SCHOOL OF ACCOUNTANCY, BUSINESS and HOSPITALITY

Accountancy Department

LMS ACTIVITIES - SHORT TERM 2020

Week 4 – June 29 – July 3, 2020

Course Code Teacher

FMGT 1013 – 031, 033, 034 Jerome D. Marquez
Financial 032, 035, 037 Rovelle Concepcion S. Siazon
Management 036 Rommel Royce V. Cadapan

Week 4 : WORKING CAPITAL MANAGEMENT, PART 1

Learning Objectives:

At the end of this session, you should be able to:

1. Explain the concept of working capital and working capital management.
2. Elaborate and calculate the operating cycle and cash conversion cycle.
3. Discuss the alternative policies as to the amount of investment in current assets.
4. Compute the optimal cash balance.
5. Analyze proposed changes in credit policy.

Good day future successful Accounting professionals!

Last week we summed up our discussion about Financial Statement Analysis. This very helpful tool in Financial
Management helps us to dig into the status of businesses based on the reports that they’ve prepared. Also,
we also discussed Cash Flow Analysis to look into the different activities of the company and how important
cash is in a specific business.

If you noticed, for the past weeks, we looked into the financials of the businesses in a total point of view. This
week, we are going to scrutinize deeper the accounts that a company is dealing with in a daily basis. We are
going to look into the different items of a particular business that moves on a day-to-day basis. So if we try to
look into these transactions and the accounts that are affected when they are being done, we could summarize
them in the table below.

Transactions done by a Business on a Daily Basis Accounts affected

Buying of merchandise on account Inventory, Accounts Payable
Selling of merchandise on account Inventory, Accounts Receivable
Payment of merchandise on account Accounts Payable, Cash
Collection of receivables Cash, Accounts Receivable

Thus, we can now say that working capital management deals with the current assets and current liabilities
of a business. These accounts normally fluctuate to a business to a daily basis.

In dealing with working capital management, there are different kinds of WORKING CAPITAL POLICIES.
These policies are guidelines of a business to the amount of working capital it should maintain given its
operations. Also, this is concerned with the level and source of financing of each level of current assets.
The different working capital policies are the aggressive, conservative and matching/hedging policy.

Aggressive approach on working capital suggests that temporary/seasonal working capital of the company
as well as half of the permanent working capital of the company is financed with short term funds. This is done
because the cost of short term funds is generally cheaper. However, because the company has few short term
funds, it may have an issue on liquidity. On the other hand, conservative working capital policy suggest
that only half of the seasonal working capital of the company should be financed with short term funds and
half of it, plus permanent and fixed assets be financed with long term funds. In this case, the company might
be very liquid but because long term funds are more expensive form of financing, the profitability of the
company may be at stake.

The suggested working capital policy that businesses should use is the matching/ moderate/ hedging
working capital policy. This policy suggests that seasonal as well as permanent current assets must be
financed by short term funds and all your long-term or fixed assets must be financed by long-term funds. In
this scenario, company may find a proper balance of current assets and current liabilities as they become
available or when debts become due.

Another thing that we should know before we dwell into the different accounts concerning working capital
management; we should know a firm’s OPERATING CYCLE and CASH CONVERSION CYCLE

To illustrate the difference between the two, you may refer to the image below:

Based on the figure above, we can now define the two terms:

 Operating Cycle (OC) – the period between the purchase of inventory (raw materials) up to the collection
of cash from the sale of the finished goods made from it.
 Cash Conversion Cycle (CCC) – the period between the payment of inventory purchase up to the collection
of cash from the sale of finished goods.

The OC offers an insight into a company’s operating efficiency. A shorter cycle is preferred and indicates a
more efficient and successful business. A shorter cycle indicates that a company is able to recover its inventory
investment quickly and possesses enough cash to meet obligations. If a company’s OC is long, it can create
cash flow problems. CCC attempts to measure how long each amount of peso is tied up in the production and
sales process before it gets converted into cash received.

Consider this problem:

Emolga Corporation purchases merchandise on 20-day term. Goods are sold, on the average , 15 days
after they are received. The average age of accounts receivable is 45 days. Emolga pays its payable
on due date.
How long is Emolga Corporation’s OC and CCC?

