MAS 2309

WORKING CAPITAL MANAGEMENT

John Carlos S. Wee, CPA MBA and Ralph Jorline M. Chua, CPA RCA

CONCEPT NOTES

WORKING CAPITAL MANAGEMENT

A. Working Capital Policy

 Conservative (Relaxed) Policy. The most conservative financing strategy should be
to finance all projected funds requirements with long-term funds and use short-
term financing only for emergencies.
 Aggressive Policy. This strategy is adopted by financing at least a firm's seasonal
requirements, and possibly some of its permanent requirements, with short-term
funds. The balance is financed with long-term funds.
 Unlike the aggressive strategy, the conservative strategy requires the firm to pay
interest on unneeded funds. The lower cost of the aggressive strategy makes it more
profitable than the conservative strategy. However, the aggressive strategy involves
more risk.

Motives for Holding Cash and Near-Cash Balances:

 Transactions Motive - Cash balance is maintained in order to pay planned
expenditures.
 Precautionary or Safety Motive - Balances are held or temporarily invested in liquid
securities that can be immediately transferred to cash. This balance protects the
firm against being unable to pay unexpected expenditures.
 Speculative Motive - The balance, oftentimes kept in marketable securities, is
intended for taking advantage of opportunities that may arise.

Operating Cycle. The amount of time that elapses from the point when the firm inputs materials
and labor into the production process to the point when cash is collected from the sale of the
finished goods. This consists of two components - average age of inventory and the average
collection period of receivables.

Cash Conversion Cycle. The total number of days in the operating cycle less the average payment
period for materials.

Improving Cash Conversion Cycle:

 Turnover inventory as quickly as possible, avoiding stockout s that might result in a loss of
sale.
 Collect accounts receivable as quickly as possible.
 Pay accounts payable as late as possible without damaging the firm's credit rating, but take
advantage of any favorable cash discounts.

Cash Management Techniques

1. Float. Funds that have been tendered or dispatched by a payer but are not yet in a form that
can be spent by the payee. Float may either be collection float or disbursement float. Net
float is the difference between the two types of float.
Components of Float:
 Mail Float - The delay between the time when a payer mails a payment and the time
when the payee receives it.
 Processing Float - The delay between the receipt of a check and its deposit 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.
Speeding up Collections:
  Concentration banking. A scheme where a firm with numerous sales outlets designate
certain offices as collection centers for a given geographic areas. These collection
centers deposit the receipts in local banks; in turn, these local banks transfer the funds
by wire to a concentration or disbursing bank.
 Lock boxes. Instead of mailing payment to a collection center, the payer sends it to a
post office box that is emptied by the firm's bank several times daily. The bank deposits
the checks in the firm's account and sends to the collecting firm a deposit slip or
computer printout indicating the payments received.
 Direct sends. Firms that have received large checks drawn on distant banks or a large
number of checks drawn on banks in a given city may arrange to present those checks
directly for payment to the bank on which they are drawn.
Slowing Down Disbursements:
 Controlled Disbursing. Involves the strategic use of mailing points and bank accounts to
lengthen mail float and clearing float, respectively.
 Playing the float
a. writing checks against funds that are not currently in the checking accounts
b. staggered funding
c. payable through draft

Economic Conversion Quantity (Optimal Transaction Size). Using the conversion and the
opportunity costs, the model calculates the economic conversion quantity, the amount (cost-
optimizing-quantity) in which the firm should convert marketable securities to cash or cash to
marketable securities.
ECQ = / 2x Conversion Cost x Annual Demand for Cash
/ Opportunity Cost (in decimal)

Conversion cost - the cost of converting marketable securities to cash. It includes the fixed
cost of placing an order for cash or marketable securities, paperwork costs, brokerage fees,
and cost of any follow-up action.

Opportunity cost - the cost of holding cash rather than marketable securities (rate of
interest that can be earned on marketable securities.

Total Cost of cash = (Cost per conversion x number of conversion) + (Opportunity cost x
Average cash balance)

Components of Accounts Receivable Management

1. Credit Policy
 Determine credit selection
 Credit standards
 Credit terms
2. Collection Policy
Key Variables of Changing Credit Standards
 Sales volume
 Investment in accounts receivable
 Bad debt expenses

Cost of Marginal Investment in Accounts Receivable

Total variable cost of annual sales
Ave. Investment in Accounts Receivable =
Turnover of Accounts Receivable

