CHAPTER 4

WORKING CAPITAL CASH MANAGEMENT

Introduction
A company requires whether from creditors or from owners to acquire assets to generate sales or revenues.
Short Term Financial Management
It is primarily concerned with the commitment of funds to various activities within the business and with the
best possible combination of types of financing.
1. How much cash should be maintained in the current, checking, or savings account?
2. How many inventories must be maintained?
3. How long would be the credit terms to old and new customers?
4. Should we company pay dividend this year or not?; and
5. Should we borrow or issue equity shares?
Determining pragmatically the appropriate or "optimal" level of working capital is impossible to achieve. Such
would require an estimation of the potential costs of liquidity which, has not yet been precisely measured now.
1. Hedging principle
2. Permanent investment
3. Temporary Investment
4. Spontaneous
5. Temporary sources
6. Permanent sources
Working Capital Management
Working capital or short-term financial management refers to the administrators and control of more liquid
resources to ensure sufficiency in covering
day to day business operations, including anticipated contingencies. It generally deals with managerial decisions
on current assets and how they are financed.
Following condition should be attained:
•Current Assets include inventory, accounts receivable, marketable, securities and cash and Current Liabilities
include notes payables,accruals and accounts payable
1.Cash should be enough to support firm’s operation;
2. Accounts Receivable should not be too lax nor too strict in granting credits .
3. Inventories should be enough to support market demand; and
4. Current liabilities must involve prudence in making use of the time before it finally pays off its obligation
Working Capital
Working capital is the difference of total current assets and total current liabilities. It is analyzed as the ability
to meet current obligations as they come due using current ratio analysis.
Effective management of working capital improves a firm's overall return on investment perfomance. Usually,
the firms goal is to minimize net working capital. This can be achieved by:
1.Having faster collection of cash from sales or service revenues;
2.Increasing inventory turnovers; and
3.Slowing down disbursements to suppliers or securing longer credit terms

USES AND IMPORTANCE OF WORKING CAPITAL MANAGEMENT

Working capital investments are made to support day-to-day operations and sales activity
Importance of Working Capital
• MANAGING LIQUIDITY
• MANAGING ACCOUNTS RECEIVABLE
• MANAGING INVENTORIES
• MANAGING SHORT TERM DEBTS
• MANAGING ACCOUNTS PAYABLE
Working Capital Management is an Important Topic for Several Reasons:
• cash flow
• protect your business
• ensure your business run smoothly
• ensuring company has enough money

OBJECTING OF WORKING CAPITAL MANAGEMENT

•SMOOTH WORKING CAPITAL OPERATING CYCLE
•LOWEST CAPITAL CYCLE
•MINIMIZE RATE OF INTEREST
•OPTIMAL RETURNED ON CURRENT ASSET INVESTMENT
ADVANTAGE OF ADEQUATE WORKING CAPITAL
1. Solvency of the business
2. Goodwill.
3. Easy Loans
4. Cash discounts
5. Regular supply of raw materials
6. Regular payments of salaries, wages and other day by day commitments.
7. Ability to face crisis
8. Quick and regular return on investment
9. Exploitation of favorable market conditions
10. High morale

Disadvantages of Excessive Working Capital

1. Excessive working capital means idle funds which earn no profits for business and hence, business
cannot earn a proper rate of return.
2. When there is a redundant working capital, it may lead to unnecessary purchasing and accumulation of
inventories causing more chances of theft, waste and losses.
3. It may result to overall inefficiency of organization.
4. Due to low rate of return on investments, the value of shares may also fall
5. The redundant working capital gives rise to speculative transaction.
6. When there is excessive working capital, relations with banks and other financial institutions may not be
maintained.

