Module 04: Financial Planning Tools and Concepts - Working Capital

Management and Managing Cash, Receivables, and Inventory

I. LEARNING COMPETENCIES
1. Describe concepts and tools in working capital management.
2. Explain tools in managing cash, receivables, and inventory.
3. Explain how to manage cash, accounts receivables, and inventories.

II. LESSON PRESENTATION

Motivation
Take a look at JFC’s 2014 SFP?

Image 4.1. JFC SFP 2014 (Source: DepEd Business Finance Teaching Guide)
What are the assets needed by Jollibee for its daily operation?

Working Capital Management

Working Capital - is the company’s investment in current assets such as cash, accounts
receivable, and inventories.
Net Working Capital - is the difference between current assets and current liabilities.

Operating Cycle
The operating cycle is the sum of days of inventory and days of receivables.

Image 4.1. The Operating Cycle (Source: DepEd Business Finance Teaching Guide)

Days of Inventory and Days of Receivables

Days of Inventory or Inventory Conversion - period or average age of inventories, is the
average number of days to sell its inventory.
- A DSI of 20 days means that on the average it takes 20 days to sell its inventory.
- Since the Statement of Financial Position tells the financial condition of a company at the end
of the period, we take Average Inventory for the year in our calculation.

Or, this formula can be used without computing for inventory turnover:

Days of Sales Outstanding (DSO) - is the average time for the company to collect its
receivables.
- For example, a DSO of 40 days means that a customer who purchased on the company on
account will pay his/her balance in 40 days.
The formula is:

- Revenue is from the Statement of Comprehensive Income and Accounts Receivables is from
the Statement of Financial Position.
- We use the Average Receivables for the year in our calculation. For revenue we generally use
the credit sales so we may have to exclude cash sales from the total sales figure.

Cash Conversion Cycle (CCC)

Cash Conversion Cycle - also called the net operating cycle, is computed as the operating cycle
less days of payable.
In formula form:

- The Cash Conversion Cycle is the length of time it takes for the initial cash outflows for goods
and services purchased (materials, labor, etc.) to be realized as cash inflows from sales (cash
sales and in the collection of receivables).

Days of Payables Outstanding

Days of Payables Outstanding (DPO) - is the average number of days for the company to pay its
creditors. A DPO of 30 days means that the company waits for 30 days before paying its
creditors.
The formula for DPO is:

- Purchases are taken from the Statement of Comprehensive Income and Accounts Payables are
taken from the Statement of Financial Position.
- Since the Statement of Financial Position tells the financial condition of a company at the end
of the period, we take Average payables for the year in our calculation.
- For purchases we are generally concerned about the credit purchases so the learner may have
to exclude cash purchases from the total sales figure.
- We can see that the numerators of the turnovers needed for the computation of cash
conversion cycle are all Income Statement Accounts, while the denominators are all Average
Balance Sheet Accounts.
To Note: Ending Balance Sheet Accounts such as Ending Accounts Receivable can also be used in the
computation of Turnover ratios however, consistency must be applied.

Image 4.2. Corelation of the Operating Cycle and Number of Days (Source: DepEd Business Finance Teaching Guide)
Also, there must be a timeline for the activities, especially since they were allotted a
specific time to do the activity.
Using the above figures, the CCC will be:
CCC = 20 + 40 – 30 = 30
30 days is the time between the cash outlay and the cash received.
If the CCC is negative, it indicates that the company has excess cash to invest. A CC of
-10 indicates that the company has excess cash to invest for 10 days.

Working Capital Policies

Working Capital Management - is the administration and control of the company’s working
capital. The primary objective is to achieve a balance between profitability and risk. Basically,
there are three types of working capital financing policies the management can choose from:
- Maturity-matching working capital financing policy
- Aggressive working capital financing policy
- Conservative working capital financing policy
Managing working capital is important because failure to do so may result in the closure
of business. It must be noted that working capital requirements increase as the size or volume
of the business increases. For example, a company needs PHP10 million in working capital to
support an annual sales of PHP50 million. If the sales increase to PHP100 million, will the PHP10
million working capital be enough? Most likely, the answer is no. Why? Because with PHP100
million sales, there will be more cash needed for the operations, more accounts receivable, and
if the company is a trading or a manufacturing company, more inventories.
Permanent and Temporary Working Capital
Permanent Working Capital - is the minimum level of current assets required by a firm to carry-
on its business operations given its production capacity or relevant sales range.
Temporary Working Capital - is the excess of working capital over the permanent working
capital given its production capacity or relevant sales range.
During the year, sales are not the same every month. This is why companies have slack
season and peak season. If a company has annual sales of PHP50 million, chances are these
sales are not generated uniformly throughout the year. Given this situation, the net working
capital requirements during the slack season is lower than those during the peak season. The
net working capital needed to support an operation during the slack season represents the
permanent working capital requirements while the additional net working capital needed
during the peak season represents the temporary working capital requirements.
Illustrative Sample: Bugay is managing the working capital of SR Ice Cream. SR Ice Cream is
engaged in the selling of different ice creams. The following are the sales volume, and the
working capital needed based on the recent years:

