Working Capital Management

Working Capital Management – the administration and control of working capital (i.e., current assets) and current
liabilities to achieve a balance between profitability and risk that contributes positively to the firm’s value.

Working Capital (Current Assets) – assets that are reasonably expected to be realized in cash or consumed or sold
during the normal operating cycle of the business. They include cash, marketable securities, receivables and
inventory.
Temporary (Seasonal) Current Assets – current assets that fluctuate with the firm’s operational needs.
Permanent Current Assets – the portion of the company’s current assets required to maintain the firm’s daily
operations. It is the minimum level of current assets required if the firm is to continue its operations.
Current Liabilities – liabilities that are expected to be liquidated within one business cycle through the use of working
capital or incurrence of other current liabilities.

Reasons Why Working Capital Management is Important

1. Working capital comprises a large portion of the firm’s total assets. Although the level of working capital varies
widely among different industries, firms in manufacturing and trading industries more often than not, keep more
than half of their assets in current assets.
2. The financial manager has considerable responsibility and control in managing the level of current assets and
current liabilities.
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.

Factors Affecting the Firm’s Working Capital Policy

1. Nature of Operations
2. Volume of Sales
3. Variation of Cash Flows
4. Operating Cycle Periods

OPERATING CYCLE AND CASH CONVERSION CYCLE

Operating Cycle – consists of the time period between the procurement of inventory of raw materials and turns them into
finished goods (for manufacturing concerns), sell them and receive payment for them.

Formula:
Days Sales in Inventory
Operating Cycle = (or Inventory Conversion + Average Collection Period
Period)

Cash Conversion Cycle – the length of time it takes for the initial cash outflows for goods and services to be
realized as cash inflows from sales.

Formula:
Average Payment Period
Cash Conversion Cycle = Operating Cycle + (or Payment Deferral
Period)

Or
Days Sales in Inventory Average Payment Period
Cash Conversion Cycle = (or Inventory Conversion + Average Collection Period + (or Payment Deferral
Period) Period)
 Inventory Conversion Period Average Collection Period

Operating Cycle

Average Payment Period Cash Conversion Cycle

Figure 1. Operating and Cash Conversion Cycle Illustration

Reducing Operating Cycles

Reasons for longer operating cycle period:

1. Defective purchasing policy and practices
2. Lack of proper production planning, coordination and control resulting to protracted manufacturing cycle.
3. Defective inventory policy.
4. Use of outdated machinery and technology, poor maintenance and upkeep of plant, equipment and
infrastructure facilities.
5. Defective credit policy and receivable collection procedures
6. Lack of proper monitoring of external environment.

Areas where improvement of operating cycles can be possible:

1. Production management
2. Purchasing management
3. Marketing management
4. Credit and collection policies
5. External environment scanning

ALTERNATIVE WORKING CAPITAL INVESTMENT POLICIES

1. Relaxed Working Capital Investment Policy - A policy under which relatively large amounts of cash,
marketable securities, and inventories are carried and under which sales are stimulated by a liberal credit
policy, resulting in a high level of receivables. In this policy, marginal carrying cost of current assets will
increase while marginal shortage costs will decrease.
2. Restricted Working Capital Investment Policy - A policy under which holdings of cash, securities,
inventories, and receivables are minimized. Marginal carrying cost of current assets will decrease while
marginal shortage costs will increase.
3. Moderate Working Capital Investment Policy - A policy that is between the relaxed and restricted
policies. This policy dictates that the firm will just have enough current assets so that the marginal
carrying cost of current assets and marginal shortage costs are equal, thereby minimizing total cost.

ALTERNATIVE WORKING CAPITAL FINANCING POLICIES

1. Conservative (Relaxed) Financing Strategy – a working capital financing policy under which the firm
funds both its seasonal and its permanent requirements with long-term debt.
2. Aggressive (Restricted) Financing Strategy – a working capital financing policy which uses short-term
liabilities to finance temporary assets and part or all of permanent assets of the company.
3. Matching (Self-liquidating/Hedging) Financing Strategy – a working capital financing policy which
matches the financing source with specific financing needs
 short-term assets are financed with short-term liabilities
 long-term assets are financed with long-term debt

RISK AND RETURN TRADE-OFF

 The greater the risk, the greater is the potential for larger returns.
  More current assets lead to greater liquidity but yield lower returns.
 Fixed assets earn greater returns than current assets.
 Long-term financing has less liquidity risk than short-term debt, but has higher explicit cost, hence, lower return.

