Our Lady of the Pillar College - San Manuel, Inc.

DISTRICT 3, SAN MANUEL, ISABELA, PHILIPPINES

E-mail: nuestrasenioradelpilar@gmail.com

Working Capital Management

Working Capital – means current assets

Net Working Capital – means the excess of current assets over current liabilities.
The working capital investment consists of cash, marketable securities, accounts receivables,
and inventories of raw materials, goods in process and finished goods. Increases in the level
of inventories and receivables throughout the production process use up cash. Hence, there
is a need for financing to carry the company through its production cycle.

WORKING CAPITAL MANAGEMENT CONCEPTS

Working Capital Management – involves the determination of the level, quality and maturity
of each major current assets and current liability. It also refers to the administration and control
of current assets and current liabilities to ensure that they are adequate and used effectively
for business purposes.
FACTORS AFFECTING WORKING CAPITAL REQUIREMENT OF A BUSINESS
 General nature of the business and product
 Effect of sales pattern
 Length of the manufacturing process
 Industry practice
 Terms of purchases and sales
SOURCES OF WORKING CAPITAL
 Profitable operations
 Sale of non-current assets
 Proceeds from long-term borrowings
 Additional investments by the owners
USES OF WORKING CAPITAL
 Non-profitable operations
 Purchase of non-current assets
 Retirement or payment of long-term debts
 Dividend payment
 Retirement of capital stock
 Withdrawal

Trade-off between Risks and Returns

The management of working capital requires consideration for the trade-off between
risk and returns. Holding more current than long-term assets means greater flexibility and
reduced liquidity risk. However, the rate of return will be less than with current assets than with
long-term assets. Long-term assets typically earn a greater return than current assets. Long-
term financing has less liquidity risk associated with it than short-term debt, but it also carries a
higher cost. Consider the following:

Working Capital Policy

Conservative Aggressive
Level of current assets High Low
Reliance on Long-Term Financing High Low
Liquidity risk Low High
Profitability Low High
WORKING CAPITAL POLICIES
1. Aggressive or Restricted – As the name implies, aggressive policies involve the greatest
amount of risk and as a result, the greatest potential for multiplied growth. Companies
using this policy have high profitability but are exposed to liquidity risk.
2. Conservative or Relaxed – Conservative is the exact opposite of Aggressive policy.
Companies using this policy trades-off profitability to attain liquidity. The risk exposure is
very low to virtually none.
3. Moderate or Maturity or Matching or Hedging – Moderate policy is a balance between
the Aggressive and Conservative. It combines the features of both policies. Some level
of profitability is given-up to attain sustainability. Overall profitability is between the two
policies. The risk is lower than Aggressive but higher than Conservative.

KEY FACTORS WHEN CHOOSING A POLICY

When deciding on a working capital financing policy, you should take your company’s growth
stage into account at all times. Before implementing any policy, carefully consider these and
other factors relevant to your business.
a. Liquidity
b. Profitability
c. Working Capital Requirement

ILLUSTRATION. WORKING CAPITAL

Given the following information of Noli Company:
Cash P12,000 Accounts Payable P10,000
Accounts Receivable 18,000 Current tax liability 3,000
Inventory 20,000 Accrued payable 7,000
Fixed Assets 50,000 Bonds payable 80,000

The bonds will mature in 10 years. All amounts are correctly stated.

Required:
1. Net Working Capital
2. Current ratio
3. Acid-test ratio
4. New current ratio (assuming all accounts payable are paid in cash)
5. New current ratio (assuming a P10,000 short-term loan is obtained from a bank)

Turnover Ratios, Conversion Periods and Cash Conversion Cycle

Income statement account

Turnover = Average balance sheet
account
Average Age/ = No. of days in a year
Conversion periods Turnover

Cash Conversion Cycle – is the average length of time a peso is tied up in current assets. It
runs from the date the company makes payment of raw materials to the date company
receives cash inflow through collection of accounts receivable. It is also known as the cash
flow cycle.

Objective: To shorten the cash conversion cycle without hurting operations. The longer the
cash conversion cycle, the greater the need for external financing; hence, the more cost of
financing.
Working Capital Activity Ratios

Net Credit Sales

Receivable Turnover = Average Receivables
It is the time required to complete one collection cycle from the time receivables are
recorded, then collected, to the time new receivables are recorded again.
 Average age of = 360 days
receivables Receivable turnover
It indicates the average number of days during which the company must wait before
receivables are collected.

Cost of goods sold

Inventory Turnover = Average Merchandise
Inventory
It measures the number of times that the inventory is replaced during the period.

