ADDRESSING WORKING

CAPITAL POLICIES AND

MANAGEMENT OF
SHORT-TERM ASSETS
AND LIABILITIES

BY : LABRADOR AND TACNA

 Expected Learning Outcomes
After studying Chapter 11, you should be able to:

1 2 3 4 5
Understand the Know the importance Identify and Appreciate the need Understand and
concept of working of working capital understand the of knowing how to calculate the
capital management. management. factors affecting the trace cash movement operating cycle and
firm's working through the firm's cash conversion cycle
capital policy. operation. of a business firm.
 Expected Learning Outcomes
After studying Chapter 11, you should be able to:

6 7 8 9
Know how the Distinguish the Identify and distinguish Know the alternative
operating cycle can alternative policies as between the costs relevant policies in financing
be shortened. to the amount of to investment in current investment in
investment in assets i.e. carrying costs current assets.
current assets. versus shortage costs.
Introduction
Working capital management is associated with short-term
financial decision making Short-term financial decisions typically
involve cash inflows and outflows that occur within a year or less.
For instance, short-term financial decisions are involved when a
firm orders raw materials or merchandise, pays in cash and
anticipates selling finished goods in one year for cash. In contrast,
long- term financial decisions are involved when a firm purchases
special equipment that will reduce operating costs over, say, the
next five years. Working capital management also involves finding
the optimal levels of cash, marketable securities, accounts
receivable, and inventory and then financing that working capital
at the least cost. Effective working capital management can
generate considerable amounts of cash.
 REASONS WHY WORKING CAPITAL
MANAGEMENT IS IMPORTANT

1. Working capital comprises a large 2. The financial manager has

portion of the firm's total assets. considerable responsibility and control
Although the level of working capital in managing the level of current assets
varies widely among different and current liabilities.
industries, firms in manufacturing and
trading industries more often than not,
keep more than half of their assets in
current assets.
 REASONS WHY WORKING CAPITAL
MANAGEMENT IS IMPORTANT
3. Working capital management
directly affects the firm's long-term
growth and survival because higher
levels of current assets are needed to
support production and sales growth.
4. Liquidity and profitability are
likewise directly affected by working
capital management. Without
sufficient liquidity, a firm may be
unable to pay its liabilities as they
mature. The firm's profitability is also
affected because current assets must be
financed and financing involves
interest expense.
FACTORS AFFECTING THE FIRM'S
WORKING CAPITAL POLICY

There is no single working capital policy that

is optimal for all firms or for any single firm
in all situations. The optimal working capital
policy is difficult to develop in practice
because not all factors are controllable by
management. The significant factors
affecting a firm's working capital position
are as follows:
1. The Nature of operations
Working capital requirements differ greatly among
manufacturing, retailing and service organizations. For
example, retailing firms have a high proportion of total assets
in the current category because they earn their return from
current assets such as inventory.

2. The Volume of Sales

More current assets such as accounts receivables and
inventories, are needed to support a higher level of sales.
3. The Variation of Cash Flows
The greater the fluctuations in the firm's cash inflows and
outflows, the greater the level of net working capital required.

4. The Operating Cycle Period

The operating cycle is the length of time cash is tied up in a
firm's operating process. For example, the operating cycle of a
manufacturing firm is the length of time required to purchase
raw materials on credit, produce and sell a product, collect the
sales receipts and repay the credit. Shortening the operating
cycle reduces the amount of time funds are tied up in working
capital and thus lowers the level of working capital required.
 Working capital management has become particularly
difficult in the declining economic environment following
the recent financial crisis. Some companies have been
stuck with unused inventory while others refrain from
purchasing additional inventory until they see sufficient
evidence that consumers would start to spin again. Also,
some companies have relied more on trade credit from
their supplier as a substitute form of financing rather
than obtaining short-term loans from financial
institutions. Suppliers on the other hand worry that
because of the weak economy, customers will not be able
to pay them back on time. Working capital management
involves risk-return trade offs because the level
composition and financing of working capital always
affect both a firm's risk and its profitability.
 TRACING CASH AND NET
WORKING CAPITAL

To trace cash movement through the

firm's operation, we must measure the
operating cycle as well as the firm's cash
conversion cycle. Understanding the
following time periods is necessary in
monitoring the working capital
movement.
 1. OPERATING CYCLE

The length of time in which the firm purchases or

. produces inventory, sells it and receives cash.

