BUSINESS FINANCE

REVIEWER FOR MONTHLY TEST

WORKING CAPITAL

WORKING CAPITAL
– refers to the part of the capital of the company which is continually circulating. It is circulating
in the sense that the initial cash funds of the firm are converted into inventories, which in turn are
converted into cash or accounts receivable and ultimately into cash again.

WORKING CAPITAL MAY BE DESCRIBED IN TWO WAYS:

1. GROSS WORKING CAPITAL
- Which is the total amount of the firm’s current assets
2. NET WORKING CAPITAL
- Which is the total amount of current assets minus current liabilities

The gross working capital of the firm is usually composed of the following:
1. Cash in the firm’s safe
2. Checks to be cashed
3. Balances in its bank accounts
4. Marketable securities (not including stocks in subsidiaries)
5. Notes and accounts receivable
6. Supplies
7. Inventories
8. Prepaid expenses
9. Deferred items

THE NEED FOR WORKING CAPITAL

Working capital is needed for the following purposes:

1. Replenishment of Inventory
- A sufficient stock of inventory is required to support the sales target of the firm. This
requirement, however, will depend on the availability of resources. An unserved
portion of demand may mean lost revenues for the firm.

2. Provision for Operating Expenses

- To maintain the operations of the firm on a day-to-day basis, a working capital is
required. This will be needed to take care of salaries and wages, advertising, taxes
and licenses, insurance premium, and interest payments.

3. Support for Credit Sales

 - At times, conditions require that credit sales be extended to the firm’s clients. This
will need sufficient working capital to enable the firm to maintain its operations until
receivables are converted into cash.

4. Provision of a Safety Margin

- The firm should have sufficient amount of capital to provide for unexpected
expenditures, delays in the expected inflow of cash, and possible decline in revenue.

CASH REQUIREMENTS
The firm needs cash to pay for expenditures that arise from time-to-time. Even if the anticipated
cash receipts is equal to the anticipated cash expenditures, it is still necessary to maintain a sufficient
cash fund for the firm to meet its cash commitments. This is needed because of the difficulty in
synchronizing cash receipts with cash disbursements. It is, therefore, required that a positive cash
balance be maintained so that the firm’s obligations are settled as they become due.

The amount of cash needed depends upon the following:

1. The amount of the firm’s purchases and cash sales.
2. The time period for which the firm receives and grants credit.
3. The time period from the dates of purchases of raw materials and payment of wages to the
dates of cash receipts from sales.
4. The amount of cash to be used for investment in inventories.
5. The amount of cash needed for other purposes such as cash dividends.

ACCOUNTS RECEIVABLE REQUIREMENTS

Since liquidity is a primary concern of sound business finance, firms prefer cash sales over credit
sales. Most companies, however, cannot avoid the extension of credit to customers for various reasons.
Credit is used to sustain and to promote production, distribution, and consumption of goods and
services.
The unpaid portion of a credit sales is represented by accounts receivable in the firm’s records.
The collection of accounts receivable from customers contribute to the cash inflow requirements of the
firm. Selling terms vary according to the degree of competition within individual industries, the
availability of bank credit, and pressures for increased sales in periods of increasing plant capacities.

INVENTORY REQUIREMENTS
The production of large stocks of inventory provides savings in terms of lower production cost. It
will also provide the firm with large quantity of stocks to meet increasing or unusually large orders from
customers. The maintenance of large stocks of inventory, however, may unnecessarily tie up funds
which could have been made available for other uses. Outside financing may even be required. In
addition, storage and warehousing costs may also increase.
The ideal set up is for the firm to make a sale as soon as finished products come out of the
production line, or to acquire raw materials and supplies as soon as they are needed. Since these are
not possible, economists have devised a method of arriving at an inventory level that will optimize
results from both requirements.
MANAGEMENT OF WORKING CAPITAL
Working capital must always be able to cover fund requirements of the company as they are
needed. There are times when unusual pressures on working capital makes the job of the finance
manager very difficult. To overcome this, a strategy should be adapted considering the following
objectives:
1. Working capital must be adequate to cover to cover all current financial requirements.
2. The working capital structure must be liquid enough to meet current obligations as they fall due.
3. Working capital must be conserved through proper allocation and economical use.
4. Working capital must be used in the attainment of the profit objectives of the firm.

LIQUIDITY MANAGEMENT
LIQUIDITY
- refers to the ability of the firm to pay its bills on time of otherwise meet its current
obligations.

