Chapter 5

WORKING CAPITAL AND FIXED ASSETS

ACADEMY OF FINANCE MANAGEMENT

CORPORATE FINANCE
DEPARMENT

1
 Learning objectives

• Understand the working capital management and its objectives.

• Understand the management of cash, inventory, accounts receivable and
accounts payable.
• Understand the different models used in finding the optimal inventory/cash
holding level.
• Understand the components of credit policy, accounts payable.
• Understand the management of short-term financing.
• Understand the fixed assets management underlying the depreciation methods,
measures of evaluating fixed assets management.
 Contents
5.1 Overview of working capital
5.2 Cash management
5.3 Receivables management
5.4 Payables management
5.5 Inventory management
5.6 Measures to evaluate the firm’s working capital management
5.7 Forecasting working capital requirements
5.8 Financing strategies for current assets
5.9 Fixed assets management
 5.1.Working capital management

5.1.1. Overview of Working capital management

WORKING CAPITAL = CURRENT ASSET
In accounting and financial statement analysis:

In finance:
 5.1.1. Overview of Working capital management

Working capital management and its objectives

Working capital management is the process of
managing and monitoring activities related to working
capital.
Objectives of working capital management:
• -
• -
Working capital decisions related to maintaining an
optimal balance of each working capital components,
allowing sufficient resources for the operation and
growth.
 5.1.1. Overview of Working capital management

Working Capital Trade-offs

Inventory
High Levels Low Levels
Benefit: Cost:
• Happy customers • Shortages
• Few production delays (always have needed • Dissatisfied customers
parts on hand) Benefit:
Cost: • Low storage costs
• Expensive • Less risk of obsolescence
• High storage costs
• Risk of obsolescence
Cash
High Levels Low Levels
Benefit: Benefit:
• Reduces risk • Reduces financing costs
Cost: Cost:
• Increases financing costs • Increases risk
 5.1.1. Overview of Working capital management
Working Capital Trade-offs
Accounts Receivable
High Levels (favorable credit terms) Low Levels (unfavorable
terms)
Benefit: Cost:
• Happy customers • Dissatisfied customers
• High sales • Lower Sales
Cost: Benefit:
• Expensive • Less expensive
• High collection costs
• Increases financing costs
Accounts Payable and Accruals
High Levels Low Levels
Benefit: Benefit:
• Reduces need for external finance--using a • Happy suppliers/employees
spontaneous financing source Cost:
Cost: • Not using a spontaneous
• Unhappy suppliers financing source
 5.1.2. Determinants of working capital

 Nature and size of business

 Production / Manufacturing Cycle
- Production policy
- Growth and expansions
 Credit policy of the firm
 Operating efficiency
 Profit element
5.2 Cash management
5.2.1 Motivations and objectives of holding cash

TRADE-OFF
 5.2 Cash Management

The term cash includes currency, checks and balance in bank accounts.
Motives of holding cash

• Transactional motive:

• Precautionary motive:

• Speculative motive:

• Trade-off between opportunity cost of holding cash relative to the

transaction cost of converting marketable securities to cash for transactions
 5.2. Cash Management

The goal of cash management

• Maintain an adequate level of cash on hand to meet the daily cash
requirement in operation
• Maximize the amount of money that are available for investments
and obtain the maximum of interest earned on excess cash while
ensuring the safety.
 5.2 Cash management

Effective cash management entails:

Improving cash flows forecasts
Synchronization of cash inflows and outflows
Acceleration of collections
Getting funds available where ever they are required
Control of cash disbursements
Investing seasonal surpluses
 5.2. Cash Management

Managing the cash balance: to find an optimal holding cash balance in

order to maximize the interest earned on funds that are not immediately
needed and reduce the cost associated with the delays in transmission of
funds. Both excess and inadequate cash can consequently degenerate a firm
into problems.
Controlling the collections and disbursements of cash. The objective of
the managing is to speed up the collections and slow down the disbursements
of cash.
The cash budget that involves the forecasts of the cash receipts and
payments for the next planning period, is used to improve the monitor of all
cash flows, estimate the cash needs for business and anticipate cash surpluses
or deficits.
 5.2 Cash management

Cash Disbursements
• Slowing down payments can increase disbursement float – but it may not
be ethical or optimal to do this
• Controlling disbursements
 Zero-balance account
 Controlled disbursement account

19-14
 5.2 Cash management

Investing Cash

• Money market – financial instruments with an original

maturity of one year or less
• Temporary Cash Surpluses
 Seasonal or cyclical activities – buy marketable securities
with seasonal surpluses, convert securities back to cash
when deficits occur
 Planned or possible expenditures – accumulate
marketable securities in anticipation of upcoming expenses