Cost of Marginal Investment = Marginal Investment in AR x Required

Return on Investment in AR

Cost of Marginal Bad Debts = Bad Debts under proposed plan - Bad Debts under present plan
Inventory Management
 1. The ABC System. Inventory is divided into three categories of descending importance based
on the peso investment in each.
2. Economic Order Quantity (EOQ) Model. 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
a. Order costs - Fixed clerical costs of placing and receiving an order.
b. Carrying Costs – Variable costs per unit of holding an item in inventory for a
specified time period; including storage, insurance, deterioration and obsolescence,
opportunity costs of tying up funds in inventory
c. Inventory costs = (Ordering cost x Number of order per year) + (Order size/2 +
safety stock) x carrying cost per unit
d. Formula:
EOQ = / 2x Annual Demand x Ordering cost
/ Carrying cost per unit

Short Term Financing

1. Accounts Payable. This is the major source of unsecured short-term financing.
a. Credit terms:
a.Credit period
b. Cash discount
c. Cash discount period
b. Analysis of Credit Terms:
a.Taking the cash discount. If Cash discount is to be taken, a firm should pay on
the last day of the discount period.
b. Giving up cash discount. If the firm has to give up cash discount, it
should pay on the last day of the credit period.
c. Cost of giving up a cash discount
= [CD/(100% - CD)] x (360/N)
where: CD = Cash discount percentage
N = Number of days payment can be delayed by giving up the cash discount

The formula above assumes that a firm gives up only one discount during the
year. If a firm continually gives up the discount during the year, the
annualized cost is calculated:

= [1 + (CD/100%-CD)]360/N - 1

c. Stretching Accounts Payable. A firm should pay the bills as late as possible without
damaging its credit rating. This strategy reduces the cost of giving up a discount.
When a firm can stretch the payment of accounts payable, the cost of foregoing the
discount can be lowered.

2. Bank Loans
a. Single-payment Notes. If the interest is payable upon maturity, the effective interest
rate is equal to the nominal rate.

b. Discounted Note. The effective interest rate is higher than the nominal rate.
Effective Rate = [Interest / (Principal Amount - Discounted Interest)]
If the term is less than a year, the interest rate is annualized.

c. Compensating Balance. An arrangement whereby a borrower is required to

maintain certain percentage of amount borrowed as compensating balance in the
current account of the borrower.
PROBLEM SOLVING
Cash Management
1. Third Company uses a continuous billing system that results in average daily receipts of P500,000. The
company's treasurer estimates that a proposed lock-box system could reduce its collection time by 3 days.
a. How much cash would the lock-box system free up for the company?
b. What is the maximum amount that Third Company would be willing to pay for the lock-box system if it
can earn 5 percent on available short-term funds?
c. If the lock-box system could be arranged at an annual cost of P50,000, what would be the net gain or loss
from instituting the system?

2. Salami Company projects that cash outlays of P45 million will occur uniformly throughout the year. Salami
plans to meet its cash requirements by periodically selling marketable securities from its portfolio. The
firm's marketable securities are invested to earn 10 percent, and the cost per transaction of converting
securities to cash P30.
a. What is the optimal transaction size for transfers from marketable securities to cash?
b. What will be Salami's average cash balance?
c. Compute the annual cost of cash based on optimal transaction size.

3. American Products is concerned about managing cash efficiently. On the average, inventories have an age of
60 days, and accounts receivable are collected in 35 days. Accounts payable are paid approximately 30 days
after they arise. The firm spends P36.5 million on operating-cycle investments each year, at a constant rate.
Assume a 365-day year.
a. Calculate the firm's operating cycle
b. Calculate the firm's cash conversion cycle.
c. Calculate the amount of resources needed to support the film's cash conversion cycle.

Receivables Management
4. Fourth, Inc. currently has sales of P6.0 million. Its credit period and days sales outstanding (DSO) are both
30 days, and 1.5 percent of its sales end up as bad debts. The credit manager estimates that, if the firm
extends its credit period to 45 days so that its days sales outstanding increases to 45 days, sales will increase
by 15 percent, but its bad debt losses on the incremental sales would be 3.0 percent. Variable costs are 60
percent, and the cost of carrying receivables, k, is 9 percent. Assume a tax rate of 30 percent and 365 days
per year.
a. Compute the incremental investment required to finance the increase in receivables.
b. What would be the incremental cost of carrying receivables?
c. What would be the effect of those changes in net income?

