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!!!
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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
Inventory conversion period
1 Management Advisory Services (MAS) Committee : Hazeleen Martinez; Jimmy Joe Miranda; Cliff Mark
Confidente; Corina Bariuan; Kristina Gaddon; Rizalyn Taguibao ;Niῆo Rey Mangupag; Marjhon Maramag; Leo
Jay Labasan
Adviser: Mary Queen Ramos, CPA
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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 is held ready for profit-making or

CASH MANAGEMENT– involves the maintenance of investment opportunities that may come up
the appropriate level of cash and investment in such as a block of raw materials inventory
marketable securities to meet the firm’s cash offered at discounted prices or merger
requirements and to maximize income on idle funds. proposal.
☛What are the reasons for holding cash? 4. Contractual motive.

A company may be required by a bank to
Business firms have to hold cash for the following maintain a certain compensating balance in
reasons: its demand deposit account as a condition
of a loan extended to it.
1. Transaction motive.
Cash is needed to facilitate the normal FLOAT IN CASH MANAGEMENT
transactions of the business, that is, to carry FLOAT – difference between the bank’s
out its purchases and sales activities. balance for a firm’s account and the balance
that the firm shows on its own books.
2. Precautionary motive.
Cash may be held beyond its normal Two aspects of float:
operating requirement level in order to 1. The time it takes a company to process its
provide for a buffer against contingencies checks internally.
such as unexpected slow-down in accounts 2. The time consumed in clearing the check
receivable collection, strike or increase in through the banking system.
cash needs beyond management’s original
projections. Types of float:
1. Negative float – book balance exceeds the
3. Speculative motive. bank balance, which means that there is
more cash tied up in the collection cycle
and it ears a 0% rate of return.
Jay Labasan
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a. Mail float – peso amount of There are several basic reasons for holding
customers’ payments that have marketable securities such as:
been mailed by a customer but not 1. They serve as a substitute for cash balances.
yet received by the seller. 2. They are held as a temporary investment
b. Processing float – peso amount of where a return is earned while funds are
customers’ payments that have temporarily idle.
been received by the seller but not 3. They are built up to meet known financial
yet deposited. requirements such as tax payments,
c. Clearing float – peso amount of maturing bond issue, and so on.
customers’ checks that have been
deposited but not yet cleared. C.
Enumerate the factors influencing the
NOTE: Good cash management dictates choice of marketable securities.
that above floats must be minimized, if Among the factors that will influence the choice of
not eliminated. marketable securities are:
2. Positive float – AKA Disbursement float. The 1. Risks, such as default risk, interest rate risk,
firm’s bank balance exceeds its book and inflation risk.
balance. (Checks issued by the firm that a. Default risk - The possibility that a
have not yet cleared.) Management should bond issuer will default, by failing
increase this type of float. to repay principal and interest in a
timely manner. Also called credit
A. What are the basic approaches to deriving risk.
optimal cash balance? b. Interest rate risk - The possibility
of a reduction in the value of
The optimal cash balance may be derived with the a security, especially a bond,
use of the following basic approaches: resulting from a rise in interest
1. Cash budget rates. This risk can be reduced by
2. Cash break-even chart diversifying the durations of
3. Optimal cash balance model the fixed-income investments that
Where: F = Fixed cost per transaction. are held at a given time.
i = Interest rate on marketable c. Inflation risk - The possibility that
securities. the value of assets or income will d
T = Total demand for cash over a ecrease as inflation shrinks the pur
period of time. chasing power of a currency.
Inflation causes money to decrease
MANAGEMENT OF MARKETABLE SECURITIES in value at some rate, and does so
Marketable Securities – short-term money whether the money is invested or
market instruments that can easily be not.
converted to cash. 2. Maturity.
3. Yield or return on securities.
B. What are the reasons for holding 4. Marketability (liquidity) risk.
marketable securities?
Jay Labasan
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I. Receivables Management
- Formulation and administration of D. What are the factors in determining
plans and policies related to sales accounts receivable policy?
on account and ensuring the The factors in determining accounts
maintenance of receivables at a receivable policy are credits standards,
predetermined level and their credit terms, collection program, and
collectability as planned. delinquency and default.
OBJECTIVE: to have both optimal amount of
receivables outstanding and the optimal amount of
bad debts
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.
Jay Labasan
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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.
To compute for the Economic Order
II. Inventory Management
- Formulation and administration of
plans and policies to efficiently and Quantity (Q*), the following formula is to be
satisfactorily meet production and followed:
merchandising requirements and Where: D = Annual demand quantity
minimize costs relative to K = fixed cost per order, setup cost
inventories. h = annual holding cost per unit,
OBJECTIVE also known as carrying cost or
 To maintain storage cost
inventory at a
level that best a. Total inventory costs = Total
balances the ordering costs + Total carrying
estimates of costs
actual savings, b. Total ordering costs = (Annual
the cost of demand in units ÷ Q*) × Ordering
carrying cost per order
additional c. Total carrying costs = Average
inventory, and inventory ÷ Carrying costs per unit
the efficiency of d. Average inventory = Q* ÷ 2
inventory e. Reorder point = Lead time usage +
control. Safety stock
F. What is inventory planning? How is G. Give some of the more generally-known

economic order quantity computed? inventory control systems.
Inventory planning involved the Inventory control is the regulation of
determination of what inventory quality, inventory within predetermined limits.
quantity, timing, and location should be in Effective inventory management should
order to meet future business provide adequate stocks to meet the
requirements. requirements of the business, while at the
same time keeping the required investment
to a minimum. Various systems and
Jay Labasan
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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:
of Fixed Order Quantity System and 1. The effective cost of credit.
Fixed Reorder Cycle System. 2. The availability of credit in the
amount needed and for the
Replenishment level is computed by period of time when financing
the following formula: is required.
P = B + D(L +R/2) 3. The influence of the use of a
Where: P = Reorder point in units particular credit source on the
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cost and availability of other Major sources of unsecured short-term
sources of financing. credit are:
4. Any additional covenants of 1. Accruals
the loans that are unique to 2. Trade credit
the sources mentioned. 3. Bank loans
4. Commercial papers
C. What are the basic sources of short-term Secured loans involve the pledge of specific
funds? assets as collateral in the event the
Short-term funds can be obtained through borrower defaults in payment of principal
either unsecured credit or secured loans. or interest.
D. Give the procedures / formula in estimating the cost of short-term credit.

1. Cost of Trade Credit
Nominal Annual Cost =
Discount percent 360 days
×
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
Jay Labasan
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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

Effective annual rate ¿
discount ×
FV of notes−Interest −Issue cost
1
(Days¿maturity ÷ 360 days)
Jay Labasan

Working Capital Management (OK Na!)

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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

Cash is held ready for profit-making or

☛What are the reasons for holding cash? 4. Contractual motive.

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

F. What is inventory planning? How is G. Give some of the more generally-known

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

Interest + Issue cost

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