Inventory conversion period + Average Collection period

Inventory X 365 + Accounts Receivable 365

Cost of Sales Credit Sales
 2. CASH CONVERSION CYCLE
The length of time funds are tied up in
working capital or the length of time between
paying for working capital and collecting cash from
the sale of inventory.
Cash conversion cycle = Operating Cycle - Average payment Period
Inventory Conversion Period - The average time
required to purchase merchandise or to purchase
raw materials and convert them into finished
goods and then sell them.
Average Inventory X 365
Cost of Sales
Average Collection Period - The average length
of time required to convert the firm's receivables
into cash, that is, to collect cash following a sale.

Average Accounts Receivable

Credit Sales
Payables Deferral Period. The average length of
time between the purchase of materials and labor
or merchandise and the payment of cash for them.
Average Payables X 365
Cost of Sales
 Calculation of Operating Cycle
Suppose that Mermaid Industries has annual sales of P1 million, cost of goods sold of
P650,000, average inventories of P116,000, and average accounts receivable of P150,000.
Assuming that all Mermaid Industries sales are on credit, what will be the firm's operating
cycle?

Solution:

Inventory X 365 + Accounts Receivable 365

Cost of Sales Credit Sales
P116,000 X 365 + P150,000 X 365
P650,000 P1,000,000
65.14 + 54.75
=119.89 days
 Calculation of Cash Convertion Cycle
Using the data from the previous example Mermaid Industries and assuming that the
average recounts payable balance is P120,000, what will be the firm's cash conversion
cycle?

Solution:

Cash conversion cycle = Operating Cycle - Average payment Period

19.89 - P120,000 X 365
P650,000
52.5 days
HOW CAN OPERATING CYCLE BE REDUCED

The aim of every management should be to reduce the length of

operating cycle or the number of operating cycles in a year in order to
reduce the need for working capital. It is therefore necessary that the
financial managers be able to identify the reasons for the prolonged
operation cycle and how it could be reduced.
 REMEDIES THAT MAY BE ADOPTED TO BE REDUCE THE
LENGTH OF OPERATING PERIOD ARE AS FOLLOWS:

1. PRODUCTION MANAGEMENT
There should be proper production planning and coordination at all levels of activity. Also, a continuing
assessment of the manufacturing cycle, proper maintenance of plant, equipment and infrastructure facilities and
improvement of manufacturing system, technology would help shorten the manufacturing cycle thus shortening the
operating cycle.
2. PURCHASING MANAGEMENT
The purchasing manager should ensure the availability of the right type, quantity and quality of
materials/merchandise obtained at the right price, time and place through proper logistics management.
3. MARKETING MANAGEMENT
The sale and production policies should be synchronized. Production of quality products at lower costs enha
their marketability and saleability. Storage costs would likewise be minimized.
 REMEDIES THAT MAY BE ADOPTED TO BE REDUCE THE
LENGTH OF OPERATING PERIOD ARE AS FOLLOWS:

4. CREDIT AND COLLECTION POLICIES

Sound credit and collection policies will enable the finance manager to minimize investment in working
capital particularly on inventory and receivables.

5. EXTERNAL ENVIRONMENT
The length of the operating cycle is equally influenced by the external environment. The financial manager
should be aware and sensitive to fluctuations in demand, entrants of new competitors, government fiscal and monetary
policies, price fluctuations, etc. to be able to anticipate and minimize any adverse impact of the changes to the company.
 ALTERNATIVE POLICIES AS TO THE SIZE OF INVESTMENT IN
CURRENT ASSETS
1. Relaxed Current Asset Investment Policy
This is a policy under which relatively large amounts of cash, marketable securities and inventories are
carried and under which sales are stimulated by granting liberal credit terms resulting in a high level of
receivables. In this policy, marginal carrying costs of current assets will increase while marginal shortage costs
will decrease.

2. Restricted Current Asset Investment Policy

This is a policy under which holdings of cash, securities, inventories and receivables are minimized.
Marginal carrying costs of current assets will decrease while marginal shortage costs will increase.