19-15
5.2 Cash management

Investment Timing
 5.2 Cash management

Characteristics of
Short-Term Securities
• Maturity – firms often limit the maturity of short-term
investments to 90 days to avoid loss of principal due to
changing interest rates
• Default risk – avoid investing in marketable securities
with significant default risk
• Marketability – ease of converting to cash
• Taxability – consider different tax characteristics when
making a decision
 5.2 Cash Management

Optimal cash levels

The optimal cash balance may vary in different firms and in different
period of time. It depends on the following factors:
• The forecasts of future cash inflows and out flows of companies.
• The efficiency of the firms’ cash flow management.
• The availability of liquidity assets to the firms.
• The companies’ borrowing capacity.
• The companies’ tolerance of risk.
The optimum cash level can be estimated by using the Miller-Orr
model or the Baumol model.
 5.2.2 Baumol Model

The Baumol model is based on the following assumptions:

The cash is used evenly over a period of time.
The cash requirements of the firm are known with certainty
in advance.
The transaction cost is known and is constant.
By holding the cash balances, the firm would incur the
opportunity cost of interest forgone by not investing in
marketable securities. The rate of carrying cost is known and
is assumed to be constant.
The short term marketable securities can be freely bought
and sold.
5.2.2 Baumol Model

Costs of Holding Cash

Costs in dollars of Trading costs increase when the firm
holding cash must sell securities to meet cash needs.

Total cost of holding cash

Opportunity
Costs
The investment income
foregone when holding cash.

Trading costs
C* Size of cash balance 19A-20
 5.2.2 Baumol Model
The Baumol Model
F = The fixed cost of selling securities to raise cash
T = The total amount of new cash needed
r = The opportunity cost of holding cash, i.e., the
interest rate on marketable securities

If we start with $C, spend at a

constant rate each period and replace
C our cash with $C when we run out of
cash, our average cash balance
will be C–
–2
C 2
The opportunity cost
of holding – –
C is C ×r
2 2
Time 19A-21
1 2 3
 5.2.2 Baumol Model

As we transfer $C each period we incur a trading cost of F.

C
If we need $T in total
over the planning
–C2 period, we will pay $F –
T
times. C

1 2 3 Time The trading cost is –

T ×F
C
19A-22
5.2.2 Baumol Model

C T
Total cost   r   F
2 C
C
Opportunity r
Costs 2

T
Trading costs  F
C
C* Size of cash balance

2T
C*  F 19A-23
R
 5.2.2 Baumol Model

The optimal cash balance is found where the opportunity costs

equals the trading costs.

Opportunity Costs = Trading Costs

C T
r  F
2 C
Multiply both sides by C
C 2 TF
r T F C  2
2

2 2TF r
C 
*

r 19A-24
 5.2.2 Baumol model
Limitations of the Model
The model assumes constant rate of use of cash which is a
hypothetical assumption and is not possible in practice by a firm.
Cash payments are seldom predictable. The model assumes
fixed nature of cash withdrawal which is also not realistic.
Transaction cost is also difficult to measure in advance since it
depends on the type of investment as well as the maturity period.
This model is concerned only with transaction balances and not
with precautionary balances.
 5.2.3 Miller – Orr Model

The basic assumptions of the model are:

There is no underlying trend in cash balance over time,
The optimal values of h and z depend not only on opportunity
costs, but also on the degree of likely fluctuations in cash
balances.
 5.2.3 Miller – Orr Model

The Miller-Orr Model

• The firm allows its cash balance to wander
randomly between upper and lower control
limits.
$ When the cash balance reaches the upper control limit U, cash
is invested elsewhere to get us to the target cash balance C.
U
When the cash balance
reaches the lower
control limit, L,
investments are sold to
C raise cash to get us up
to the target cash
L balance.

19A-27
Time
 5.2.3 Miller – Orr Model
The Miller-Orr Model: Math
• Given L(lower limit), which is set by the firm, the Miller-
Orr model solves for z (return point) and U (Upper limit)

3 Fσ 2 U  3 z  2 L  Spread  L
*

z3 L
4i 3 xFx  2
Spread  33
4i
where s2 is the variance of net daily cash flows.
F: transaction costs
i= daily % interest rate on investments i.e. carrying cost per
VND of cash
19A-28
 5.2.3 Miller – Orr Model

To use the Miller-Orr model, the manager must

do four things:
1. Set the lower control limit for the cash balance.
2. Estimate the standard deviation of daily cash
flows.
3. Determine the interest rate.
4. Estimate the trading costs of buying and selling
securities.