Inventory Management
5. Bing Products is involved in the production of camera parts and has the following inventory, carrying and
storage costs:
 Orders must be placed in round lots of 200 units.
 Annual unit usage is 600,000
 The carrying cost is 15 percent of the purchase price.
 The purchase price is P3 per unit
 The ordering cost is P90 per order.
 The desired safety stock is 15,000 units (This does not include delivery time stock.)
 The delivery time is one week.
Required:
a. EOQ
b. Order Point (Assume a 50 week year)

Payables Management
6. Compute the cost of foregoing the cash discount (approximate and effective) for each of the following:
a. 3/5, net 15 days.
b. 2/10, net 40; The firm issues check on the 15th day, net of 2 percent discount
c. 2/10, net 40; The firm pays on the 55th day.

7. Sixth Company is negotiating with Island City Bank for a P1 million, 1-year loan. Island City Bank has offered
Sixth Company the following alternatives. Calculate the effective annual interest rate for each alternative.
Which alternative is the most attractive?
a. An 8 percent annual rate on a simple interest loan, with no compensating balance required and interest
due at the end of the year.
b. A 6.25 percent annual rate on a simple interest loan, with a 20 percent compensating balance required
and interest again due at the end of the year.
c. A 5.50 percent annual rate on a discounted loan, with a 25 percent compensating balance.
d. A 4.5% add-on interest, payable in equal monthly installments.
Other WCM
8. The 2010 sales of First Company amounted to P6 million. The dividend payout ratio is 30%. The percent of
sales in each balance sheet item that varies directly with sales are expected to be as follows:
Current assets 25%
Net fixed assets 40%
Accounts payable & accrued expenses 15%
Net profit rate 15%
Required:
a. Suppose that in 2011 sales increased by 20% percent over 2010 sales. How much additional (external)
capital will First Company require?
b. What would happen to capital requirements if First Company can increase its sales by 30% and the
payout ratio is decreased to 25%?

9. Second, Inc., has P5,000,000 in current assets, P3,000,000 of which are considered permanent current
assets. In addition, the firm has P5,000,000 invested in fixed assets.
a. Second wishes to finance all fixed assets and half of its permanent current assets with long-term
financing costing 8 percent. Short-term financing currently costs 6 percent. Second's earnings before
interest and taxes are P800,000. Determine Second's earnings after taxes under this financing plan. The
tax rate is 40 percent.
b. As an alternative, Second might wish to finance all fixed assets and permanent current assets plus half of
its temporary current assets with long-term financing. The same interest rates apply as in part a.
Earnings before interest and taxes will be P800,000. What will be Second's earnings after taxes? The tax
rate is 40 percent.

10. The management of Rica Co. anticipates P45,000,000 in cash outlays during the coming year. The firm has
determined that it costs P30 to convert marketable securities to cash and vice versa. The marketable
securities portfolio currently earns a 6% annual rate of return.
Required: (1) What is the optimal transaction size (OTS)? (2) Compute the total cost of cash.

THEORY:
Working capital management
1. Working capital management involves investment and financing decisions related to:
A. plant and equipment and current liabilities.
B. current assets and capital structure.
C. current assets and current liabilities.
D. sales and credit.

2. The goal of managing working capital, such as inventory, should be to minimize the:
A. costs of carrying inventory
B. opportunity cost of capital
C. aggregate of carrying and shortage costs
D. amount of spoilage or pilferage

Working capital financing policy

Aggressive
3. Za Company follows an aggressive financing policy in its working capital management while Zi Corporation
follows a conservative financing policy. Which one of the following statements is correct?
A. Za has low ratio of short-term debt to total debt while Zi has a high ratio of short-term debt to total
debt.
B. Za has a low current ratio while Zi has a high current ratio.
C. Za has less liquidity risk while Zi has more liquidity risk.
D. Za finances short-term assets with long-term debt while Zi finances short-term assets with short-term
debt.

Temporary & Permanent working capital

4. Temporary working capital supports
A. the cash needs of the company. C. acquisition of capital equipment.
B. payment of long term debt. D. seasonal peaks.

Cash Management
Motives for holding cash
5. The transaction motive for holding cash is for:
A. a safety cushion C. compensating balance requirements
B. daily operating requirements D. none of the above
Float
6. The difference between the cash balance on the firm's books and the balance shown on the bank statement
is called:
A, the compensating balance C. a safety cushion
B. float D. none of the above

Cash conversion cycle

7. The length of time between payment for inventory and the collection of cash is referred to as:
A. payables deferral period C. operating cycle
B. receivables conversion period D. cash conversion cycle

8. The longer the firm's accounts payable period, the:

A. longer the firm's cash conversion cycle is.
B. shorter the firm's inventory period is.
C. more the delay in the accounts receivable period.
D. less the firm must invest in working capital.

9. The average length of time a peso is tied up in current asset is called the:
A. net working capital. C. receivables conversion period.
B. inventory conversion period. D. cash conversion period.

