takers taking discounts
Decrease Increase
New receivables due to new customers
Increase Decrease
Bad debts expense Decrease Increase

COLLECTION POLICIES
Collecting the receivables of a company significantly improves its liquidity. At times, a
company finds difficult to collect its receivables. To avoid bad debts the following are
employed to improve collection:

✓ Demand Letters
✓ Telephone Calls
✓ Personal Visits
✓ Collection Agencies
✓ Legal Actions

The following table summarizes the possible effects of a stringent collection technique.

Variable Direction of Change Effect on Profits

Sales volume May decrease May decrease
Accounts receivable Decrease Increase
Bad debts expense Decrease Increase
Collection expense Increase Decrease