Disadvantages of Inadequate Working Capital

 It may affect to the inability of the firm to pay its short-term liabilities in time. This losing its reputation
and its chances of getting good credit facilities.
 The firm cannot buy its requirements in bulk and cannot avail of discounts.
 It becomes difficult for firm to exploit favorable market conditions and undertake profitable projects due
to lack of writing capital.
 The rate of return on investments also falls with shortage of working capital
 The firm cannot pay day-to-day expenses of its operations resulting to inefficiencies, increased costs
and reduced business profits
 Net Working Capital Fundamentals: Trade- off between profitability and Risk
• Profitability
- is the relationship between revenues and costs generated by using the firm’s assets, both current and
fixed, in productive activities.
- A firm can increase its profits by increasing revenues and/or decreasing costs.
- Risk (of insolvency) is the probability that a firm is unable to pay its bills as they come due.
- A firm that is insolvent is cannot pay its bills as they come due.
Cash Conversion Cycle and Operating Cycle
OPERATING CYCLE
 A firm's operating cycle (OC) is the time from the beginning of the production process to the collection
of cash from the sale of the finished product.
 It is measured in elapsed time by summing the average selling period (ASP) and the average collection
period (ACP).
 A firm can lower its working capital if it can speed up its operating cycle.
OC = ASP + ACP
CASH CONVERSION CYCLE
 The cash conversion cycle is the length of time required for a company to convert cash invested in its
operations to cash received as a result of its operations.
 The time it takes to pay the accounts payable, measured in days, is the average payment period (APP).
 The operating cycle less the average payment period yields the cash conversion cycle. The formula for
the cash conversion cycle is:
CCC= OC – APP
Or
CCC= ASP + ACP – APP
 Illustration:
Brgy. Bagets have an average production process time of 50 days. Finished goods are kept on hand for
an average of 20 days before being sold. Accounts receivable are outstanding on an average of 35 days,
and the firm receives 50 credit on its purchases from suppliers.
1. Estime the average length of the firm's short-term operating cyle. How often would the cycle turm
over in a 365-day year?
 Answer:
OPERATING CYCLE
= AVERAGE SELLING PERIOD + AVERAGE COLLECTION PERIOD
= 50+35+20
= 105 DAYS
CYCLE TURNOVER= 365/105 Days
= 3.48 TIMES
2. Assume net sales of P1,000,000.00 and cost of goods sold of P800,000.00.
Determine the average investment in accounts receivable, inventories, and accounts payable.
What would be the net financing need considering only these three accounts?
Answer:
INVESTMENT IN THE INVENTORY = (800,000/365)X(50+20)
= 153,424.66 pesos
INVESTMENT IN AR = (1,000,000/365) X 35
= 95,890 pesos
ACCOUNT PAYABLE = (800,000/365) x 50
= (109,598 pesos)
NET FINANCING = 139,725.66 PESOS

Cash Conversion Cycle

The Cash Conversion Cycle also known as the net operating cycle or ccash cycle, measures the time a company
takes to encash its inventory. The Cash cycle estimates the time a company takes to convert each net input
dollar used for the production and sale of products into cash received in their bank account.
Key Elements of CCC
1. Inventory
2. Receivables
3. Payables
CCC= ASP+ACP-APP
Where
ASP- Average Selling Period
ACP- Average Collection Period
APP- Average Payment Period
Other Formulas
ASP= (Average Inventory / COGS ) x 365
ACP= (Average AR / net credit sales) x 365
APP= (Average AP / COGS) x 365
CCC Sample Problem
In its 2021 annual report, Riddle corporation reported that it had revenues of 18 billion pesos cost of goods
sold of 16.8 billion pesos accounts receivable of 2.4 billion pesos inventory of 2.1 billion pesos and
accounts payable off 1.25 billion pesos total purchases for the year was 11.25 billion pesos.