Based on the diagram, a company’ OC starts from the time raw materials are purchased. This is basically the
age of inventory or the number of days a finished good is converted into a receivable. This is also called
Inventory Conversion Period. In the problem, this is 15 days. Then we are going to add the number of days
that it would take the said receivable to be converted into cash. This is also called the age of receivables or
day sales outstanding (DSO). DSO is also called Receivables Conversion Period. In case of this problem, it is
45 days. So we are going to add the age of inventory and the age of receivables to get the company’s OC.
Therefore our answer for Emolga Corporation’s OC would be 60 days (15 days + 45 days).

To compute the CCC, we should deduct from the company’s OC the time that it purchased the inventory up
to the time that the company has paid its payable. This is called the company’s Payables Deferral Period or
the age of payables. In this case, the problem stated that the company is purchasing inventory on 20-day term
and also pays on due date. Therefore, the company’s age of payables is 20 days. Subtract 20 days from the
company’s 60 day OC; we are now going to get the company’s CCC is which 40 days.
CASH MANAGEMENT

After knowing the reasons to study working capital management, the different working capital policies and how
to compute for the firm’s operating cycle and cash conversion cycle, we are now going to learn how to manage
the different components of our working capital. We are going to start on cash management. There is a
famous maxim in financial management that states “Cash is the King, not profits.” In order to discover what
underlies that maxim, we should learn how to manage our cash.

According to John Maynard Keynes, there are three reasons why a company should hold cash, the following
are the reasons:

Optimal Transaction Size

In a typical business, it should be noted that all funds must be managed properly. For example, if a company
has excess cash, it should invest this amount to marketable securities so that the interest income it will earn
will not be foregone. If the company failed to invest their excess cash to marketable securities, they will be
incurring the so-called CARRYING COST of CASH. This means that because you just ‘carry’ your excess
funds and not invest it, the income will be converted to opportunity cost. To take advantage of this interest
income, a business must all its cash to marketable securities. However, if a company will be needing cash for
its daily transactions, it must convert its marketable securities back to cash in order to support its transactions
motive of holding cash. However, banks normally charge businesses with a fee when they are converting
marketable securities into cash. This is called the CONVERSION COST of CASH.

The question now is … how much cash must I carry so that I can balance the carrying cost and
conversion cost of cash?

William Baumol, an economist who introduced the concept of economic order quantity, observed that this
could be applied to cash management. He said that companies must determine a specific ‘size’ of marketable
securities that should be converted to cash to finance the needs of a company in order to maintain a balance
between the carrying cost and conversion cost of cash. This is now called as the OPTIMAL TRANSACTION
SIZE (OTS). The formula for OTS is as follows:

√2 x Conversion cost x annual demand for cash

𝑂𝑇𝑆 = Opportunity cost

Conversion Cost – the cost of converting marketable securities to cash

Opportunity Cost – the cost of holding cash rather than marketable securities (rate of interest
that can be earned on marketable securities.

To illustrate, please refer to this problem:

Assume that the fixed cost of selling marketable securities is P10 per transaction and the interest rate
on marketable securities is 6% per year. The company estimates that it will make cash payments of
P36,000 per quarter.
Required:
a. Determine the company’s OTS.
b. Determine the company’s average cash balance
c. Determine the number of times during the year that the company has to convert marketable
securities to cash.
d. The total cost of converting marketable securities to cash
e. Total carrying cost of cash
Please watch this video for the rationalization of answers:

https://www.youtube.com/watch?v=hH1tri2PDvE

Float Management

When a company is using the imprest system for its transactions to suppliers and customers, it may encounter
delays in the collection and disbursement of cash. These delays are called FLOATS. The 2 main types of float
are collection float and disbursement float.

Collection float refers to the time delay when customer pays a receivable until it credited to the company’s
bank account. Sound financial management policy states that collection float should be reduced so that we
can accelerate collections. One good strategy that a company may implement is the LOCKBOX system
wherein the customers directly send their payments to a post-office or a bank facility. In this case, the
depository bank of the company will be the one to process the payment thus reducing the time the company
must undertake to process the payments of the customers.