19A-29
 5.2.3 Miller – Orr Model

The model clarifies the issues of cash

management:
 The optimal cash position, is positively related to
trading costs, F, and negatively related to the
interest rate i.

19A-30
 5.2.3 Miller – Orr Model

Other Factors Influencing the Target

Cash Balance
• Borrowing
 Borrowing is likely to be more expensive
than selling marketable securities.
 The need to borrow will depend on
management’s desire to hold low cash
balances.

19A-31
 5.3. Receivable Management

Objectives of management of receivables:

To attain not maximum possible but optimum volume of
sales.
To exercise control over the cost of credit and maintain it
on a minimum possible level.
To keep investments at an optimum level in the form or
receivables.
To plan and maintain a short average collection period.
 5.3. Receivable Management
5.3.1 Trade credit

When a firm sells products or services, there are three main

types of sale transactions that regard when the cash is collected
from the sales:
Cash sales:.
Advance payment sales:
Credit sales:
 5.3. Receivable Management
5.3.2 Components of credit policy
Credit sales:
(1) Term of sale: refers to the conditions that a firm establishes for selling
products and services on credit, consist of three elements:
• The credit period.
• The cash discount and the discount period.
• The types of credit instruments.
Example: A credit with terms of 3/10, net 30.
The credit period: is the length of time for which credit is extended.
Factors that a firm has to consider in setting a credit period:
Credit risk of the buyer:
The customers’ probability of nonpayment.
The size of the account:.
 5.3. Receivable Management
5.3.2 Components of credit policy
The cash discount
The cash discount is offered to accelerate the receivable
collection. There is a cost related to the customers’ use of cash for the
credit period.
Example: A firm bought good that cost VND 100 million and is
offered credit term of 3/15, net 60, but it decided to give up the
discount and will pay promptly at 60 days. What is the effective
annual rate or the cost that the firm has to pay for the use of the cash
for 60-day credit?
Receivable Management
 Exercise 2: A company places an order for 500 units
of inventory. Each unit costs the company VND
80,000 and it is offered credit term of 3/10, net 30.
a. Explain the meaning of the credit term: 3/10, net 30
b. If the company gives up the discount and decides to
pay promptly at 30 days. What is the implicit interest
rate or the cost the firm has to pay for the use of cash
for the credit period?
Exercise 2 solution:
 5.3. Receivable Management
5.3.2 Components of credit policy
(2) Credit Analysis
Credit information:
• The customers’ financial statements
• Credit reports on customers’ payment history with other firms
• Banks
• The customers’ payment history with the firm
Credit evaluation and scoring:
Firms would use the five Cs of credit as guidelines:
• Character
• Capacity.
• Capital
• Collateral
• Conditions.
 5.3. Receivable Management
5.3.2 Components of credit policy
(3) Collection policy
Monitoring Account Receivables:
• The average collection period
• Aging schedule: shows the relationship between the accounts and their
due date
Several procedures that firms can apply to deal with over-due customers:
 Firstly send payment reminder letters to these customers.
 Secondly, telephone calls can be made.
 Thirdly, if the customers’ accounts are too far behind the due date or
if they have not responded to the firms’ reminder, firms then could
employ a collection agency.
 Fourthly, the legal action against those customers is applied if they
have made any responses related to the payment.
 Further more, another method that firms can employ is factoring.
 5.3. Receivable Management
5.3.3 Credit instruments

Promissory
note (IOU)
Bank
Cheques
draft

The type of
credit
instruments Bill of
…
exchange

… …
 5.3. Receivable Management
5.3.3 Credit instruments
Credit instrument refers to documents that evidence a debt.
• A cheque is the most common instrument of credit and almost
works like money. It is a written order on a printed form by a
depositor (drawer) to his bank to pay a sum of” money to himself or
to somebody else, whose name is entered on it, or to the bearer, i.e.,
the man who holds it (i.e., drawee).
• Promissory note (IOU) is used when the order is large and when
the firm anticipates a problem in collections (signed by the customers
after goods are delivered)
• Bank draft is a cheque drawn by a bank on its own branch or on
another bank requiring the latter to pay a specified amount to the
person named in it or to the order thereof.
 5.3. Receivable Management
5.3.4 Credit policy’s effects

Credit policy effects:

Revenue Effects
Delay in receiving cash from sales
May be able to increase price
May increase total sales
Cost Effects
Cost of the sale is still incurred even though the cash from the sale
has not been received
Cost of debt – must finance receivables
Probability of nonpayment – some percentage of customers will not
pay for products purchased
Cash discount – some customers will pay early and pay less than
the full sales price
 5.3. Receivable Management
5.3.5. Monitoring receivables