Average age of = 360 days

Inventory Inventory turnover
It indicates the average number of days during which the company must wait before the
inventories are sold.

ILLUSTRATION. JADE Corporation purchases merchandise on 20 day-term. Goods are sold, on

the average, 15 days after they are received. The average accounts receivable is 45 days.
Jade pays its payable on due date. (Assume a 360-day year).

Required:
1. How long is the company’s normal operating cycle?
2. How long is the company’s cash conversion cycle?
3. What is the number of cash conversion cycles in one year?
4. What is the accounts payable turnover ratio?
5. What is the inventory turnover ratio?
6. Assuming the average inventory amounts to P200,000, how much is the COGS?
7. What is the accounts receivable turnover ratio?
8. Assuming an average receivable balance of P700,000, how much is the net credit
sales?

CASH MANAGEMENT
- Cash management involves the maintenance of a cash and marketable securities
investment level which will enable the company to meet the cash requirements and
at the same time optimize the income on idle funds.
- The thrust of cash management is to accelerate cash receipts and delay cash
payments.

REASONS FOR HOLDING CASH

 Contractual Motive (Compensating balance requirements) – A company is
required by a bank to maintain a certain compensating balance in its demand
deposit account as a condition of a loan extended to it.
 Precautionary Motive (Contingent Motive) – Cash is held beyond the normal
operating requirement level to provide for buffer against contingencies, such as
slow-down in accounts receivable collection, possibilities of strikes, etc.
 Transaction Motive (Liquidity Motive) – Cash is held to facilitate normal
transactions of the business (daily operating requirements).
 Speculative Motive – Cash is held to avail of business incentives (e.g. discounts)
and investment opportunities.
FLOAT
The simplest definition of cash float is the total amount of checks written or received that
have not yet been cashed or credited to your bank account. There are two types of cash
float: disbursement float and collection float. Disbursement float is maximizing the delay
when paying cash, on the other hand, Collection float is the delay in cash receipts. The
delay can be caused by many factors.
Sources of Float
 1. Mail float – the delay between the time the payment was mailed to the payee and
the time when the payee receives it.
2. Processing float – the delay between the receipt of a check by the payee and the
deposit of it in the firm’s account.
3. Clearing float – arises from the time required for a check to clear the banking system.
Net float – Difference between disbursement float and collection float.

ILLUSTRATION
Chris Company writes checks averaging P15,000 a day and it takes five days for these
checks to clear. The firm also receives checks in the amount of P17,000 per day, but the firm
loses three days while its receipts are being deposited and cleared. What is the firm’s net
float?

DETERMINING THE CASH NEED

The optimal cash balance may be derived with the use of the following approaches,
namely:
1. Cash Budget – similar to the statement of cash receipts and disbursements.
2. Cash break even chart – this chart shows the relationship between company’s cash
needs and cash sources. It indicates the minimum amount of cash that should be
maintained to enable the company to meet its obligation.
3. Optimal Cash Balance Model:
The optimal cash balance is determined by computing for the cash balance that will
minimize the total costs associated with it, namely:
a. Short costs – arise as the firm hold less and less cash. They increase as cash balance
approaches zero. Examples are lost trade discounts, deteriorating credit rating and
increase cost of financing.
b. Long cost – are costs incurred because the firm had forfeited opportunities for profit
by holding rather investing idle cash. The opportunity costs increase as the size of
the idle cash balance increases.
c. Procurement costs – include the fixed cost associated with supervision, accounting
and other office overhead related to cash management program. These,
however, are not affected by adjustments made to the firm’s cash balances.

FORMULA FOR TOTAL CASH MANAGEMENT COSTS:

TC = P +TSC + TLC
Where:
TC: Total cash management costs
P: Procurement costs
TSC: Total short costs
TLC: Total long costs

THE OPTIMUM CASH BALANCE

-Theoretically, a desired cash balance is the optimum cash balance where the total relevant
costs of cash would be at the minimum (holding costs and opportunity costs)
-A desired cash balance may be established by using the subjective model or quantitative
model.
- In the subjective model, the company sets the desired cash balance based on a related
factor (i.e. the minimum cash balance is 50% of the next month’s sales).
- In the quantitative model, the Baumol model or the Miller-Orr model is used.

The optimum conversion quantity model

ECQ= √(2 X AD X CPT)/OCR

Where: ECQ = Economic Conversion Quantity

AD = Annual Demand
CPT = Cost per Transaction
OCR = Opportunity Cost Ratio
AVERAGE CASH BALANCE = ECQ/2
Using this model, it is assumed that cash inflows and outflows are known with certainty.

