WORKING CAPITAL

MANAGEMENT
Working Capital Management
Lesson Objectives: At the end of the topic, the
students are expected to:
1. Define net working capital, and the related
trade-off between profitability and risk;
2. Compute the cash conversion cycle, its funding
requirements, and the key strategies for
managing it;
3. Manage receipts and disbursements including
float, speeding up collections, slowing down
payments, cash concentration, zero balance
accounts, and investing in marketable securities;
4. Appreciate the use of the different techniques in
managing working capital.
Working Capital Terminology
 Working capital – current assets.
 Net working capital – current assets minus
non-interest bearing current liabilities.
 Working capital policy – deciding the level of
each type of current asset to hold, and how
to finance current assets.
 Working capital management – controlling
cash, inventories, and A/R, plus short-term
liability management.

17-3
 Working Capital Management
It is concerned with the efficient and
effective utilization of working capital to
attain predetermined objectives of the
company relative to profitability of
operations, liquidity of financial resources,
and minimization of risks and company
costs.
Working Capital (Current Assets)
Investment Policies
 Relaxed – the firm holds a greater
amount of current assets relative to
sales
 Restricted – holding of current assets
are constrained or minimized relative to
sales
 Moderate – lies between relaxed and
restricted investment policies.
17-5
Working Capital (Current Assets)
Investment Policies
Current Current
Policy assets per asset
P750 of Sales turnover
Relaxed P75 10.0x
Moderate 50 15.0
Restricted 25 30.0

17-6
 Working Capital Financing
Policies
 Maturity matching – Match the maturity
of the assets with the maturity of the
financing.
 Aggressive – Use short-term financing to
finance permanent assets.
 Conservative – Use permanent capital
for permanent assets and temporary
assets.
17-7
 Aggressive Financing Policy
P Temp. C.A.
S-T
Loans

Perm C.A. L-T Fin:

Stock,
Bonds,
Spon. C.L.
Fixed Assets

Years
Lower dashed line would be more aggressive.
Conservative Financing Policy
Marketable
P securities
Zero S-T
Debt

L-T Fin:
Stock,
Perm C.A. Bonds,
Spon. C.L.

Fixed Assets

Years
 Net Working Capital
“Profitability” versus “Liquidity”

It is critical to point out that “profitability” and

liquidity” (or cash flow) are not necessarily the same.
A business can be profitable, and yet experience
serious cash flow problems.
The key is in the length of the working capital
cycle -- or how long it takes to convert cash back
into cash.
Working Capital Management and
Risk-Return Trade-Off

More current assets on hand means

lesser risk and lesser return to the
firm

Less current assets on hand means

greater risk and higher return to
the firm
How to Manage Working Capital?
1. By looking at the financial ratios
and/or cycles.
2. By putting proper internal control.
3. By changing company policies
4. Budget preparation.
 The Cash Conversion Cycle
The goal of short-term financial
management is to manage each of the
firms’ current assets and liabilities to
achieve a balance between
profitability and risk that contributes
positively to overall firm value.
Cash Conversion Cycle

The cash conversion cycle focuses on the

length of time between when a company
makes payments to its creditors and when a
company receives payments from its
customers.
Inventory Receivable s Payables
CCC  conversion  collection  deferral
period period period

17-14
 Calculating the Cash Conversion Cycle
MAX Company, a producer of paper dinnerware, has annual
sales of $10 million, cost of goods sold of 75% of sales, and
purchases that are 65% of cost of goods sold. MAX has an
average age of inventory (AAI) of 60 days, an average collection
period (ACP) of 40 days, and an average payment period (APP)
of 35 days.

The cash conversion cycle for MAX is 65 days (60 + 40

- 35).
Calculating the Cash Conversion Cycle
 Calculating the Cash Conversion Cycle
The resources MAX has invested in the cash conversion cycle
assuming a 360-day year are:

Inventory (P10,000,000 x 0.75) x

(60/360) = P1,250,000
Accounts
receivable (P10,000,000 x 40/360) = 1,111,111
(P10,000,000 x 0.75 x 0.65) x
Accounts payable (35/360) = (473,958)
Resources
invested P1,887,153
 Shortening the Cash Conversion
Cycle
Shortening the cash conversion cycle contributes to maximizing
shareholder value.

Ways to minimize cash conversion cycle:

Turn over inventory as quickly as possible;

Collect account receivable as quickly as possible;

Pay accounts as slowly as possible, and

Reduce mail, processing, and clearing time.

18
 Cash Management
Cash management’s objective is to minimize
the usage of cash and maintain optimum
cash at the right time.

Cash management is also concerned in the

acceleration of cash receipts and delaying
of cash disbursements.
Reasons for Maintaining Cash
1. Transaction motive. This intends to
meet the minimum business operations
requirement.
2. Speculative motive. These are cash
balances used to take advantage of bargain
purchases on materials or unusual cash
discounts.
3. Precautionary motive. This is cash held
intended for unforeseen fluctuations in
cash inflow and cash outflow.
 Cash Equivalents
Cash equivalents are short-term highly liquid
investments that are readily convertible to cash.