MANAGEMENT OF CURRENT ASSETS

CASH MANAGEMENT

Cash Management – involves the maintenance of the appropriate level of cash and investment in marketable securities to
meet the firm’s cash requirements and to maximize income on idle funds.

Objective: to invest cash for a return while retaining sufficient liquidity to satisfy future needs.

REASONS FOR HOLDING CASH

1. Transaction purposes
2. Compensating balance requirement
3. Precautionary reserves
4. Potential investment opportunities
5. Speculation

CASH FLOW MANAGEMENT

Target cash balance may be derived by:

1. Preparing cash budgets

2. Preparing cash break-even chart
3. Determining the optimal cash balance using:
a. Baumol Cash Management Model
b. Miller-Orr Model

Cash Budget

Cash budget is the tool used to present the expected cash inflows and cash outflows.

Cash Break-Even Chart

Cash Break-Even Chart shows the relationship between the company’s cash needs and cash sources in a chart
form, indicating the amount of cash that should be maintained to enable the company meet its obligation.
Sales or Cash
Inflows

Total cash costs or

Cash Outflows
Cash Excess {
Cash Break-Even Point

Cash Fixed Costs

} Cash Deficiency

Figure 2. Cash Break-Even Chart

Optimal Cash Balance Determination: Baumol Model

Baumol Cash Management Model (or simply Baumol Model) – an EOQ-type model which can be used to
determine the optimal cash balance where the costs of maintaining and obtaining cash are at the minimum. The following
costs are to be considered:

1. Transaction costs – costs of transacting securities or costs of obtaining a loan; and

2. Holding costs – opportunity costs of holding cash which includes the return foregone by non-investment in
marketable securities or the cost of borrowing cash.

Formula:

2TD where: OC = Optimal cash balance

OC =
ί T = Transaction cost
ί = Interest rate on marketable securities or the
cost of borrowing cash
D = Total deman for cash over a period of time

Optimal Cash Balance Determination: Millaer-Orr Model

The Miller-Orr Model takes a different approach in calculating the optimal cash management strategy. It assumes
that the distribution of daily net cash flows is normally distributed and allows for both cash inflows and outflows.

Formulae:

To compute for the Optimal Cash Return Point

3
3Tσ2 where: OCR = Optimal cash return point
OCR = 4 ίday + LCL T = Transaction cost of trading marketable
securities
σ = Standard deviation
ίday = Daily interest rate on marketable securities
LCL = Lower control limit for cash balances

To compute for the Upper limit for cash balances:

UCL = 3OCR – 2L where: UCL = Upper Control Limit for cash balances

Interpretation of results:
When the cash balance gets up to the UCL, the firm has to reduce its cash to the OCR by investing at marketable
securities. When the cash gets down to the LCL, the company has to increase its cash to OCR by selling its marketable
securities.

THE CONCEPT OF FLOAT

Float – the difference between the bank’s balance for a firm’s account and the balance that the firm shows on its own
books.

Two Aspects of Float

1. The time it takes a company to process its checks internally

2. The time consumed in clearing the check through the banking system
Types of Float

1. Negative Float (Collections Float) – represents the amount of checks received but were not yet
credited by the bank to the company’s account. In this type of float, book balance exceeds bank
balance, hence there is more cash tied up in the collection cycle and it earns a 0% rate of return.
a. Mail Float – peso amount of customers’ payments that have been mailed by a customer but
not yet received by the seller.
b. Processing Float – peso amount of customers’ payments that have been received by the
seller but not yet deposited.
c. Clearing Float – peso amount of customers’ checks that have been deposited but not yet
cleared.

2. Positive Float (Disbursement Float) – represents the value of the checks the firm has written but
are still being processed and have not yet been deducted from the firm’s account balance by the
bank. Thus, in this type of float, bank balance exceeds book balance.