-Improve firms ability to assess the creditworthiness of the

client
-Establish a credit limit based on the client’s expected ability
to repay its debts
-Limiting the effects of a client’s default
 5.3. Receivable Management
5.3.5. Monitoring receivables

Assess the creditworthiness of the client

• The process of deciding which customers receive credit
• Gathering information
– Financial statements
– Credit reports
– Banks
– Payment history with the firm
• Determining Creditworthiness
– 5 Cs of Credit
– Credit Scoring
 5.4. Payables management

Accounts payables management is the trade-off between the

opportunity costs and the relationship with the suppliers in the
future.
Factors to consider in payables management:
1. Whether payables are handled from a centralized location or
decentralized.
2. Details of the supply chain such as the number, size and location of
vendors. For example, a company may restrict buying from vendors
that are below a certain size, or it may want to buy only from local
vendors.
3. Details of the trade credit, and the alternative costs of borrowing.
4. Details of inventory management system as they affect how fast
payables can be processed.
5. Adoption of commerce and electronic payments for improved
efficiency.
 5.5. Inventory Management
Inventory components:
 Raw material stock
 Work-in-progress
 Finished goods stock
Inventory management concerns about:
 What level of inventory a firm should hold
 When the new order should be made to effectively operate its
business.
 The inventory management aims at finding an optimal
inventory level that allows a firm to provide uninterrupted
production, sales and customer service at a minimum cost.
 5.5. Inventory Management
The inventory costs and inventory trade - off

The inventory
costs

Carrying costs Ordering Stock-out

costs costs
 5.5. Inventory Management

The inventory costs and inventory trade - off

• Carrying costs or holding costs, which involves in keeping
inventory over time, are available costs increasing in direct proportion
to the level of inventory held.
• Ordering costs are fixed costs associated with placing and
receiving an order.
• Stock-out costs are costs occurring when there is insufficient
inventory for using in operation. This may happen in the order lead
time (the time between the replacement of an order and the arrival of
that order).
 5.5. Inventory Management

The inventory trade-off

If low inventory levels then risk is: If high inventory levels then:
•High ordering cost versus •Cost of tying up cash (lost interest)
•Cost of “stock-outs” Storage costs
•Loss of sales Management costs
•Loss of profits Obsolescence
•Loss of goodwill Deterioration
•Production dislocation Insurance costs
Protection (e.g. security patrols)
 5.5. Inventory Management

Inventory management model

The Economic Order Quantity (EOQ) is used to calculate the optimal
inventory level at which the carrying costs and ordering costs are
minimized.
The model’s assumption
• Inventory demand for the year is certain and known. The demand
occurs at constant rate.
• Inventory replacement is instantaneous. There is no order lead time.
• The cost of the orderings remains constant.
• The purchase price is constant.
• The optimal plan is calculated for only one product.
 5.5. Inventory Management

Typical Inventory Cycle

Inventory
level
Q Constant
Demand

Q/2 Average Inventory

Time
 5.5. Inventory Management

EOQ and Inventory Cost

Cost
s$ Carrying
costs

Ordering
costs

EOQ
Order size Q
Economic order quantity
The EOQ model allows to calculate an economic order - is
the optimum size of order at a minimum total cost combined
of the carrying costs and ordering costs.
 5.5. Inventory Management

Total annual = Number of order x Cost of each order

per period
ordering cost
= (Total annual demand/ X Cost of each order
Order size)

= (D/Q) x F

Total carrying = Carrying costs per unit x Average inventory

cost per period level (in units)
= C x (Q + 0)/2 = C x Q/2

The total cost = F x D/Q + C x Q/2

(TC)
 5.5. Inventory Management

The economic order quantity EOQ or Q* is determined to give

the lowest total cost.

EOQ = Q* =

Where: Q is size of inventory

D is total annual demand
F is the cost of each order (fixed cost of
reordering)
C is carrying cost per unit
 5.5. Inventory Management

Example
X Ltd has estimated that it will require 10,000 units of components
for use in its manufacturing next year. It is estimated that the ordering
costs per unit are VND 250,000 and carrying costs are VND 20,000
per components. What would be the X’s economic order quantity?
 5.5. Inventory Management

EOQ model with safety order

• The EOQ model with its assumptions does not take the risk of late
delivery (or order quantity is not delivered on time) into account.
Therefore, inventory management need to concern about the lead
time. The lead time is the time it takes from ordering to receiving an
order.
• To ensure that a firm has enough inventories to operate in the time
it is waiting for new order arrives, it need to adjust for the lead time,
deciding when it need to reorder or calculating reorder point – a safe
inventory level at which a new order should be placed to avoid
running out of stocks.
 5.5. Inventory Management

