Working

Capital
MAnagement
 WORKING CAPITAL MANAGEMENT
Working capital (or short-term financial) management is
the management of current assets and current
liabilities.

Working capital management is concerned with short

term financial decisions.
 COMPONENTS OF WORKING CAPITAL
CURRENT ASSETS

Current assets are the assets which can be converted

into cash within a period of one year in an ordinary
course of business, without disrupting the operations of
the firm. The current assets are namely, cash,
marketable securities, account receivables (including
debtors and bills) and inventories.
 COMPONENTS OF WORKING CAPITAL
CURRENT LIABILITIES

Current liabilities are claims of outsiders which are to be

paid within a period of one accounting year in an
ordinary course of business. Current liabilities include
notes payable, accruals, and accounts payable.
 RATIOS
The efficient working capital management is mandatory
to maintain a balance of liquidity and profitability.

PROFITABILITY is the relationship between revenues and

costs generated by using the firm’s assets—both current
and fixed—in productive activities.

LIQUIDITY is the ability of the company to pay its bills as

they come due.
 CLASSIFICATION OF WORKING CAPITAL
Based on Based on Need
Concept & Time

Gross Working Net Working Permanent Temporary

Capital Capital Working Working
Capital Capital
 PERMANENT WORKING CAPITAL
It is the bottom level of the investment required to
maintain current asset at such a level so that day-to-day
operations can be carried on without any impediment or
hurdles.
 TEMPORARY WORKING CAPITAL

It is dependent on the changes in production and sales.

WORKING CAPITAL BASED ON NEED AND TIME
 WORKING CAPITAL FINANCING POLICY
The two major sources of working capital finance are:
1. Short term sources:
They provide funds for a short period say up to one year.
The main sources are: trade credit, Short term bank
credit, factoring of receivables, commercial papers.
2. Long term sources
They provide funds for a comparatively longer period.
The main sources are equity share capital, Preference
share capital, Debentures, long term borrowings, etc.
APPROACHED ON WORKING CAPITAL FINANCING POLICY

a) Hedging Approach
b) Conservative Approach
c) Aggressive Approach
 HEDGING APPROACH
Under Hedging Approach, each asset should be
counterbalanced with a financial instrument of the
same estimated maturity.
 CONSERVATIVE APPROACH
Under the conservative
approach (relaxed
policy), the management
allows itself a margin of
safety and decides to
finance a portion of
short term working
capital needs from long
term sources.
 AGGRESSIVE APPROACH
Under this approach, a firm finances some of its
enduring requirements using short-term sources.
 AGGRESSIVE APPROACH

Amount of
Policy Current Liquidity Profitability Risk
Assets
 COMPUTATION OF COSTS OF POLICY
For Aggressive:
Compute the monthly permanent working capital.
Compute the average monthly temporary working
capital.
Compute the costs using the Short Term Fund Costs
and Long Term Fund Costs.

For Conservative:
Highest permanent working capital multiplied by Long
Term Fund Costs.
 EXAMPLE: COMPUTATION OF COSTS OF POLICY
Ace Business Forms
Current Fixed Total
Month Assets Assets Assets
January $125,000 $250,000 $375,000 The firm pays 8 percent on short-
February 130,000 250,000 380,000 term funds and 10 percent on
March 135,000 250,000 385,000 long-term funds. Determine:
April 150,000 250,000 400,000 (a) the monthly average
May 150,000 250,000 400,000 permanent funds requirement
June 125,000 250,000 375,000 (b) the monthly average
July 115,000 250,000 365,000 seasonal funds requirement
August 120,000 250,000 370,000 (c) the annual financing costs
September 115,000 250,000 370,000 (aggressive strategy)
October 100,000 250,000 350,000 (d) the annual financing costs
November 110,000 250,000 360,000 (conservative strategy)
December 115,000 250,000 365,000
 EXAMPLE: COMPUTATION OF COSTS OF POLICY
Month Current Assets Fixed Assets Total Assets
January $60,000 $70,000 $130,000 What is the total cost of
February 58,000 70,000 128,000 financing under the
March 55,000 70,000 125,000
April 47,000 70,000 117,000
aggressive and
May 40,000 70,000 110,000 conservative strategies.
June 41,000 70,000 111,000 Assume short-term
July 40,000 70,000 110,000
funds costs 4.5 percent
August 37,000 70,000 107,000
September 38,000 70,000 108,000 and the interest rate for
October 33,000 70,000 103,000 long-term funds is 12
November 40,000 70,000 110,000
percent.
December 50,000 70,000 120,000
 WORKING CAPITAL CYCLE
Cash Conversion Cycle / Operating Cycle

It 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.
 COMPUTATION OF WORKING CAPITAL CYCLE
Working Capital Cycle = OC – APP

Operating cycle (OC) is the time from the beginning of the

production process to collection of cash from the sale of the
finished product. It is measured in elapsed time by summing the
average age of inventory (AAI) and the average collection period
(ACP).