ILLUSTRATION:
Pure Gold Corporation expects to make even monthly cash payments of P160,000 during
the year. The average return on money market placements is 8% per annum and it expects
to pay P250 per cash transfer. Determine the following:
1. Optimum cash balance per transaction
2. Average cash balance
3. Number of cash transfer per year
4. Total relevant cost at the optimum cash balance
5. Total relevant cash cost at the following cash transfers:
a. P50,000 b. P400,000

TECHNIQUES FOR LESSENING CASH NEEDS

1. Accelerating cash collections
 Prompt billing
 Offering trade and cash discounts
 Enclosing self-addressed stamped envelope with the bill
 Maintenance of regional collection officer
2. Slowing disbursements
 Delaying payment
 “Pay the float” – taking advantage of the time it takes for the company’s check
to clear the banking system
 Less frequent payroll – instead of paying the workers weekly, they may be paid
semi-monthly.
3. Reducing the need for precautionary balance
 Opening lines of credit – is a pre-arranged loan where the company can
withdraw anytime within the period agreed upon.
 Temporary Investments – investments in highly liquid securities may be
maintained instead of holding idle precautionary cash balance.

SOME WAYS OF DELAYING CASH DISBURSEMENTS

 Use of drafts in paying bills.
 Use of crossed checks.
 Mail checks in post office with limited service or where processing will be at many
points.
 Draw checks on remote banks.
 Use credit cards.

MARKETABLE EQUITY SECURITIES

Marketable Equity Securities are short-term, interest earning, money market instruments that
can easily be converted into cash. It is the objective of the Financial Manager to choose
securities that will maximize value to the company.

Reasons for short-term financing:

1. Short-term financing (or current liabilities) is intended to primarily sustain short-term
investment (or current assets) operations.
2. In as much as current assets are expected to be recovered within a short period of
time, normally not exceeding a year, the current liabilities are likewise expected to be paid
within a year.
3. Short-term financing is tapped to lessen the equity exposure and risk of the firm to
finance its operating activities.
4. Since, operating supplies benefit significantly from the enterprise’s operations, they are
inherently willing to equitably share in financing and sustaining the operating activities of the
firm.
INSTRUMENTS CLASSIFIED AS MARKETABLE EQUITY SECURITIES
Government Issued Instruments:
1. Treasury bills
2. Treasury notes
Non-Government Instruments:
1. Negotiable Certificates of Deposit (CD)
2. Commercial Paper
3. Banker’s Acceptances
4. Money Market Mutual Funds
5. Repurchase Agreements

Comparative Analysis of Securities

Type of Security Maturity Safety Marketability
Government Securities 3-6 MONTHS EXCELLENT EXCELLENT
Treasury Bills 1 -10 YEARS EXCELLENT EXCELLENT
Treasury Notes
Non-Government Securities
Certificates of Deposits 3 MONTHS GOOD GOOD
Commercial Papers 3 MONTHS GOOD FAIR
Banker’s Acceptances 3 MONTHS GOOD GOOD
Money Market Funds OPEN GOOD NONE
Repurchase Agreements OPEN EXCELLENT NONE

Cost of Bank Loans:

Without compensating balance:

1. If not discounted (cash proceeds normally equal face value):
Cost = Interest/Amount Received (Face)
2. If discounted (cash proceeds is net of interest – deducted in advance):
Cost = Interest/Face Value – Interest
With compensating balance:
1. If not discounted
Cost = Interest/ (Face Value -CB)
2. If discounted
Cost = Interest / (Face Value – Interest – CB)
ILLUSTRATION:
Eddie Wau Trading Co. was granted a P200,000 bank loan with 12% stated interest.
Required: The effective annual rate under the following cases:
1. Eddie receives the entire amount of P200,000.
2. Eddie was granted a discounted loan.
3. Eddie is required to maintain a CB of 10,000 under the non-discounted loan.
4. Eddie is required to maintain a CB of 10% under a discounted loan.
5. Assuming the same data in No. 4but in addition, the compensating balance bears
interest equivalent to 4% annually.
6. Assuming the same data in No.5 but the term of the loan is only for 60 days.
ADD-ON INTEREST

A method of calculating interest whereby the interest payable is determined at the

beginning of a loan and added onto the principal. The sum of the interest and principal is
the amount of repayable upon maturity.
EIR, ADD-ON = Interest Expense/ Average principal
Where: Average principal = [Principal + (Principal/12)]/2

*Assuming the loan is payable in 12 equal monthly installments.