Disbursement float refers to the time delay when the company sends a payment to its supplier until the
payment is credited to the bank account of the supplier. A company would like to have a longer disbursement
float considering that if its cash payment is not yet credited to the bank of the supplier, it still earns interest
income in its favor. If a company wants to make longer disbursement float, it could implement a REMOTE
DISBURSEMENT FACILITY. In this method, the company makes a check payment from a bank that is far
away from the supplier. Because of this, the supplier will be forced to pass through the check clearing process
and not encashing it thereby slows down disbursement.

The following are the other types of float:

a. MAIL FLOAT – time between the when a payment is made until it is mailed to the payee.
b. PROCESSING FLOAT – time between when a payment is received until it is ready for deposit to the
bank.
c. CLEARING FLOAT – time between when a check is deposited to the bank until it is cleared and
credited to the depositor’s bank account.
ACCOUNTS RECEIVABLE MANAGEMENT

After dealing with Cash Management, we are now ready to learn how to manage our accounts receivables.
As we all know, accounts receivables are open debts to us by our customers and thus has a greater risk of
non-collection because no collateral is made by the customers to back-up these debts. It is therefore needed
that we should know how to properly manage these accounts receivable to the company’s advantage and how
changes to its balance may affect the over-all profitability of the firm.

The first thing that we should take into consideration in A/R management is how to monitor its balance. By
doing so, we can see our exposure to our customers and how much is our investment in A/R. There are two
things that we could use to monitor our A/R balance. First is by using an AGING SCHEDULE to determine if
these accounts are still current as to their status on a receivable balance basis. Another thing that we can
consider is to determine the age of our receivables also known as Day Sales Outstanding (DSO). By computing
the DSO, when can compute our A/R balance. We can use the formula below to compute our A/R balance:

Accounts Receivable Balance = Daily Credit Sales x DSO

The second thing that we should do in doing A/R management is to look into the CREDIT POLICY of the
company. This is composed of the company’s credit standards, credit terms and collection policy.

Credit standards are guidelines followed by a firm in giving credit sales to its customers. This determines the
‘worthiness’ of a customer to be receiving a credit line from the company. Naturally, there is what we call the
Five C’s of Credit. Please take a look on it and how it is used to determine the credit standards of a customer.

When we talk about credit terms, we are looking on how long are willing to hold to our A/R. This also determines
when a receivable becomes past due or are there discounts we are willing to extend to motivate payment.
Collection policy on the other hand will state how we are going to collect our A/R so that we can use the cash
from it to other opportunities.

In managing our A/R, we should also be aware of the difference between the A/R balance of the company and
the Investment in A/R of the company. A/R balance refers to the amount presented in the financial statement
of the firm with regard to its receivables. On the other hand, Investment in A/R refers to the relevant cost that
the company has invested to generate it’s A/R balance. Normally, this is the variable cost portion of the A/R
balance.

Lastly, in order for us to know the over-all impact of changing the components of A/R on the profits of the firm,
the following items are also considered in doing our analysis:
a. Change in the amount of discounts taken
b. Change in the amount of bad debts
c. Change in the costs that will be incurred relating to collection
d. Changes in the carrying cost relating to A/R (this is the opportunity cost of not investing in other
instruments because the company chose to invest in A/R)
e. Effect of taxes
To illustrate this concept, please answer this problem:
Mimikyu Corporation has annual credit sales of P4 million. Its average collection period is 40 days and
bad debts are 5% of sales. The credit and collection manager is considering instituting a stricter
collection policy whereby bad debts would be reduced to 2% of total sales, and the average collection
period would fall to 30 days. However, sales would also fall by an estimated P500,000 annually.
Variable costs are 60% of sales and the cost of carrying receivables is 12%. Assume a tax rate of 30%
a 360-day year.
Compute the incremental profit/loss from the revised policy.

Answer to this problem may be viewed in this video:

https://www.youtube.com/watch?v=5xp025slyDE

References:
FM 1 book by Sir Ferdinand Timbang
FM book by Brigham
Online YT lecture of sir Toby Cabug (YT channel is Toby Unravels)