The operating cycle less the average payment period (APP) yields
the cash conversion cycle.
 COMPUTATION OF WORKING CAPITAL CYCLE
Working Capital Cycle = OC – APP
OC = AAI + ACP
Working Capital Cycle = AAI + ACP – APP

AAI = 360 / Inventory Turnover or Inventory / Average COS

Inventory Turnover = COS/Average Inventory

ACP = 360 / AR Turnover or AR / Average Credit Sales

AR Turnover = Net Credit Sales /Average AR

APP = 360 / AP Turnover or AP / Average Credit Purchases per Day

AP Turnover = Credit Purchases /Average AP
 COMPUTATION OF WORKING CAPITAL CYCLE
Minny Fishing Products is analyzing the performance of its cash
management. On the average, the firm holds inventory 65 days,
pays its suppliers in 35 days, and collects its receivables in 15
days. The firm has a current annual outlay of P1,960,000 on
operating cycle investments. Minny currently pays 10 percent for
its negotiated financing. (Assume a 360 day year.)
(a) Calculate the firm’s cash conversion cycle.
(b) Calculate the firm’s operating cycle.
 CASH MANAGEMENT
The goal of cash management is to reduce the amount of cash
that is being used within the firm so as to increase profitability,
but without reducing business activities or exposing the firm to
undue risk in its financial obligations
 MOTIVES OF HOLDING CASH
1. Transaction Motive – Firms hold cash in order to satisfy the
cash inflow and cash outflow needs that they have.
2. Precautionary Motive – Holding cash as a precaution serves
as an emergency fund for a firm.
3. Compensating Motive – a minimum balance is required to be
kept.
4. Speculative Motive – holding cash as creating the ability for a
firm to take advantage of special opportunities.
 BAUMOL’S MODEL
Optimum cash balance under certainty.
 EXAMPLE: BAUMOL’S MODEL
For the coming year, the expected cash disbursements total
P432,000. The interest rate on marketable securities is 5% per
annum. The fixed cost of selling marketable securities is P8 per
transaction. Compute the optimal cash balance to minimize total
cost.
 CASH PLANNING
The cash budget or cash forecast is a statement of the firm’s
planned inflows and outflows of cash that is used to estimate its
short-term cash requirements.

Typically, the cash budget is designed to cover a 1-year period,

divided into smaller time intervals.

The more seasonal and uncertain a firm’s cash flows, the greater
the number of intervals.
 CASH PLANNING
A sales forecast is a prediction of the sales activity during a given
period, based on external and/or internal data. The sales
forecast is then used as a basis for estimating the monthly cash
flows that will result from projected sales and from outlays
related to production, inventory, and sales.
The sales forecast may be based on an analysis of external data,
internal data, or a combination of the two.
An external forecast is a sales forecast based on the relationships observed between
the firm’s sales and certain key external economic indicators.
An internal forecast is a sales forecast based on a buildup, or consensus, of sales
forecasts through the firm’s own sales channels.
CASH PLANNING
 CASH MANAGEMENT STRATEGIES
1. Accelerating Collections
2. Slowing Disbursements
3. Reducing precautionary idle cash
 ACCELERATING CASH COLLECTIONS
How to accelerate cash collection?
• decentralized collections
• lock-box system
• prompt payment by customers
• early conversion of payment into cash

Ways to improve cash collection:

• changing customer paying habits
• improve the delivery system (reduce the negative float)
• bypass the problem (factoring of receivable)
 LOCKBOX SYSTEM
A lock-box system is a procedure in which customers mail
payments to a post office box that is emptied regularly by the
firm’s bank, which processes the payments and deposits them
in the firm’s account. This system speeds up collection time by
reducing processing time as well as mail and clearing time.
• Advantage:
o receive remittances sooner which reduces processing float
• Disadvantage
o additional cost of creating and maintaining a lock-box
system; generally, not advantageous for small remittances
 LOCKBOX SYSTEM
Lock-box process
1. customers are instructed to mail their remittances to the lock-
box location
2. bank picks up remittances several times daily from the
lockbox
3. bank deposits remittances in the customers account and
provides a deposit slip with a list of payments
4. company receives the list and any additional mailed items
 EXAMPLE: LOCKBOX SYSTEM
It takes ABC Corporation about 10 days to receive and deposit
payments from customers. Therefore, a lockbox system is
being considered. It is expected that the system will reduce
the float time to 8 days. Average daily collections are
P500,000. The rate of return is 12 percent.

REQUIRED:
The reduction in outstanding cash balances arising from implementing the lockbox
system is:
The return that could be earned on these funds is:
The maximum monthly charge the company should pay for this lockbox arrangement is
therefore:
 EXAMPLE: LOCKBOX SYSTEM
XYZ Corporation is exploring the use of a lockbox system that will
cost P100,000 per year. Daily collections average P350,000.
The lockbox arrangement will reduce the float period by 2
days. The firm’s rate of return is 15 percent.

