Working Capital Management (OK Na!)

UNIVERSITY OF SAINT LOUIS-TUGUEGARAO
School of Business Administration and Accountancy, 2013-2014

Junior Philippine Institute of Accountants
MEMORY AID IN MANAGEMENT ADVISORY SERVICES
Any form of reproduction of this copy is strictly prohibited!!!
CHAPTER 13:
Working Capital Management
☛Distinguish between a relaxed current assets nonspontaneous debt, and permanent

investment policy and a restricted current asset current assets and fixed assets are financed
investment policy. with long-term debt or equity, plus
spontaneous debt. Under an aggressive
 Under a relaxed current asset investment approach, some permanent current assets,
policy, a firm holds relatively large amounts and perhaps some fixed assets, are financed
of each type of current asset. Under a with short-term debt. A conservative
restricted current asset investment policy, approach would be to use long-term capital
the firm holds minimal amounts of these to finance all permanent assets and some of
items. the temporary assets.
☛Distinguish between permanent current assets MANAGEMENT OF CURRENT ASSETS

and temporary current assets. OBJECTIVES: Determination of the appropriate
mix of the current assets
 Permanent current assets are those assets components, considering safety,
that the firm holds even during slack times, liquidity, as well as profitability.
whereas temporary current assets are the
additional current assets that are needed Cash and Marketable Securities Management
during seasonal or cyclical peaks. The
methods used to finance permanent and ☛CASH CONVERSION CYCLE (or OPERATING CASH
temporary current assets define the firm’s CONVERSION CYCLE)
current asset financing policy.  The length of time it takes for the initial
cash outflows for goods and services to be
☛Describe the moderate, aggressive, and realized as inflows from sales.
conservative approaches to current asset financing.
☛DETERMINATION OF CASH CONVERSION CYCLE
 A moderate approach to current asset (CCC)
financing involves matching, to the extent CCC = inventory conversion period + receivables
possible, the maturities of assets and collection period – payable deferral period
liabilities, so that temporary current assets = average age of inventories + average age of
are financed with short-term receivables – average age of payables
Management Advisory Services (MAS) Committee: Hazeleen Martinez; Jimmy Joe Miranda; Cliff Mark Confidente;
81 Corina Bariuan; Kristina Gaddon; Rizalyn Taguibao ;Niῆo Rey Mangupag; Marjhon Maramag; Leo Jay Labasan
Adviser: Mary Queen Ramos, CPA
Inventory conversion period

Or = (365 ÷ A Inventory turnover) or (Ave. Inventory ÷ Ave. COGS/day)
Average age of inventories
A
Inventory turnover = (COGS ÷ Ave. Inventory)
Receivables collection period

Or = (365 ÷B A/R turnover) or (Ave. A/R ÷ Ave. Sales/day)
Average age of receivables
B
A/R turnover = (Net credit sales ÷ Ave. A/R)
Payable deferral period
Or = (365 ÷C A/P turnover) or (Ave. A/P ÷ Ave. Purchase/day)
Average age of payables
C
A/P turnover = (Net credit purchases ÷ Ave. A/P)
CASH MANAGEMENT– involves the maintenance of Cash is held ready for profit-making or
the appropriate level of cash and investment in investment opportunities that may come up
marketable securities to meet the firm’s cash such as a block of raw materials inventory
requirements and to maximize income on idle funds. offered at discounted prices or merger
proposal.
☛What are the reasons for holding cash?
4. Contractual motive.
Business firms have to hold cash for the following A company may be required by a bank to
reasons: maintain a certain compensating balance in
its demand deposit account as a condition
1. Transaction motive. of a loan extended to it.
Cash is needed to facilitate the normal
transactions of the business, that is, to carry FLOAT IN CASH MANAGEMENT
out its purchases and sales activities. FLOAT – difference between the bank’s
balance for a firm’s account and the
2. Precautionary motive. balance that the firm shows on its own
Cash may be held beyond its normal books.
operating requirement level in order to
provide for a buffer against contingencies Two aspects of float:
such as unexpected slow-down in accounts 1. The time it takes a company to process its
receivable collection, strike or increase in checks internally.
cash needs beyond management’s original 2. The time consumed in clearing the check
projections. through the banking system.
3. Speculative motive. Types of float:

1. Negative float – book balance exceeds the
bank balance, which means that there is
more cash tied up in the collection cycle Marketable Securities – short-term money
and it ears a 0% rate of return. market instruments that can easily be
a. Mail float – peso amount of converted to cash.
customers’ payments that have
been mailed by a customer but not B.
What are the reasons for holding
yet received by the seller. marketable securities?
b. Processing float – peso amount of There are several basic reasons for holding
customers’ payments that have marketable securities such as:
been received by the seller but not 1. They serve as a substitute for cash balances.
yet deposited. 2. They are held as a temporary investment
c. Clearing float – peso amount of where a return is earned while funds are
customers’ checks that have been temporarily idle.
deposited but not yet cleared. 3. They are built up to meet known financial
NOTE: Good cash management dictates requirements such as tax payments,
that above floats must be minimized, if maturing bond issue, and so on.
not eliminated.
2. Positive float – AKA Disbursement float. The C.
Enumerate the factors influencing the
firm’s bank balance exceeds its book choice of marketable securities.
balance. (Checks issued by the firm that Among the factors that will influence the choice of
have not yet cleared.) Management should marketable securities are:
increase this type of float. 1. Risks, such as default risk, interest rate risk,
and inflation risk.
A. What are the basic approaches to deriving a. Default risk - The possibility that a
optimal cash balance? bond issuer will default, by failing
to repay principal and interest in a
The optimal cash balance may be derived with the timely manner. Also called credit
use of the following basic approaches: risk.
1. Cash budget b. Interest rate risk - The possibility
2. Cash break-even chart of a reduction in the value of
3. Optimal cash balance model a security, especially a bond,
resulting from a rise in interest
rates. This risk can be reduced by
diversifying the durations of
Where: F = Fixed cost per transaction. the fixed-income investments that
i = Interest rate on marketable are held at a given time.
securities. c. Inflation risk - The possibility that
T = Total demand for cash over a the value of assets or income will d
period of time. ecrease as inflation shrinks the pur
chasing power of a currency.
MANAGEMENT OF MARKETABLE SECURITIES Inflation causes money to decrease
in value at some rate, and does so
whether the money is invested or predetermined level and their

not. collectability as planned.
2. Maturity. OBJECTIVE: to have both optimal amount of
3. Yield or return on securities. receivables outstanding and the optimal amount of
4. Marketability (liquidity) risk. bad debts
I. Receivables Management D. What are the factors in determining

- Formulation and administration of accounts receivable policy?
plans and policies related to sales The factors in determining accounts
on account and ensuring the receivable policy are credits standards,
maintenance of receivables at a credit terms, collection program, and
delinquency and default.
E. Discuss the trade-off in credit and collection policies.
Trade-offs
Benefit Cost
1. Relaxation of a. Increase in sales and a. Increase in credit
credit total contribution processing costs.
standards. margin.
b. increase in collection
costs
c. Higher default costs
(bad debts).
d. Higher capital costs
(opportunity costs).
2. Lengthening a. Increase in sales and a. Higher capital costs

of credit period. total contribution (opportunity cost of
margin. higher investment in
receivables).
3. Granting cash a. Increase in sales and a. Lesser profit.

discount. total contribution
margin.
b. Opportunity income
on lower investment in
receivable.
Trade-offs
Benefit Cost
4. Intensified a. Lower default costs a. Higher collection

collection (bad debts). expenses.
efforts.
b. Lower opportunity b. Lower sales.
cost or capital costs.
order to meet future business
II. Inventory Management requirements.
- Formulation and administration of
plans and policies to efficiently and
satisfactorily meet production and
merchandising requirements and To compute for the Economic Order
minimize costs relative to Quantity (Q*), the following formula is to
inventories. be followed:
OBJECTIVE Where: D = Annual demand quantity
 To maintain K = fixed cost per order, setup cost
inventory at a h = annual holding cost per unit,
level that best also known as carrying cost or
balances the storage cost
estimates of
actual savings, a. Total inventory costs = Total
the cost of ordering costs + Total carrying
carrying costs
additional b. Total ordering costs = (Annual
inventory, and demand in units ÷ Q*) × Ordering
the efficiency of cost per order
inventory c. Total carrying costs = Average
control. inventory ÷ Carrying costs per unit
d. Average inventory = Q* ÷ 2
F. What is inventory planning? How is e. Reorder point = Lead time usage +
economic order quantity computed? Safety stock
Inventory planning involved the
determination of what inventory quality, G. Give some of the more generally-known
quantity, timing, and location should be in inventory control systems.
Inventory control is the regulation of of Fixed Order Quantity System and