Cash conversion cycle

10. The S Company has an inventory conversion period of 75 days, a receivables conversion period of 38 days,
and a payable payment period of 30 days. What is the length of the firm’s cash conversion cycle?
A. 83 days C. 67 days
B. 113 days D. 45 days

11. SN Supplies, Inc. has P5 million in inventory and P2 million in accounts receivable. Its average daily sales are
P100,000. The company has P1.5 million in accounts payable. Its average daily purchases are P50,000. What
is the length of the company’s cash conversion period?
A. 50 days C. 30 days
B. 20 days D. 40 days

Economic conversion quantity (ECQ)

12. SL Inc. has a total annual cash requirement of P9,075,000 which are to be paid uniformly. Simile has the
opportunity to invest the money at 24% per annum. The company spends, on the average, P40 for every
cash conversion to marketable securities.
What is the optimal cash conversion size?
A. P60,000 C. P45,000
B. P55,000 D. P72,500

Discount loan
13. You plan to borrow P10,000 from your bank, which offers to lend you the money at a 10 percent nominal, or
stated, rate on a one-year loan. What is the effective interest rate if the loan is a discount loan?
A. 10.00% C. 12.45%
B. 11.11% D. 14.56%

Discount loan with compensating balance

14. What is the effective rate of a 15% discounted loan for 90 days, P200,000, with 10% compensating
balance? Assume 360 days per year.
A. 20.0% C. 17.4%
B. 15.0% D. 22.2%

Compensating balance with interest

15. The P Company obtained a short-term bank loan for P1,000,000 at an annual interest rate 12%. As a
condition of the loan, P is required to maintain a compensating balance of P300,000 in its checking
account. The checking account earns interest at an annual rate of 3%. P would otherwise maintain only
P100,000 in its checking account for transactional purposes. P’s effective interest costs of the loan is
A. 12.00% C. 16.30%
B. 14.25% D. 15.86%
Receivables management
16. All of these factors are used in credit policy administration except:
A. credit standards C. peso amount of receivables
B. terms of trade D. collection policy

17. Which of the following statements is most correct? If a company lowers its DSO, but no changes occur in
sales or operating costs, then:
A. the company might well end up with a higher debt ratio.
B. the company might well end up with a lower debt ratio.
C. the company would probably end up with a higher ROE.
D. the company's total asset turnover ratio would probably decline.

18. All but which of the following is considered in determining credit policy?
A. Credit standards C. Accounts payable deferral period
B. Credit limits D. Collection efforts

19. The C Company has an inventory conversion period of 60 days, a receivable conversion period of 30 days,
and a payable payment period of 45 days. The Camp’s variable cost ratio is 60 percent and annual fixed
costs of P600,000. The current cost of capital for C is 12%.
If C’s annual sales are P3,375,000 and all sales are on credit, what is the firm’s carrying cost on accounts
receivable, using 360 days year?
A. P281,250 C. P 20,250
B. P168,750 D. P 56,250

20. AIM Company’s budgeted sales for the coming year are P40,500,000 of which 80% are expected to be
credit sales at terms of n/30. AIM estimates that a proposed relaxation of credit standards will increase
credit sales by 20% and increase the average collection period from 30 days to 40 days. Based on a 360-
day year, the proposed relaxation of credit to standards will result in an expected increase in the average
accounts receivable balance of
A. P 540,000 C. P2,700,000
B. P 900,000 D. P1,620,000

Investment in receivables
21. Currently, Charlie Company has annual sales of P2,500,000. Its average collection period is 45 days, and
bad debts are 3 percent of sales. The credit and collection manager is considering instituting a stricter
collection policy, whereby bad debts would be reduced to 1.5 percent of total sales, and the average
collection period would fall to 30 days. However, sales would also fall by an estimated P300,000 annually.
Variable costs are 75 percent of sales and the cost of carrying receivables is 10 percent. Assume a tax rate
of 40 percent and 360 days per year.
What would be the decrease in investment in receivables if the change were made?
A. P 9,688 C. P 96,875
B. P 12,988 D. P129,975

Comprehensive
Question Nos. 33 through 35 are based on the following data:
S Company is considering changing its credit terms from 2/15, net 30 to 3/10, net 30 in order to speed
collections. At present, 40 percent of S Company‘s customers take the 2 percent discount. Under the new
term, discount customers are expected to rise to 50 percent. Regardless of the credit terms, half of the
customers who do not take the discount are expected to pay on time, whereas the remainder will pay 10 days
late. The change does not involve a relaxation of credit standards; therefore bad debt losses are not expected
to rise above their present 2 percent level. However, the more generous cash discount terms are expected to
increase sales from P2 million to P2.6 million per year. S Company’s variable cost ratio is 75 percent, the
interest rate on funds invested in accounts receivable is 9 percent, and the firm’s income tax rate is 40
percent.