3. Moderate Current Asset Investment Policy

This is a policy that is between the relaxed and restricted policies. This policy dictates that the firm will
have just enough current assets so that the marginal carrying costs and marginal shortage costs are equal, thereby
minimizing total cost.
 COSTS RELEVANT TO INVESTMENT IN CURRENT ASSETS

CARRYING COSTS
are the cost associated with having current assets. Generally, they consist of
(a) opportunity costs associated with having capital tied up in current assets instead
of more productive fixed assets and (b) explicit costs which are costs necessary to
maintain the value of the current assets (e.g., storage costs).

SHORTAGE COSTS
are the costs associated with not having current assets and can include (a)
opportunity costs such as, sales lost due to not having enough inventory on hand
and (b) explicit transaction fees paid (e.g., extra shipping costs, interest expense for
money borrowed) to replenish the particular type of current asset.
ALTERNATIVE STRATEGIES IN FINANCING WORKING CAPITAL

1. Long-Term/Permanent Assets
These consist of property, plant and equipment, long-term investments and
the portion of a firm's current assets that remain unchanged over the year.

2. Fluctuating or Seasonal Assets

These current assets that vary over the year due to seasonal or cyclical needs.
DISCUSSION
Policy I Flexible Financing Policy
involves the decision to finance the peaks of asset requirement with long-
term debt and equity. It provides the firm with a large investment surplus in cash
and marketable securities most of the time.

Policy II Restricted Financing Policy

involves a decision to finance the valleys or troughs of asset, with long-term
debt and equity but will have to seek short-term financing for all peak demand
fluctuations for current assets as well as for in-between demand situations. This
policy is considered the most "conservative" but the least convenient because it
involves seeking some level of short-term financing almost all of the time.
DISCUSSION
Policy III Compromise Financing Policy
involves a firm financing the seasonally adjusted average level of asset
demand with long-term debt and equity. It uses both short-term financing and
short-term investing as needed. With this compromise approach, the firm borrows
in the short-term to cover peak financing needs but it maintains a cash reserve in
the form of marketable securities during slow periods. As current assets build up,
the firm draws down this reserve before doing any short-term borrowing. This
allows for some run-up in current assets before the firm has to resort to short-term
borrowing.
 WHICH FINANCING POLICY SHOULD BE
CHOSEN?
However, the following should be considered in analyzing the
advantages/disadvantages of the alternative financing policy for working
capital.

1. Maturity Hedging. 2. Cash Reserves.

Most firms attempt to match the maturities
of assets and liabilities. They finance inventories
with short-term bank loans and long-term assets
with long-term financing. Firms tend to avoid
financing long-lived assets with short-term
borrowing. This type of maturity mismatching would
necessitate frequent refinancing and is inherently
risky because short-term interest rates are more
volatile than longer-term rates.
The flexible financing policy implies surplus
cash and a little short-term borrowing. This policy
reduces the probability that a firm will experience
financial distress. Firms may not have to worry as
much about meeting recurring, short-run
obligations. However, investments in cash and
marketable securities are zero net present value
investments at best.
 WHICH FINANCING POLICY SHOULD BE
CHOSEN?
However, the following should be considered in analyzing the
advantages/disadvantages of the alternative financing policy for working
capital.

3. Relative Interest Rates. 4. Availability and Costs of Alternative Financing

Short-term interest rates are usually lower Firms with easy and sustained access to
than long-term rates. This implies that it is, on the alternative sources will want to shift toward more
average, more costly to rely on long-term borrowing restricted policy.
as compared to short-term borrowing. If we expect
rates to rise in the future, the firm may want to lock
in fixed rates for a longer time by shifting towards a
flexible financing policy. With falling rates, the
opposite would of course hold true.
 WHICH FINANCING POLICY SHOULD BE
CHOSEN?
However, the following should be considered in analyzing the
advantages/disadvantages of the alternative financing policy for working
capital.

5. Impact on Future Sales

A more restricted short-term financial policy probably
could reduce future sales to a level that would be achieved under
flexible policy. It is also possible that prices can be charged to
customers under flexible working capital policy. Customers may be
willing to pay higher prices for the quick delivery service and more
liberal credit terms implicit in flexible policy.
QUIZ