Example
From example above, considering that company X in has to
wait one week from ordering to receiving stock. Assuming that
the demand is constant at 10,000 units per year, so the demand
per week is predicted as 10,000/52 = 192 units per week.
 5.5. Inventory Management

Company X’s inventory level

pattern with lead time is not 0
Inventory
level
Q = 500 units

Q =192 units

Time

Reorder Reorder Reorder

• Exercise 6: Monthly demand for coffee at Tom’s coffee shop is 30 packs. It
incurs a fixed cost of VND 1 million each time an order is placed. The
carrying cost per pack of coffee per year is VND 50,000. Determine the
optimal order quantity and the total minimum inventory cost for coffee at
the shop.
• Exercise 7: The demand for Similac Mum Advance EyeQ milk powder
(400 gram) at BB Mart is estimated as 600 units per month. A unit costs BB
Mart VND 200,000. The carrying cost per unit per year is about 40% of the
purchase price per unit. The ordering costs are VND 2 millions per order
and it takes 4 days for delivery. BB Mart has 360 working days per year.
Identify the size orders should BB Mart place to minimize those costs?
Determine the total annual costs and the reorder point?
• Exercise 9: XinhXinh shop sells a variety of beauty products. A particular
lipstick costs the shop VND 550,000 per unit. The annual demand is
approximately 2,400 units. The annual carrying cost is about 30% of the
lipstick’s value. It costs approximately VND 1,000,000 to place an order.
The shop currently makes an order of 200 units every month.
• Calculate the ordering, carrying and total inventory cost for the current
order quantity.
• Calculate the economic order quantity (EOQ)
• How many orders will be placed per year using EOQ?
• Calculate the ordering, carrying and total inventory cost for the EOQ. How
much is saved per year by ordering the EOQ?
 5.6. Measures to evaluate working capital
management

1. Receivable turnover

Annual credit sales

AR turnover =
Average AR

2. Days of Receivables

360
Days of receivables 
AR turnover
 5.6. Measures to evaluate working capital
management

3. Inventory turnover

COGS
Inventory turnover =
Average Inventory

4. Days of Inventory

360
Days of Inventory 
Inventory turnover
 5.6. Measures to evaluate working capital
management

5. Accounts payable turnover

Total purchases
AP turnover =
Ending AP balance

6. Days of Payables

360
Days of AP 
AP turnover
 5.6. Measures to evaluate working capital
management

7. Working capital turnover

Total sales
WC turnover =
Average of Current Assets

8. Days of Working Capital

360
Days of WC 
WC turnover
 5.6. Measures to evaluate working capital
management

9. Return on Working Capital

EBT or Net Income

Return on WC =
Average of Current Assets
 5.7 Forecasting working capital needs
Working capital requirements = Estimated (Accounts receivable +
Inventory – Accounts payable) + Desired level of cash balance

1. Direct method
2. Indirect method
Working capital requirements = estimated
revenues x working capital turnover

The percentage of sale approach

• Predicted sales are the driven
• Most of the financial variables on the balance sheet and
income statement are functions of the forecasted sales
• Results in pro forma statements such as pro forma balance
sheet and income statement.
 5.7 Forecasting working capital needs

• As profits earned depend upon magnitude of sales and

they do not convert into cash instantly, thus there is a
need for working capital in the form of CA so as to deal
with the problem arising from lack of immediate
realization of cash against goods sold.

• This is referred to as “Operating or Cash Cycle” .

• It is defined as «The continuing flow from cash to

suppliers, to inventory , to accounts receivable & back
into cash».
 5.7 Forecasting working capital needs

• Therefore needs for working capital arises from

cash or operating cycle of a firm.
• Which refers to length of time required to complete
the sequence of events.
• Thus operating cycle creates the need for working
capital. Its length in terms of time span required to
complete the cycle is the major determinant of the
firm’s working capital needs.
 5.7 Forecasting working capital needs

How this approach works to generate pro forma

statements?
1. Analyzing the relationship of balance sheet items and
income statement items, that are functions of sale as
percentages of sales.
2. Based on the assumption that some items are constant
percentages of sales, with the forecasted sales, some items
on pro forma statements are estimated.
3. Determining of the plug and external fund needed
4. Pro-forma statements are constructed.
5. Sensitive and scenario analysis and testing may be
applied to look at different possibility in financial planning.
 5.7 Forecasting working capital needs

Indirect method
The Percentage of Sales Approach
Example of constructing pro-forma income statement and
balance sheet:

For XYZ Corporation, Table 5.7.1 and Table 5.7.2 present the
most recent statements of the year N. Using the percentage of sale
approach to construct the pro-forma income statement and balance
sheet for the next coming year with the assumption that there is a 10%
increase in sales for the year N+1.
 5.7.1. The Percentage of Sales Approach

Table 5.7.1. XYZ corporation’s Income Statement in year N (VND in billions)

Sales 1,000
Operating Costs (700)
EBIT 300
Interest payments on debt (at 10%) (50)
EBT 250
Income tax expense (at 20%) (50)
Net profit after tax 200

Dividends (Pay out ratio is 60%) (120)

Addition to retained earnings 80
 5.7.1. The Percentage of Sales Approach

Table 5.7.2. XYZ corporation’s Balance Sheet at 31/12/N (VND in billions)

Assets Liabilities and Equity
Current Assets Current Liabilities
Cash 50 Accounts Payable 100
Account Receivable 300 Short-term debt 100
Inventories 450 Total Current Liabilities 200
Total Current Assets 800 Long-term debt 400
Total Debt 600
Fixed Assets Owner’s Equity
Net plan and equipment 700 Common Stocks 500
Accumulated Retained Earning 400
Total Equity 900
Total Asset 1,500 Total Liabilities and Equity 1,500
 5.7.1. The Percentage of Sales Approach
Table 5.7.3. XYZ Corporation’s Pro-forma Income Statement
year N+1 (VND in billions)
Year N Year N+1
Sales Increase10% => 1,100
1,000
Operating Costs (700) 70% of Sales => (770)
EBIT 300 330
Interest payments on debt (at 10%) (50) (50)
EBT 250 280
Income tax expense (at 20%) (50) (56)
Net profit after tax 200 224

Dividends (Pay out ratio is 60%) (120) Unchanged dividend pay out ratio => (134.4)

Addition to retained earnings 80 89.6

 5.7.1. The Percentage of Sales Approach

Table 5.7.4. Forecast items on the Balance Sheet for the year N+1 (VND in billions)
Year % of Year Year % of Year
N Sales N+1 N Sales N+1
Sales 1,000 1,100
Current Assets Current Liabilities
Cash 50 5% 55 Accounts Payable 100 10% 110
Account Receivable 300 30% 330 Short-term debt 100 100
Inventories 450 45% 495 Total Current Liabilities 200 210
Total Current Assets 800 880 Long-term debt 400 400
Total Debt 600 610
Fixed Assets Owner’s Equity
Net plan and 700 70% 770 500 500
Common Stocks
equipment
Accumulated Retained 400 489.6
Earning
Total Equity 900 989.6
Total Asset 1,500 1,650 Total Liabilities and Equity 1,500 1,599.6
 5.7.1. The Percentage of Sales Approach

Table 5.7.5. XYZ corporation’s Pro-forma Balance Sheet (VND in billions)

Assets Liabilities and Equity
Current Assets Current Liabilities
Cash 55 Accounts Payable 110
Account Receivable 330 Short-term debt 150.4
Inventories 495 Total Current Liabilities 260.4
Total Current Assets 880 Long-term debt 400
Total Debt 660.4
Fixed Assets Owner’s Equity
Net plan and equipment 770 Common Stocks 500
Accumulated Retained Earning 489.6
Total Equity 989.6
Total Asset 1,650 Total Liabilities and Equity 1,650
 5.7.2. Operating Cycle method

The Cash Conversion Cycle

• Firm begins with cash which then
becomes inventory and labour
– Which then becomes product for sale
– Eventually this will turn into cash again

• Firm’s operating cycle is time from

acquisition of inventory until cash is
collected from product sales
 5.7.2. Operating Cycle method

The Cash Conversion Cycle

(Operating Cycle)

Product is
converted into
cash, which is
transformed into
more product,
creating the cash
conversion cycle.
 5.7.2. Operating Cycle method

Time Line Representation of the Cash

Conversion Cycle
 5.7.2. Operating Cycle method

• Based on the duration of operating cycle.