CASH MANAGEMENT STRATEGIES/TECHNIQUES

1. Accelerating Cash Collections – using mechanisms in speeding up recovery from debtors for credit sales.
a. Prompt customer billing
b. Offering incentives for prompt payment such as cash discounts
c. Use of lockbox system – customers mail their payments to a post office box in a specific city. The local
bank collects the checks from this box and deposits them in the firm’s account.
d. Maintenance of local collection office
e. Direct deposit to the firm’s depository bank
f. Use of Automatic/Electronic Fund Transfer (EFT) or payment by wire
2. Controlling/Slowing Disbursements
a. Delaying of payments
b. Maintenance of Zero-Balance Account (ZBA)
c. Play the float
d. Less frequent payroll
3. Reducing the Need for Precautionary Balance
a. More accurate cash budgeting
b. Have ready lines of credit – a pre-arranged loan where the company can withdraw anytime within
the period specified in the agreement.
c. Temporary investment in highly liquid, short-term securities/investments

MARKETABLE SECURITIES MANAGEMENT

Marketable Securities (MS) – short-term money market instruments that can easily be converted to cash.

Examples:
a. Treasury Bills – debt instruments representing obligations of the National Government issued by the
Central Bank and sold at a discount through competitive bidding.
b. Commercial Papers – short-term, unsecured promissory notes issued by corporations with very high
credit standing.
c. Negotiable Certificates of Deposit – short-term transferrable instruments representing deposit of a certain
amount in a commercial bank.
d. Banker’s Acceptance – short-term marketable securities arising from bank guarantees of business
transactions.

REASONS FOR HOLDING MARKETABLE SECURITIES

1. They serve as substitutes for cash balances.

2. They serve as temporary investment of idle cash.
 3. They are built up to meet known financial obligations such as tax payments, maturing bond issue and loan
amortization.

DECISION CRITERIA FOR MARKETABLE SECURITIES CASH MANAGEMENT

1. Risk
a. Default Risk
b. Interest Rate Risk
c. Inflation Risk
2. Marketability – refers to how quickly a security can be sold before maturity without a significant price
concession.
3. Maturity

ACCOUNTS RECEIVABLES MANAGEMENT

Accounts Receivables Management – the formulation and administration of plans and policies related to sales on
account and ensuring the maintenance of receivables at a predetermined level and their collectability as planned.

Objective: to have both the optimal amount of receivables outstanding and the optimal amount of bad debts.

CREDIT POLICY

Credit policy – a set of guidelines for extending credit to customers

Factors in Determining Accounts Receivable (Credit) Policy:

1. Credit Standards – the criteria that determine which customers will be granted credit and how much.
Five C’s of Credit:
a. Character – refers to the probability that the customers will pay their debts or obligations.
b. Capacity – the customer’s ability to pay/generate cash flows.
c. Capital – measurement of the customer’s general financial condition as indicated by the analysis
of the firm’s financial statements.
d. Collateral – the asset that the customer may offer as security to obtain credit.
e. Conditions – current economic conditions and special developments that might affect the
company’s ability to meet obligations.
2. Credit Terms – define the credit period and any discount offered for early payment.
3. Collection Policies – the procedures the firm follows to collect past-due accounts.
4. Delinquency and Default

Costs and Benefits of Credit Extension Policy:

1. Cash Discounts
2. Credit and collection costs
3. Bad debt losses
4. Financing costs

WAYS OF ACCELERATING COLLECTION OF RECEIVABLES

1. Shorten credit terms.

2. Offer special discounts to customers who pay their accounts within a specified period.
3. Speed up the mailing time of payments from customers to the firm.
4. Minimize float, that is, reduce the time during which payments received by the firm remained uncollected funds.

DETERMINANTS OF THE SIZE OF RECEIVABLES

1. Terms of sale
 2. Paying practices of customers
3. Collection policies and practices
4. Volume of credit sales
5. Credit extension policies and practices
6. Cost of capital

TRADE-OFFS IN CREDIT AND COLLECTION POLICIES

INVENTORY MANAGEMENT

Inventory Management – the formulation and administration of planes and policies to efficiently and satisfactorily meet
production and merchandising requirements and minimize costs relative to inventories.

Objective: to maintain inventory at a level that best balances the estimates of actual savings, the cost of carrying
additional inventory, and the efficiency of inventory control.