Examples:
1. A 90 day treasury bill
2. A 180 day treasury bill but was purchased within 90
days before its maturity
3. A 90 day time deposit
4. A 90 day commercial papers
5. Long term commercial paper but was purchased
within 90 days before its maturity.
6. Other money market instruments whose maturity
is within three months.
Possible Placements for Excess Cash
1. Certificate of time deposits. These are placements with
holding period. It is normally taxed at 20% of the interest
income.
2. Savings account or checking accounts. These are bank
placements with no holding period. However, the interest
earned in this kind of placement is lower than those placed in
the certificate of time deposit.
3. Stocks. These are shares of stocks traded in the formal stock
exchange and are bought from stockbroker.
4. Treasury Bills. These are short-term obligations issued by
the government.
5. Commercial papers. These are unsecured promissory note
issued by firms with high credit standing. The interest earned
is normally higher than the savings account.
 FLOATS
1. Mail float – from the time the check was
issued up to the time the check was
received by the payee.
2. Processing float – the time from which
the check was received by the payee until
the time it was deposited to its bank
account.
3. Clearing float – from the time the check
was deposited up to the time the check
was cleared and made available for use.
 Accelerating Cash Collection
1. Collecting center or agent. Float can be reduced by
strategically locating a collection center near to your customer.

Cunanan Corporation has an agreement with Rizal Commercial

Banking Corporation (RCBC) to collect P3,000,000 a day in
exchange for a compensating balance of P1,000,000. The firm,
with a significant increased in its customer in the area, is
thinking of canceling the agreement and dividing the service
provided by RCBC with ABC Bank. With this plan, RCBC will
handle the collection of P2,000,000 with a compensating balance
of P800,000. On the other hand, ABC bank will handle the
other P1,000,000 collection in exchange for a compensating
balance of P700,000. With the planned arrangement with the
two banks to perform the collection, the firm is expecting to
reduce the collection period by one day. The firm’s rate of
return is 9%. Should Cunanan Corporation pursue with the
division of service between RCBC and ABC bank?
 Collecting Center or Agent
Analysis on the above problem is as follows:

Amount of cash collection per day P3,000,000

Number of days freed on the collection x 1
Amount of cash freed P3,000,000
Less: Increased in compensating balance 500,000
Increased in cash inflow P2,500,000
Rate of return x 0.09
Incremental income P 225,000
 Lockbox System
It is a system wherein the company will have a “P.O. Box
number” address.

Example
Cunanan Corporation has an average of seven (7) days to receive
and deposit the checks received from costumers. The owner
believes that it is too long for them to make use of the funds to
support its operations. With this problem, a bank offered their
service through the use of a lockbox system. The banker explained
that with the system in place, it is expected that the float time will
be reduced to 4 days. The bank is charging an amount of P10,000
per month for its overhead cost on the service that will be
provided. Should Cunanan Corporation avail of the service as
offered by the bank? How much is the advantage or disadvantage
of availing the lockbox system considering an average daily
collections of P450,000 and that the annual rate of return in the
market is 12 percent?
 Reasons for Maintaining Cash
The cost benefit analysis is as follows:

Average cash receipts per day P 450,000

Number of days cash is freed (7 days – 4 days) x 3
Amount of cash freed-up P1,350,000
Rate of return x 12%
Expected return (benefit) P 162,000
Less: Cost of the lockbox system (P10,000 x 12) 120,000
Net advantage of availing the lockbox system P 42,000
 Cash Disbursements
1. Playing the Float. It is a process of taking advantage of the clearing system in
order to make use of the funds in the firm’s bank account.
2. Payment by Draft. A draft is an unconditional order made in writing addressed
by one person to another and signed by the person giving it, requiring the person
to whom it is addressed to pay on demand or at a fixed or determinable future
time a certain sum of money to order or bearer.
3. Auto-Debit Transfer. An auto debit transfer is one of the products of the bank
being offered. The firm availing this kind of product has to maintain certain amount
to their account, normally called average daily balance.
4. Debit Transfer. The features are practically the same as the auto-debit transfer.
The only difference is that, the debit transfer is done manually and it is usually
done at the end of the banking day or early next banking day.
5. Stretching of Payables. It is the process of extending payments to suppliers or
creditors.
6. Centralize Disbursements. Other firms control their cash disbursements by
centralizing its disbursements.
7. Statistics can also be used by the firm by predicting how much of the
checks issued will be presented for clearing. Looking at the historical
disbursements of the firm, they can be able to establish as to how much funds
must be deposited to cover the checks issued.
 Formula of Cash Discount

Discount % x 360
100% - Discount % Final due date – Discount period
 Optimum Transaction Size

MS = 2 (FC)(CR)
I

Total relevant Costs

FC x CR + I x MS
MS 2
Where:
MS = the amount of marketable securities sold each time the cash
balance is replenished
FC = the fixed cost associated with the transaction
CR = the total cash required for the given period of time
I = rate of return on the marketable securities