• Longer the period of the cycle, bigger will
be the working capital requirements.
• Operating cycle = the cycle of raw material
 work in progress  finished goods 
accounts payable  cash.
• Operating cycle time is the time taken
starting from raw material purchases to its
conversion into cash.
 5.7.2. Operating Cycle method

• Working capital requirements = Estimated

(Accounts receivable + Inventory –
Accounts Payable) + Desired level of cash
balance
• Each component of working capital will
have to be known by using the
assumptions on its operating cycle.
• Working capital requirements = Estimated
revenues x working capital turnover
 5.7.3. Regression method

• Regress the working capital and revenue

to express the relationship between two
variables
• Based on estimated level of revenue in the
future to calculate the level of working
capital requirements
 5.8. Financing Strategies for current assets

 Factors needed to be taken into account:

 Cost associated with the capital sources
 Risk of the finance
 There are three types of assets that need to be financed:
 Non-current assets (NCA):
Permanent current assets (PCA):
Fluctuation current assets (FCA):
 5.8. Financing strategies for current assets
Notes to funding strategies for working capital :
• Each financing strategy brings both advantages and disadvantages
for companies.
• Firms’ managers have to decide the balance between long-term
and short-term finance based on the trade-off between risk and
profitability.
• There is no existence of sound theoretical formula to help firms
finding an optimal combination of short- and long-term sources to
finance working capital.
• Managers should take other important factors such as the
variability of sales and cash flows into account in order to choose a
suitable financing strategy that can maximize the firms’ owner
wealth.
 5.8. Financing policies for current assets

There are 4 different strategies for working capital:

• Relaxed working capital policy
• Moderate working capital policy
• Aggressive working capital policy
• Highly aggressive strategy
 5.8. Financing strategies for current assets

Relaxed strategy:

Aggressive strategy:

Highly aggressive strategy:

Moderate strategy:
• Within the three above approaches, no policy is the best for a firm because there
are no absolute benchmarks. These are primarily used in analyzing ways that a
company approaches operational problems of working capital management.
 5.8. Financing strategies for current assets

Four funding strategies for working capital:

Moderate financing strategy – the matching principle

$ Short-term finance

FCA

PCA
Long-term finance

NCA

Time
 5.8. Financing strategies for current assets

Aggressive financing strategy

$
Short-term finance
FCA

PCA
Long-term finance

NCA

Time
 5.8. Financing strategies for current assets

Conservative financing strategy

$ Short-term finance

FCA

PCA
Long-term finance

NCA

Time
 5.9 Fixed assets and depreciation

• Fixed asset is an asset held with the intention of

being used for the purpose of producing or
providing goods or services and is not held for sale
in the normal course of business.
• Following three criteria:
– It is certain to gain economic benefit in the future from
the use of such asset;
– Having the utilization time of over 01 year;
– Primary price (original cost) of assets must be
determined reliably.
 5.9 Fixed assets and depreciation

• Classification of fixed assets:

– Tangible assets
– Intangible assets
Or can be classified as follows:
- For business purposes
- For welfare purposes, career, security, …
- …
 5.9 Fixed assets and depreciation
DEPRECIATION METHODS

• Straight-line depreciation method

• Accelerated method:
– Sum-of-the-years’-digits
– The Declining-balance method
• Activity method
 5.9 Fixed assets and depreciation

• Primary price = Purchased price paid +

taxes + directly related costs to be paid by
the time inserting the assets into use
• Principles of depreciation of fixed assets:
All of fixed assets served in production must be
depreciated excluding those have been fully
depreciated but still used in production and
business activities, … (Circular 45/2013/BTC)
 5.9 Fixed assets and depreciation

Straight-line depreciation method

Annual average rate of depreciation for the

fixed assets = (Primary price of fixed
assets – salvage value)/Estimated service
life
 5.9 Fixed assets and depreciation
Accelerated method

The accelerated depreciation rate is determined by the following formula:

Accelerated depreciation rate (%) = Rate of depreciation by straight line
method X Adjustment coefficient

Time of depreciation of fixed assets Adjustment coefficient (time)

Up to 4 years ( t  4 years) 1,5
Over 4 to 6 years (4 years <t  6 years) 2,0
Over 6 years (t> 6 years) 2,5
 5.9 Fixed assets and depreciation
EXAMPLE OF DECLINING-BALANCE METHOD
• Company A has purchased a new device producing electronic
components with the primary price (original cost) of 50 million
dong. The time of depreciation of fixed assets determined in
accordance with the Regulatory is 5 years, estimated salvage
value is zero. Determining the annual rate of depreciation as
follows:
– Annual rate of depreciation of fixed assets by the straight-line method is
20%.
– Accelerated depreciation rate by the reducing balance method is equal to
20% x 2 (adjustment coefficient) = 40%
– In the last 2 years, depreciation rate must be ½=50%
– Annual rate of depreciation of the above fixed assets is determined in the
following table:
 5.9 Fixed assets and depreciation
EXAMPLE (CONTINUES)

Year Residual Annual Annual Depreciation Year-end

value of FA at Depreciation Depreciation rate Accumulated
the Depreciation
beginning
1 50.000.000 50.000.000 x 20.000.000 2x20% 20.000.000
40%