FUNCTIONS OF INVENTORIES

1. Pipeline or transit inventories – inventories moved or transported from one location to another and they
fill the supply pipelines between stages of the entire production-distribution system.
2. Organizational or decoupling inventories – inventories maintained to provide each link in the
production distribution chain a certain degree of independence from the others.
3. Seasonal or anticipation stock – inventories built-up in anticipation of price increase or as part of
promotional sales campaign.
4. Batch or lot-size inventories – inventories maintained whenever the user makes or buys material in
larger lots than are needed for his immediate purposes.
5. Safety or buffer stock – inventories maintained to protect the company from uncertainties such as
unexpected customer demand, delays in delivery of goods ordered, etc.

INVENTORY MANAGEMENT TECHNIQUES

INVENTORY PLANNING – determination of the quality and quantity and location of inventory, as well as the time of
ordering, in order to meet future business requirements.

Economic Order Quantity (EOQ)

The economic order quantity (EOQ) is the amount of inventory ordered at one time that minimizes annual
inventory cost. If a company buys materials infrequently and in large quantities, the cost of carrying the inventory is high
due to the sizable average investment in inventory. If purchases are made in small quantities, with frequent orders, high
ordering costs may correspondingly result. Therefore, the optimum quantity to order at a given time is determined by
balancing the two factors: (1) the carrying cost, and (2) the ordering cost.
The cost of carrying the inventory is the real out of pocket cost associated with having inventory on hand, such as
warehouse charges, insurance, lighting, losses due to handling, spoilage, breakage etc, and another important component
of carrying cost is the amount of interest lost due to the investment in the inventory. Carrying costs will go on increasing if
the quantity of material in inventory goes on increasing.
Ordering cost is the cost of placing an order. In other words, it can be said that when an order is placed, the
company has to incur certain costs at the time of order. These costs include costs like handling and transportation costs,
stationery costs, costs incurred for inviting quotations and tenders etc. The more is the frequency of order, the more are
these costs.
The formula in computing the EOQ is:
2 X U X OC where: U = Annual demand/Required Annual consumption
EOQ = CC OC = Ordering cost per unit
CC = Carrying cost per unit

The EOQ formula assumes a uniform rate of materials usage. To illustrate, assume a company has an
annual requirement of 2,400 units, an ordering cost per unit of P20 per order, and a carrying cost of P0.15. The
EOQ is:
2 X 2,400 X
2 X U X OC P96,000
EOQ = = P20 =
= √ 640,000 = 800 units
CC P0.15 P0.15

Quantity Discounts. Some purchase prices are discounted if larger quantities are ordered. Larger shipments can also
generate freight savings. These changes result in a lower unit cost and thus can alter the EOQ calculation.
Suppose the annual usage of an item is 3,600 units costing P1 each, with no quantity discount available;
the carrying cost is 20% of the average inventory investment; and the cost to place an order is P10. The EOQ is:
2 X 3,600 X
2 X U X OC P72,000
EOQ = = P10 =
= √ 360,000 = 600 units
CC P1 X 20% P0.20

Now, assume the following quantity discounts become available:

 The following table illustrates the effect of quantity discounts by comparing total costs for various order
quantities:

With quantity discounts, the cost of materials is not a constant because it is affected by the size of the discount.
Therefore, the objective is to identify an order quantity that minimizes not just the sum of the ordering and carrying costs,
but the sum of these costs plus the cost of the materials.
Determining the Time to Order
The EOQ formula addresses the quantity problem of inventory planning, but the question of when to order is
equally important. The question is controlled by three factors: (1) time needed for delivery, (2) rate of inventory usage,
and (3) safety stock. Determining the order point would be relatively simple if precise predictions were available for both
rate of usage and lead time (the interval between the time an order is placed and the time the materials are on the factory
floor ready for production). For most stock items, there is a variation in either or all of these factors that almost always
causes one of three results:
(1) If lead time or usage is below expectation during an order period, the new materials arrive before the existing stock is
consumed, thereby adding to the cost of carrying inventory;
(2) If lead time or usage is greater than expected, a stockout will occur, with its many forms of costs, including customer loss;
and
(3) If average or normal lead time and usage are used to determine an order point,, a stockout can be expected on every other
order.
To prevent possible stockouts, most companies often require safety stocks. The basic problem, however, is the
determination of the quantity of stocks to be kept safe to avoid stockouts. The optimum safety stocks should be that
quantity which would result in the smallest total costs of stockouts plus the carrying cost of the safety stocks. The annual
cost of stockouts depends on the frequency of their occurrence and the cost of each stockout.
To illustrate, assume that a company uses an item for which it places 10 orders per year, the cost of stockout is
P30, the carrying cost is P0.50 per year per unit, and the following probabilities of a stockout have been estimated for
various levels of safety stocks:

The total carrying cost and stockout cost at each level of safety stock are determined as follows:
 In this illustration, the optimum level of safety stock is 100 units.
Order Point
Order point is reached when available quantity is just equal to the foreseeable needs; that is when the available
units of inventory on hand and quantities due in equals the sum of the quantity of units for use during the lead time plus
the safety stock quantity. Thus,
Order Point units = Lead time quantity + Safety Stocks
For example, a company has the following data on its inventory carriage and order:

Thus the computation for the order point is:

Just-In-Time (JIT) System

Just-in-time (JIT) is a philosophy centered on the reduction of costs through elimination of inventory. All
materials and components should arrive at the work station when they are needed – no earlier, no later. Elimination of
inventories eliminates storage and carrying costs; however, it also eliminates the cushion against production errors and
imbalances that inventories provide.
The most visible aspect of JIT is the effort to reduce inventories of Work in Process (WIP) and Raw Materials.
Most writings on JIT concentrate on this one aspect, which is called stockless production, lean production, or zero
inventory production (ZIP). In JIT, authorization for a part to be made at a work station is generated by the need for that
part at the next work station in the production line. As parts are used in final assembly, the production of their
replacements is authorized. The process is repeated at all proceeding work stations, thus “pulling” parts through the
production system as they are needed and in turn pulling materials from suppliers.
JIT differs from traditional systems, in which large stocks of WIP generally are kept at many work stations. The
JIT ideal is to eliminate these stocks of WIP and produce parts only as needed. For JIT to operate properly, setup time
must be short. Also, production flow through the various work stations must be uniform, a usual characteristic of
repetitive manufacturing.
 JIT seeks to reduce inventories because it views inventories as wasteful. Inventory represents resources not being
used and is a form of slack or fat that covers up other forms of waste.
To avoid inventory buildup, the entire production line is stopped if parts are missing at any stage or defects are
found. Defects must be caught early before they can be built into a large number of units, so if a reasonable flow rate is to
be achieved, the number of defects must be small. Workers must be highly involved in quality, because a defect at any
station shuts down operation/production.

INVENTORY CONTROL – regulation of inventory within predetermined level.

Order Cycling Method

The order cycling method (cycle review method) periodically examines the status of quantities of materials on
hand for each item or class. Different companies use different time periods between reviews and can use different cycles
for different types of materials. At each review period in the order cycling system, orders are placed to bring quantities up
to some desired level, which is expressed as a number of days’ or weeks’ supply.
Min-Max Method
The min-max method is based on the premise that the quantities of most stock items are subject to definable
limits. A maximum quantity for each item is established. A minimum level provides the margin of safety necessary to
prevent stockouts during a reorder cycle. The minimum level sets the order point, and the order quantity usually brings
inventory up to the maximum level.
Two-Bin Method
The two-bin method is a variation of min-max method. Under this method, each stock item is stored in two bins,
piles, or bundles. The first bin contains enough stock to satisfy usage that occurs between receipt of an order and the
placing of the next order; the second bin contains the normal amount used from order data to delivery plus the safety
stock. When the first bin becomes empty and the second bin is being tapped, a purchase requisition for a new supply is
prepared.
ABC Classification System
Under the ABC Plan, the cost significance of each item is evaluated. Items carried by the company are classified
into three categories – the A, B and C item categories. Those that belong to Category A are items which are of the highest
value of investment by the company, the items which are considered to be the most critical ones, and account to about
10% to 20% of the physical items carried by the company. These items are also usually of low turnover and are under the
tightest control by the firm.
Items in Category B are items which have moderate value of investment by the company, the items which are less
critical compared to Category A items, accounted to about 20% to 30% of the physical items carried by the company.
Category B items only require moderate control.
Category C items are the non-critical, low-value investment which accounts to about 20% or less of the total
inventory investment amount but which account for 50% to 70% of the total physical inventory carried by the company.
Items under Category C need not have sophisticated control procedures.
Short-Term Financing Decision