ILLUSTRATION:
Strike Company borrowed from a bank an amount of P1,000,000. The bank charged a 12%
stated rate in an add-on arrangement, payable in 12 equal monthly installments.

Required:
1. Compute for the effective interest rate.
2. Compute for the effective interest rate assuming the loan is payable for 9 months only.

COST OF COMMERCIAL PAPERS:

Commercial paper – is an unsecured, short-term debt instrument issued by a corporation,

typically for the financing of accounts receivable, inventories and meeting short-term
liabilities. Maturities on commercial paper rarely range any longer than 270 days.
Commercial paper is usually issued at a discount from face value and reflects prevailing
market interest rates.

Cost = [(Interest + Issue Costs)/ (Face Value- Interest-Issue Cost)] x (360 days/Term)

ILLUSTRATION
MAJA plans to sell P100,000,000 in 180-day maturity paper, which it expects to pay
discounted interest at an annual rate of 12%. Due to this commercial paper, Maja expects to
incur P100,000 in dealer placement fees and paper issuance costs. What is the effective cost
of commercial paper?

ADDITIONAL FUNDS NEEDED (AFN)/ EXTERNAL FINANCING NEEDED (EFN)

AFN is the amount of money a company must raise from external sources to finance the
increase in assets required to support increase level of sales.

Financial management requires thorough analysis of the firm’s capital requirements.

Generally, the “additional (external) funds needed” can be determined by using the
following formula:

Required increase in assets = Change in Sales * (Assets/Sales)

Less: Spontaneous increase in liabilities = Change in Sales * (Liabilities/Sales)
Increase in retained earnings = Earnings after tax – Dividend payment
ADDITIONAL FUNDS NEEDED

ILLUSTRATION:
Drax Corporation’s sales are expected to increase from P5,000,000 in 2023 to 6,000,000 in
2024. Its assets totaled P3,000,000 at the end of 2023. Drax has full capacity, so its assets must
grow in proportion to projected sales. At the end of 2016, current liabilities are P1,000,000
(P200,000 of accounts payable, P500,000 of notes payable and P300,000 of accruals). The
after-tax profit margin is projected to be 10%. The forecasted pay-out ratio is 75%.

Required: determine the additional funds needed from external sources.

RECEIVABLE MANAGEMENT

OBJECTIVE OF RECEIVABLE MANAGEMENT

-To encourage sales and gain additional customers by extending credit.
It is the responsibility of the finance officer to evaluate pertinent costs and benefit related to
credit extension, to finance the firm’s investment in accounts receivables, implement the
firm’s chosen credit policy and to enforce collection.
Accounts receivable management entails ensuring that customers pay their invoices. Good
receivables management aids in the prevention of late or non-payment. As a result, it is a
quick and effective way to improve the company’s financial or liquidity position.
Receivables management strategy, extend credit if incremental revenues are greater than
incremental costs (Cost benefit analysis), or extend credit sales at the point where marginal
cost is equal to marginal revenue (Profit Maximization).

The Five C’s of credit

1. Character 2. Capacity 3. Conditions 4. Capital 5. Collateral

FACTORS IN DETERMINING ACCOUNTS RECEIVABLE POLICY

1. Credit standards
2. Credit terms
3. Collection Program
4. Delinquency and Default

COSTS ASSOCIATED WITH ACCOUNTS RECEIVABLE

1. Credit analysis, accounting and collection costs – the costs of hiring and maintaining
collection managers plus assistants and bookkeepers within the finance department;
of acquiring credit information sources and of generally maintaining and operating a
credit and collection department.
2. Capital costs – the costs of obtaining additional funds to finance the extension of
credit; the interest to be paid if the funds are borrowed or the opportunity cost of
equity capital.
3. Delinquency costs – costs incurred when the customer is late in paying. This delay adds
collection costs above those associated with normal collection.
4. Default costs (bad debts) – the firm loses the costs of goods sold not paid for. It must
write of the entire sales once it decides the delinquent account has defaulted and is
no longer collectible.