2 30.000.000 30.000.000 x 12.000.000 2x20% 32.000.000

40%

3 18.000.000 18.000.000 x 7.200.000 2x20% 39.200.000

40%

4 10.800.000 10.800.000/2 5.400.000 50% 44.600.000

5 10.800.000 10.800.000/2 5.400.000 50% 50.000.000

 5.9 Fixed assets and depreciation
The sum-of-the-years’-digits method results in a
decreasing depreciation charge based on a decreasing
fraction of depreciable cost (original cost less salvage value).
Example: Estimated service life of a fixed asset is 5 years.
Depreciation rate in this case is a fraction uses the sum of
the years as a denominator(5+4+3+2+1=15). The numerator
is the number of years of estimated life remaining as of the
beginning of the year. In this method, the numerator
decreases year by year, and the denominator remains
constant (5/15, 4/15, 3/15, 2/15, and 1/15).
At the end of the asset’s useful life, the balance remaining
should equal the salvage value.
 5.9 Fixed assets and depreciation

Activity method

Annual rate of depreciation of fixed assets =

Amount of products yearly made X Average rate
of depreciation for a unit of product

Average rate of depreciation for a unit of product =

Primary price of fixed assets /Output by design
capacity
 5.9 Fixed assets and depreciation

• Company A purchased bulldozer (new 100%)

with the primary price of 450 million dong. The
design capacity of this bulldozer is 30m 3/hour.
The output by the design capacity of this
machines 2.400.000 m3. The product volume
gained in the first year of this bulldozer is:
 5.9 Fixed assets and depreciation
Month Volume of product finished (m3) Month Volume of
product finished
(thousand m3)
M1 14.000 7 15
M2 15.000 8 14
M3 18.000 9 16
M4 16.000 10 16
M5 15.000 11 18
M6 14.000 12 18

The rate of depreciation by the method of depreciation based on volume is

determined as follows:
- The average rate of depreciation for 1m3 of bulldozed land= 450 million
dong/2.400.000 m 3 = 187.5 dong/m3
- Rate of depreciation of the bulldozer is calculated in the following table:
 5.9 Fixed assets and depreciation
Month Volume of product finished (m3) Monthly rate of
Depreciation (VND)

M1 14.000 14.000 x 187,5=2.625.000

M2 15.000 15.000x187,5=2.812.500

M3 18.000 18.000x187,5=3.375.000

M4 16.000 16.000x187,5=3.000.000

M5 15.000 15.000x187,5=2.812.500

M6 14.000 14.000x187,5=2.625.000
 5.9.3 Measures to evaluate the firm’s fixed
assets management

1. Sales to fixed assets

2. Accumulated depreciation to fixed assets ratio

 5.9.3 Measures to evaluate the firm’s fixed
assets management
3. Cash flow to fixed assets requirements

4. Return on fixed assets employed

5. Intangibility index
 Summary

- The purpose of managing working capital is to improve profitability

and ensure sufficient liquidity.
- There are three alternative working capital policies including relaxed,
moderate and aggressive working capital policy.
- There are four motives for holding cash: transactional motive,
precautionary motive, speculative motive and trade-off, but companies
should hold an optimal level of cash depends on its need.
- There are costs associated with holding a high level of inventory
because of cash tied up into raw materials, work-in-progress and goods,
it is relevant to make question of what is the optimal level of inventory
held an what time it is held for, in order to efficiently manage the
inventory.
- The economic order quantity model (EOQ) can be used to determine
the optimum order quantity.
 Summary

- The Receivables management also termed as credit management deals

with the establishment of the company credit policy. The credit policy
decision should be made based on the trade-off between the benefits and
the costs of granting credit.
- Credit policy consists of three components: terms of sales, credit
analysis and collection policy.
- The management of short-term financing concerns with decisions of
choosing an appropriate mixture of fund sources to invest in short-term
assets.
- There are three types of financing fund policy: conservative, aggressive
and moderate policy. There is no existence of sound theoretical formula
to find an optimal combination of short- and long-term sources to
finance working capital. Managers should choose a suitable financing
policy that can maximize the firms’ owner wealth.
 Summary

- Financial planning helps firms to improve the effectiveness in

controlling and managing their businesses.
- Percentage of sales approach: the forecasted sales are the driven
and most of items on balance sheet and income statements are
functions of sales. Using the historical financial statements as the
inputs, the percentage of sales method provides the pro-forma
statements used for decision-making and planning
- There are two more approaches: operating cycle and regression to
estimate the working capital requirements
- The CFO can also evaluate the possible proposals to finance firm’s
current assets.
- Last section provided different depreciation and a set of evaluating
measures of fixed assets management.