inventory within predetermined limits. Fixed Reorder Cycle System.
Effective inventory management should
provide adequate stocks to meet the Replenishment level is computed by
requirements of the business, while at the the following formula:
same time keeping the required investment P = B + D(L +R/2)
to a minimum. Various systems and Where: P = Reorder point in units
techniques have been developed to provide B = Buffer stocks in units
effective control over inventories. D = Average demand per
day
Some of the more generally-known R = Time between review
inventory control systems are as follows: in days
1. Fixed Order Quantity System L = Lead time in days
This is a system wherein each time the
inventory goes down to a 4. ABC Classification System
predetermined level known as the Under this system, segregation of
reorder point, an order for a fixed materials for selective control is made.
quantity is placed. Inventories are classified into “A” or
high-value items, “B” or medium cost
items, and “C” or low cost items.
2. Fixed Reorder Cycle System
This is also known as the periodic SHORT-TERM CREDIT FOR FINANCING
review or the replacement system CURRENT ASSETS
where orders are made after a review A. What are the basic problems encountered
of inventory levels has been done at in managing the firm’s use of short-term
regular intervals. financing?
There are two basic problems encountered
Replenishment level is computed by in managing the firm’s use of short-term
the following formula: financing. These are:
M = B + D(R + L) 1. Determining the level of short-
Where: M = Replenishment level term financing the firm should
in units use.
B = Buffer stocks in units 2. Selecting the source of short-
D = Average demand per term financing.
day
R = Time interval in days, B. What are the factors to be considered in
between reviews selecting the source of short-term
L = Lead time in days financing to be availed of by a business
firm?
3. Optional Replenishment System The basic factors to be considered in
This system represents a combination selecting among alternative short-term
of the important control mechanisms financing opportunities are:
1. The effective cost of credit. C. What are the basic sources of short-term
2. The availability of credit in the funds?
amount needed and for the Short-term funds can be obtained through
period of time when financing either unsecured credit or secured loans.
is required. Major sources of unsecured short-term
3. The influence of the use of a credit are:
particular credit source on the 1. Accruals
cost and availability of other 2. Trade credit
sources of financing. 3. Bank loans
4. Any additional covenants of 4. Commercial papers
the loans that are unique to Secured loans involve the pledge of specific
the sources mentioned. assets as collateral in the event the
borrower defaults in payment of principal
or interest.
D. Give the procedures / formula in estimating the cost of short-term credit.

1. Cost of Trade Credit
Discount percent 360 days
Nominal Annual Cost = ×
100−Discount percent Days credit is outstanding−Discount period
2. Cost of Bank Loans

Interests on bank loans are calculated in five ways:
a. Simple interest
b. Discount interest
c. Add-on interest
d. Simple interest with compensating balances
e. Discount interest with compensating balances
Equations to compute the effective annual rate are as follows:

a. Simple interest
In a single interest loan, the borrower receives the face value of the loan and repays the
principal and interest at maturity date.
Formula to compute the effective interest rate is:
Interest
Effective annual rate simple=
Face value−Interest
b. Discount interest
In a discount interest loan, the bank deducts the interest in advance or discounts the loan.
Formula to compute the effective annual rate is:
Interest
Effective annual rate discount=
Amount Received
c. Add-on interest
Add-on interest is interest that is calculated and added to funds received to determine the
face amount of an installment loan.
Formula:
2 ×Annual no.of payments× Interest
1. Approximate annual rate add-on = (Total
no.of payments+1)×Principal
2. The effective annual rate may be computed using the procedure in getting internal
rate of return or effective yield.
d. Simple interest with compensating balance

Compensating balance is the minimum account balance that a lending bank requires the
borrower to maintain. Its effect is to raise the effective rate on a loan because the net
withdrawable amount is reduced.
Interest
Effective annual rate simple/CB=
Face value−Compensating balance
or
Nominal rate (%)
1.0−Compensating balance %
e. Discount interest with compensating balance

The formula to compute for the effective annual rate if the loan is on a discount basis is:
Interest
Face value−Compensating balance−Interest
or
Nominal rate (%)
1.0− Compensating balance %−Nominal rate %
3. Cost of Commercial Paper

To calculate the effective cost of credit, through issuance of commercial paper, the formula is:
Interest+Issue cost 1
Effective annual rate discount= ×
FV of notes−Interest−Issue cost (Days to maturity ÷360 days)

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UNIVERSITY OF SAINT LOUIS-TUGUEGARAO

School of Business Administration and Accountancy, 2013-2014

☛Distinguish between a relaxed current assets nonspontaneous debt, and permanent

☛Distinguish between permanent current assets MANAGEMENT OF CURRENT ASSETS

Inventory conversion period

Receivables collection period

3. Speculative motive. Types of float:

whether the money is invested or predetermined level and their

I. Receivables Management D. What are the factors in determining

E. Discuss the trade-off in credit and collection policies.

2. Lengthening a. Increase in sales and a. Higher capital costs

3. Granting cash a. Increase in sales and a. Lesser profit.

4. Intensified a. Lower default costs a. Higher collection

Inventory control is the regulation of of Fixed Order Quantity System and

D. Give the procedures / formula in estimating the cost of short-term credit.

2. Cost of Bank Loans

Equations to compute the effective annual rate are as follows:

d. Simple interest with compensating balance

e. Discount interest with compensating balance

3. Cost of Commercial Paper

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