CREDIT TERMS
Credit terms specify the repayment terms required of a firm’s credit customers. It is
composed of three major factors:
1. The discount period.
2. The cash discount
3. The credit period.
The following summarizes the possible effects of changing credit terms:
Increase in Credit Period
Variable Direction of Change Effect on Profits
Sales volume Increase Increase
Accounts Receivable Increase Decrease
Bad debts expense Increase Decrease
Increase in Discount Period
Variable Direction of Change Effect on Profits
Sales volume Increase Increase
Non-discount receivable- Decrease Increase
takers taking discounts
Discount-taking receivables Increase Decrease
paying later
Bad debts expense Decrease Increase
Increase in Cash Discount
Variable Direction of Change Effect on Profits
Sales volume Increase Increase
Non-discount receivable- Decrease Increase
takers taking discounts
Discount-taking receivables Increase Decrease
paying later
Bad debts expense Decrease Increase
CONSEQUENCES OF RELAXING CREDIT TERMS
The most common credit term is 2/10; n/30. Relaxing the credit terms is a strategy used to
increase profits. The following us a summary of effect of relaxing the credit terms.
-increase in credit sales
-increase in Accounts Receivable
-increase in Bad debts
-increase in Collection cost
-increase in Opportunity cost on incremental investment in receivables
-increase in Sales discounts

INVENTORY MANAGEMENT

OBJECTIVE OF INVENTORY MANAGEMENT

To maintain a sufficient amount of inventory to ensure the smooth operation of the firm’s
production and marketing functions and at the same time avoid tying up funds in excessive
and slow-moving inventory.

RELEVANT COSTS IN INVENTORY MANAGEMENT

CARRYING COSTS – are the costs of maintaining an inventory. Examples: Warehousing and
storage cost, property taxes, insurance on inventory cost of capital tied up in inventory
(Interest and opportunity cost), losses from obsolescence and spoilage, clerical costs of
keeping inventory records and handling and transportation costs.

ORDERING COSTS – are those incurred every time an order is placed and include the clerical
costs involved in the preparation of purchase requisitions and purchase orders, following up
an order and receiving the goods, cost of man hours spent on canvassing of pieces and
differential freight-in costs from small and frequent orders.

STOCKOUT COSTS – refers to the effect of the failure of the company to service customers of
conduct manufacturing operations smoothly because goods, raw materials and or supplies
are out of stock. It includes lost contribution margin, loss of customer’s goodwill, extra cost of
uneconomic volume of purchases or production runs, purchase discount lost and the cost
incidental to unstabilized manufacturing operations such as those of idle time and overtime.

ECONOMIC ORDER QUANTITY (EOQ) refers to the order size that will minimize the total of
ordering costs and the carrying costs. The formula is:

EOQ = √(2 X Annual Usage X Ordering cost per order)/Carrying Cost Per unit

ECONOMIC LOT SIZE refers to the size of production run that will minimize the total set-up cost
and carrying cost. The formula is:

ELS = √(2 X Annual Usage X Set-up cost)/Carrying Cost Per unit

LEAD TIME – refers to the number of days or length of period it takes to order and receive the
goods
LEAD TIME USAGE – refers to the usage during lead time.

SAFETY STOCK is the additional quantity of goods that must be on hand at the time an order
is placed to take care of unforeseeable delays and usage above normal while awaiting
delivery of the goods; it is based on the difference between maximum and normal usages
during lead-time. It is computes as follows:

= Maximum usage during lead time – Normal usage during lead time
OR
= (Maximum daily – Normal daily usage) x No. of days in lead time
REORDER POINT refers to the inventory level at the time the order is places. It is equal to the
lead-time usage plus safety stock.

ILLUSTRATION
NORTON Corporation has been buying Product XY in lots of 1,250 units which represents a
three-month’s supply. The cost per unit is P220. The ordering cost is P900 per order; and the
annual inventory carrying cost per unit is P25.00. Assume that the units will be required evenly
throughout the year.

COMPUTE THE FOLLOWING:

a. Economic Order Quantity
b. Number of orders in a year
c. Average inventory based on EOQ.
d. Total carrying cost, ordering cost and relevant inventory costs at EOQ.
e. Total relevant inventory cists for order sizes of:
e.1 1,000 units e.2 750 units e.3 600 units e.4 500 units

KEN Corporation determined the manufacturing cost per order of Material AB at P25.00.
The company expects to use P50,000 of this material. Its carrying charge is 10% of inventory.

COMPUTE:
a. Economic Order Quantity in pesos
b. Number of times the RM be ordered in the coming year
c. Average inventory
d. Total relevant inventory costs at EOQ.

MARSHALLS Corporation makes available the following information relative to its Material G-
224

Annual Demand 30,000 units Working days in a year 300 days

Normal lead time 12 days Maximum lead time 19 days
Maximum usage 125 units Economic order size 6,000 units

COMPUTE:
A. Lead time quantity
B. Safety Stock Quantity
C. Maximum inventory
D. Reorder point
E. Average inventory