LIQUIDITY MANAGEMENT
- Activities geared towards achieving the liquidity objectives of the firm
- The objective of management is to acquire sufficient amounts of funds to cover the
cash requirements of the firm.

The cash inflows of the firm come from various sources, namely:
1. Cash sales – the percentage of cash derived from sales vary company to company and to
industry.
2. Collection of Accounts Receivables – the credit policies and the pattern of company sales
determine the frequency and volume of collections from receivables.
3. Loans – loans from banks and other creditors may be availed of by management mostly on its
own initiative. The timing and amount of cash receipts derived from loans depend largely of the
borrowing firm.
4. Sale of Assets – assets are sometimes sold by the company for various reasons. Obsolescence is
one of those reasons.
5. Ownership Contribution – additional contributions from the owners are sometimes tapped to
improve the liquidity posture of the firm.
6. Advances from Customers – manufacturers, at times, require cash advances from customers as
soon as an order is made and before production is started.

CASH MANAGEMENT
Idle cash earns nothing and even if it is deposited in a bank, it earns minimal interest. If
sufficient amounts of profits must be attained, cash should be invested. Sufficient cash must be
maintained, however, to cover the firm’s cash expenditures. The activities involved in achieving these
two opposite goals is called cash management.

ACCOUNTS RECEIVABLE MANAGEMENT

Accounts receivable, when not properly managed, may impair the financial viability of any firm.
Objectives: one of the goal of business finance is to maximize profitability.
The purpose of credit extension to clients is to maximize sales. Thus, if more sales is required by
the firm, more credit is extended. Increased sales, however, is not an end in itself. Any advantage gained
in extending credit to customers may be offset or even surpassed by problems brought about by bad-
debt losses and the consequent tie-up of funds in receivables.

OBJECTIVES OF ACCOUNTS RECEIVABLE MANAGEMENT:

1. To determine the cost and profitability of credit sales.
2. The projection of cash flows from receivables. This will provide as essential input in the
preparation of the firm’s financial plan.
3. Relates to the direction and control of activities involved in the extension of credit to customers.

ELEMENTS OF THE COST OF CREDIT

1. BAD DEBTS COST
- Refers to accounts receivable uncollected and subsequently written off
2. COST OF INVESTED FUNDS
- The cost of invested funds refers to the rate at which the firm could borrow funds to
finance credit sales
3. ADMINISTRATIVE COSTS
- Refers to expenditures involved in servicing credit sales.

SOURCES OF CREDIT INFORMATION

1. PERSONAL INTERVIEWS
- Provide basic information concerning an applicant for credit. The applicant is usually
required to fill up an application form. The credit application form contains the
following items:
a. The name of the applicant
b. Residence and former address
c. Occupation or business
d. Business address
e. Bank where the applicant maintains an account
f. Property owned

2. REFERENCES
- Also provide a valuable source of information. The credit applicant is usually
required to furnish names of at least three credit references.

3. CREDIT BUREAUS
- Are institutions organized for the exchange of ledger information among associated
creditors. Among the services rendered by credit bureaus are the following:
a. Reports
b. Bulletins
c. Credit guides
d. Special services
 4. CREDIT REPORTING AGENCIES - Consist of more specialized forms of credit bureaus
5. BANKS – constitute a valuable source of credit information.

EVALUATION CREDIT RISK

In evaluation of a credit risk, the basic criteria used are the following:
1. Capital – refers to the financial resources of the credit applicant
2. Capacity – refers to the ability of the applicant to operate successfully
3. Character – refers to the reputation for honesty and fair dealing of the applicant or the owners
of the firm applying for credit
4. Conditions – refers to the environment required for the extension of credit.

INVENTORY MANAGEMENT
Inventory management consists of two aspects:
1. Liquidity aspect – is usually measured in terms of inventory turnover.
2. Profitability aspect – is measured in terms of inventory level at a given level of sales and profit.

A successful inventory management main objective is to strike a balance among the three key elements:
1. Customer service
2. Inventory investment
3. Profit

Forms of inventory
Inventories are composed of three major forms:
1. Raw materials – consist of all parts, sub-assemblies, and components purchased from other
firms but not yet put into the manufacturer’s own production processes.
2. Work-in-progress – when material and labor is added into the basic raw material inputs, they are
combined and transformed into work-in-process inventories.
3. Finished goods – when they are completed and stocked