Determine the cash conversion cycle

ASP= (2.1 Billion / 16.8B) x 365
= 45.63
ACP= (2.4B/18B) x 365
= 48.67
APP= (1.25/16.8) x 365
= 27.16

CCC= ASP + ACP-APP

CCC= 45.63 +48.67-27.16
CCC= 67.14

Cash Conversion Cycle

Funding Requirement and strategies
A permanent funding requirement is a constant investment in operating assets resulting from constant sales
overtime. a seasonal funding requirement is an investment in operating asset that varies overtime as a result
of cyclic sales.
An aggressive funding strategy it's a funding strategy under which the firm finds its seasonal requirements
with short term debt and it's permanent requirements with long term debt. this approach seeks to increase
profit by using less expensive short term financing as much as possible.
A conservative banding strategy it's a funding strategy under which the firm funds but it's seasonal and
permanent requirement with long term debt. The strategy results in relatively lower profits Because the firm
uses more expensive long term financing.
Lestrange company has a permanent funding requirement of 400,000 pesos in operating assets and seasonal
funding requirements the vary between 0-600,000 and an average of 120,000 pesos. The firm can borrow
short-term funds at 6% and long term funds at 8% and it can earn 5% on the investment of any surplus
business.

1. What is the total cost of an aggressive strategy for seasonal funding?

2. What is the total cost of a conservative strategy for seasonal funding?
3. Which funding strategy would be less costly? What is the net advantage?

A. Cost Of An Aggressive Strategy for seasonal funding

Cost Of Short Term Financing= 7,200

Cost OF Long term Financing =32,000
Total Cost of Aggressive Strategy= 39,200

B. Cost of Conservative Strategy for seasonal Funding

Cost of Short Term financing= 0

Cost of Long Term Financing= 80,000
Earning on Surplus= (24,000)
Total Cost of Conservative Strategy= 56,000

Management of Cash
1. Cash is the most important and challenging resource to manage.
2. The optimal cash level is influenced by a subjective factor.
3. Effective management of the cash collection cycle can both reduce the demand for cash and increase its
supply.
4. The normal operating cycle is a cash to cash cycle.
5. Sound cash management techniques are based on a Thorough understanding of the cash flow process.
6. it is necessary to try to have unacceptable balance between holding too much cash and holding too little
cash.
7. a large cash investment minimizes insolvency but sacrifices profitability.

Motives of Holding Cash Balances

1. Transaction motive- transaction balances allowed the firm to make payments that arise in the
ordinary course of doing business.
2. precautionary motive- precautionary balances provide a buffer stock of liquid assets that can be
drawn if there are unexpected demands for cash.
 3. Speculative Motive- Speculative balances permit the economic you need to take advantage of future
income producing activities.

Possible Placement Of Cash

1. Savings and or Current Accounts
2. Time Deposits
3. Stocks
4. Treasure Bills
5. Commercial Papers

MANAGEMENT RESPONSIBILITIES RELATING TO CASH

 To prevent losses from fraud or theft.
 To provide an accurate accounting of cash receipts, cash payments, and cash balances.
 To maintain enough cash at all times to make necessary payments plus reasonable balances for
emergencies
 To prevent unnecessary large amounts of cash from being held idle in bank accounts which produce no
revenue

Management Techniques in Controlling Cash Flows

 Include managing cash floats on payments and collections extending cash payment availing of cash
discount and establishing the optimum transaction size float management.
Speed-Up Collections
 Bill customers promptly
 Offer cash discounts for prompt payment
 Use lockbox system. Customers mail their payments to a post office in a specific city. The local bank
then collects the checks from this box and deposits them in the firms account.
 Establish local collection office.
 Use automatic fund transfer or electronic fund transfer.
 Request customers to make direct payments to the firm’s depository bank
Concentration Banking
CONCENTRATION BANKING
 is the arrangement used by the firms, wherein the funds from all the regional banks in different locations
get concentrated or collected into the single bank account

LOCKBOXES
 A Collection procedure wherein payers send their payments to a nearby post office box that the firm’s
bank emptied several times daily.