What is the advantage of using the lockbox system?

 DECELERATING CASH PAYMENTS
How to decelerate cash payment?
• playing the float
• control of disbursement
o payable through draft (PTD)
o payroll and dividend disbursement
o zero balance account (ZBA)
• remote and controlled disbursement
 FLOAT
Float refers to funds that have been sent by the payer but are not
yet usable funds to the payee. Float is important in the cash
conversion cycle because its presence lengthens both the
firm’s average collection period and its average payment
period. However, the goal of the firm should be to shorten its
average collection period and lengthens its average payment
period. Both can be accomplished by managing float.
 COMPONENTS OF FLOAT
Float has three components parts:
1. Mail float is the time delay between when payments are
placed in the mail and when it is received.
2. Processing float is the time between receipt of the payment
and its deposit into the firm’s account.
3. Clearing float is the time between deposit of the payment and
when spendable funds become available to the firm. This
component of float is attributable to the time required for a
check to clear the banking system.
COMPONENTS OF FLOAT
 TYPES OF FLOAT
1. Negative Float
It exists when book balance exceeds the bank balance, which
means that there is more cash tied up in the collection cycle
and it earns a 0% rate of return.
2. Positive Float
It exists when the firm’s bank balance exceeds its book
balance, e.g. checks written or issued by the firm that have not
yet cleared.
Note: good cash management dictates that negative float must
be minimized, if not eliminated; and positive float must be
maximized.
 DISBURSEMENT AND COLLECTION FLOAT
Float = Firm’s Available Balance – Firm’s Book Balance

Disbursement Float is generated when a firm writes a check,

causing a decrease in the firm’s book balance but to change
in its available balance.

Collection Float is created when a firm receives a check, causing

an increase in the firm’s book balance but no change in its
available balance.
 MEASUREMENT OF FLOAT
The size of the float is a function of both the amount of pesos
and length of delay involved. A common measure of float is
Average Daily Float and is calculated by multiplying the
amount of float by the number of days it is outstanding, and
then dividing that by the number of days in the period
 EXAMPLE: MEASUREMENT OF FLOAT
Consider Company Z that has P500 of float outstanding for the
first 12 days of the month and P750 outstanding for the last
19 days.
 COST OF FLOAT
The cost of collection float is simply the opportunity cost of not
having that money in cash. At the very least, the firm could
earn interest on that cash if it were available for investing.
 MARKETABLE SECURITIES MANAGEMENT
Marketable Securities are short-term money market instruments
that can easily be converted to cash

EXAMPLES:
• Treasury bills
• Commercial papers
• Certificates of deposits
• Bank deposits
 MILLER ORR MODEL
It assumes that net cash flows are normally distributed with a
zero value of mean & standard deviation.
 EXAMPLE MILLER ORR MODEL
Given are the following:
Fixed cost of a securities transaction = 50
Variance of daily net cash flows = 2500
Daily interest rate on securities = 0.0003 (10% per annum, so
10%/360 days = 0.0003 daily)
Minimum balance required by the company = 1000
 INVENTORY MANAGEMENT
Inventory management is the formulation and administration of
plans and policies to efficiently and satisfactorily meet production
and merchandising requirements and minimize costs relative to
inventories.
 MOTIVES FOR HOLDING INVENTORY
There are three general motives for holding inventories:
1. Transactions motive emphasizes the need to maintain
inventories to facilitate smooth production and sales operations.
For uninterrupted and proper running of any firm it is necessary
to have an appropriate level of inventory.
2. Precautionary motive necessitates holding of inventories to
guard against the risk of unpredictable changes in demand and
supply forces and other factors.
3. Speculative motive influences the decision to increase or
reduce inventory levels to take advantage of price fluctuations.
ECONOMIC ORDER QUANTITY
 EXAMPLE: EOQ
XYZ Company has been buying product A in lots of 1,250 units
which represents a three months supply. The cost per unit is
P220. the order cost is P900 per order; and the annual inventory
carrying cost per one unit is P25. Assume that the units will be
required evenly throughout the year, compute the EOQ.
 REORDER POINT
Reorder point = lead time in days x daily usage
 ABC CLASSIFICATION SYSTEM
ABC Classification System: inventories are classified for selective
control

A items: high value items requiring highest possible control

B items: medium cost items requiring normal control
C items: low cost items requiring the simplest possible control
 ABC CLASSIFICATION SYSTEM
Steps for the classification of items:
• Find out the unit cost and and the usage of each material over a given period;
• Multiply the unit cost by the estimated annual usage to obtain the net value;
• List out all the items and arrange them in the descending value (Annual Value);
• Accumulate value and add up number of items and calculate percentage on total
inventory in value and in number;
• Draw a curve of percentage items and percentage value;
• Mark off from the curve the rational limits of A, B and C categories.
 EXAMPLE: ABC CLASSIFICATION SYSTEM

The percentage of Items classified as A items is 20%, for B and C

items the percentage of Items considered is 40% for both.