22. What are the days sales outstanding (DSO) before and after the change of credit policy?
A. 27.0 days and 22.5 days, respectively C. 22.5 days and 21.5 days, respectively
B. 22.5 days and 27.0 days, respectively D. 21.5 days and 22.5 days respectively

23. The incremental carrying cost on receivable is

A. P 843.75 C. P 643.75
 B. P8,889.00 D. P6,667.00

24. The incremental after tax profit from the change in credit terms is
A. P68,493 C. P60,615
B. P65,640 D. P57,615

Inventory management
25. The use of safety stock by a firm will:
A. reduce inventory costs C. have no effect on inventory costs
B. increase inventory costs D. none of the above

26. When a specified level of safety stock is carried for an item in inventory, the average inventory level for
that item
A. decreases by the amount of the safety stock.
B. is one-half the level of the safety stock.
C. Increases by one-half the amount of the safety stock.
D. Increases by the number of units of the safety stock.

27. Which of the following statements is correct for a firm that currently has total costs of carrying and ordering
inventory that are 50% higher than total carrying costs?
A. Current order size is greater than optimal
B. Current order size is less than optimal
C. Per unit carrying costs are too high
D. The optimal order size is currently being used

Days inventory
28. What is the inventory period for a firm with an annual cost of goods sold of P8 million, P1.5 million in
average inventory, and a cash conversion cycle of 75 days?
A. 6.56 days C. 52.60 days
B. 18.75 days D. 67.50 days

29. ST Supplies, Inc. has P5 million in inventory and P2 million in accounts receivable. Its average daily sales are
P100,000. The company has P1.5 million in accounts payable. Its average daily purchases are P50,000. What
is the length of the company’s inventory conversion period?
A. 50 days C. 120 days
B. 90 days D. 40 days

EOQ
30. What is the economic order quantity for the following inventory policy: A firm sells 32,000 bags of premium
sugar per year. The cost per order is P200 and the firm experiences a carrying cost of P0.80 per bag.
A. 2,000 bags C. 8,000 bags
B. 4,000 bags D. 16,000 bags

Annual demand
31. MM Co. has determined the following for a given year:
Economic order quantity (standard order size) 5,000 units
Total cost to place purchase orders for the year P40,000
Cost to place one purchase order P 100
Cost to carry one unit for one year P 4
What is MM’s estimated annual usage in units?
A. 1,000,000 C. 500,000
B. 2,000,000 D. 1,500,000
Order quantity
32. For Raw Material L12, a company maintains a safety stock of 5,000 pounds. Its average inventory (taking
into account the safety stock) is 12,000 pounds. What is the apparent order quantity?
A. 18,000 lbs. C. 14,000 lbs.
B. 6,000 lbs. D. 24,000 lbs

Annual inventory costs

33. DY Furniture Company uses about 200,000 yards of a particular fabric each year. The fabric costs P25 per
yard. The current policy is to order the fabric four times a year. Incremental ordering costs are about
P200 per order, and incremental carrying costs are about P0.75 per yard, much of which represents the
opportunity cost of the funds tied up in inventory.
How much total annual costs are associated with the current inventory policy?
A. P19,550 C. P38,300
 B. P18,750 D. P62,500

Maximum interest rate

34. N Company is considering a switch to level production. Cost efficiencies will occur under level production
and after tax cost would decline by P70,000 but inventory would increase from P1,000,000 to P1,800,000.
N would have to finance the extra inventory at a cost of 10.5 percent.
What is the maximum interest rate that makes level production feasible?
A. 7.00 percent C. 8.75 percent
B. 5.83 percent D. 10.00 percent

Trade credit
35. With credit terms of 3/8, n/30, what is the customer’s payment decision date?
A. Three days after the invoice is received.
B. The 8th day is the customer’s decision date.
C. Anytime during the period, 8th to the 30th.
D. The 30th day is the primary decision date.

36. If a firm is given a trade credit terms of 2/10, net 30, then the cost to the firm failing to take the discount is:
A. 2.0%. C. 36.7%
B. 30.0%. D. 10.0%.

37. The cost of discounts missed on credit terms of 2/10, n/60 is

A. 2.0 percent C. 12.4 percent
B. 14.9 percent D. 21.2 percent