 Illustration 1:
 Barter King obtains average cash receipts of P200,000 per day. Normally, it takes 5 days for a check to
be mailed for its availability for use. How much cash is tied up?
Formula:
Amount of Cash Tied Up
= Average Cash Receipts per day x Number of Days Tied Up
Given:
Amount Cash Receipts Per Day = P 200,000
Number of Days Tied Up= 5 Days

Average Cash receipts per day P200,000

Number of days tied up x 5

AMOUNT OF CASH TIED UP P 1,000,000

Illustration 2:
It usually takes BARTER KING. 10 calendar days to receive and deposit customer remittances. The
system is expected to reduce mailing time by 1.5 days, reduce the processing time by 1.0 day, and
reduce check clearing time by 0.5 day. The average daily cash receipts are P 200,000. The expected rate
of return is 5%.
If the Lock-box system could be arranged at an annual cost of P 22,000, what would be the annual net
gain from instituting the system?
Solution
Benefit (P200,000x3daysx5%) P30,000
Cost (22,000)
P 8,000

DIRECT SENDS
 Is a collection procedure in which the payee presents payment checks directly to the banks from which
they are drawn, thus reducing clearing float.
SLOWING DOWN DISBURSMENTS
Controlled disbursing is the strategic use mailing points and bank account to lengthen mail float and
clearing float respectively by:
1. Stretching payable by paying as late as possible within a credit period.
 2. Maintaining zero-balance accounts. Checks are written from special disbursement accounts having
zero-peso balance.
3.Less frequently payroll and scheduled issuance of checks to suppliers.
Reduce the need for a precautionary cash balance with the following techniques:
1. Make more accurate cash budgeting;
2. Have ready lines of credit; and
3. Invest idle cash in highly liquid short-term investments, instead of holding idle precautionary cash
balances.

PLAYING THE FLOAT

Is a method of consciously anticipating the resulting float associated with the payment process and using it to
keep funds in an interest-bearing form for as long as possible.

ESTIMATING CASH BALANCES

Two quantitative models that management can use to determine the appropriate transactional cash balances are
the BAUMOL MODEL and MILLER-ORR MODEL.

BAUMOL MODEL
 Transaction Cost- Cost of Converting Securities or investments.
 Opportunity Cost- Benefit Foregone by converting securities or investments.
FORMULA

WHERE
• ECQ- Economic Conversion Quantity
• Conversion Cost
• Demand For Cash
• Opportunity Cost
TOTAL COST OF CASH
= Total Conversion + Total Opportunity Cost
Where in;
Total Conversion Cost = Cost Per Conversion x No. Of Conversion
Total Opportunity Cost= Opportunity Cost x Average Cash Balance

THE MILLER ORR MODEL

argues that changes in cash balance over a given period are random in size, as well as in direction.

• The minimum cash of P20,000 is required at Blink Co. and transferring money to or from the bank costs
P50 per transaction. Inspection of daily cash flows over the past year suggests that the standard
deviation is P3,000 per day, and hence the variance (standard deviation squared) is P9 million. The
interest rate is 0.03% per day.

1. The spread between the upper and lower limit;

2. The upper limit; and
3. The return point.

Given: Transaction Cost= P50

Variance Of Cash Flow = P 9,000,000
Interest Rate= 0.03% (0.0003)

( )
1
3 Transcation Cost x Variance of Cash Flows
• Spread=3 x 3
4 Interest Rate

Spread=3 ( x
0.0003 )
1
3 50 x 9,000.00 3
•
4
• Spread=P 31,200

UPPER LIMIT
Formula: Minimum Cash Balance + Spread = UPPER LIMIT
• =20,000 + 31,200
• UPPER LIMIT=P 51,200
 (
Formula: Return Point =Lower Limit +
1
3
x Spread )
Given: Lower Limit= P 20,000
Spread= P 31,200

31,200
¿ 20,000+
3

Return Point¿ P 30,400