We can see that the working capital never goes below PHP120,000. That is the
permanent working capital requirement. The maximum temporary working capital is
PHP180,000 (difference between the PHP300,000 working capital and the permanent working
capital of PHP120,000) at the peak season with PHP900,000 sales level. For the 4th Quarter, the
temporary working capital is PHP30,000 (difference between the PHP150,000 working capital
and the permanent working capital of PHP120,000).

Maturity-Matching Working Capital Financing Policy

• Based on the maturity-matching working capital financing policy, permanent working capital
requirements should be financed by longterm sources while temporary working capital
requirements should be financed by short-term sources of financing.
• Long-term sources of financing include long-term debt and equity such as common stock and
preferred stock. Short-term sources include short-term loans from a bank.
• These short-term loans from banks are called working capital loans which perfectly describe
the reasons why these loans are incurred.
• In maturity-matching, all permanent working capital must be financed by long-term sources
while temporary working capital requirements should be financed by short-term sources.
 Image 4.3. Maturity-Matching Working Capital Financing Policy (Source: Cayanan and Borja. Business Finance, 2016)
Aggressive Working Capital Financing Policy
• Under the aggressive working capital financing policy, some of the permanent working capital
requirements are financed by short-term sources of financing.
• Why do managers of some companies adopt this policy? It is because long-term sources of
funds have higher cost as compared to shortterm sources of financing. By financing some of the
permanent working capital requirements with short-term sources of financing, financing cost is
minimized which in turn, improves net income.
• But what is the trade-off? Since it is short-term, the debt has to be paid soon and the
company may not yet have enough cash by the time the debt matures. This refers to liquidity
risk and this risk increases with the aggressive working capital financing policy.

Image 4.4. Aggressive Working Capital Financing Policy (Source: Cayanan and Borja. Business Finance, 2016)
Conservative Working Capital Financing Policy
• Based on the conservative working capital financing policy, even some of the temporary
working capital requirements are financed by long-term sources of financing.
• This policy minimizes liquidity risk but it also reduces the company’s profitability because
long-term sources of financing entail higher cost.
 Image 4.5. Conservative Working Capital Financing Policy (Source: Cayanan and Borja. Business Finance, 2016)
Illustrative Sample: B. Bugay is managing the working capital of SR Ice Cream. SR Ice Cream is
engaged in the selling of different ice creams. The following are the sales volume, and the
working capital needed based on the recent years:

The following banks offered the following loans:

What banks will be probably chosen by B. Bugay when choosing different policies?
Answer Key:
Permanent working capital = P120,000
Temporary working capital = P300,000 – P 120,000 = P180,000
 The central issue in managing the working capital is the ability to reduce operating cycle
days. This is to ensure that such operating cycle days will be shorter than the payable days. The
quickness of completing the operating cycle is measured by the operating cycle days. The
following are some of the strategies in efficiently managing the cash conversion cycle:
1. Turn over inventory as quickly as possible without stockouts that result in lost sales.
2. Efficiently manage the accounts receivable consistent with the company’s credit policies. You
need to also consider accelerating the collection of receivables through:
A. Shorter credit terms.
B. Offering special discounts to customers who pay their accounts within a specified
period.
C. Speeding up the mailing time of payments from customers to the firm.
D. Minimizing the float or reducing the time during which payments received by the firm
remain uncollected funds. For example, a customer deposited a check in the name of
the company on a Friday and the check will be cleared on Monday. The payment is said
to be floating for two days.
3. Manage mail, processing, and clearing time to reduce them when collecting from customers
and to increase them when paying suppliers.
4. Pay accounts payable as slowly as possible without damaging the firm’s credit rating.

Managing Cash, Receivables, and Inventory

Cash being the most liquid asset, cash is an important account in the balance sheet that
will affect the liquidity, and solvency of a company. It is also the most vulnerable when it comes
to theft.
A good internal control must be properly implemented to safeguard this asset. A basic
internal control system entails the assignment of custodial function and recording function to
separate individuals, unless you are the owner. Why is this so? Imagine a cashier of a company
who is also the chief accountant. If tempted, this person can steal cash from the company and
can manipulate the records so that nobody can discover that he is stealing. If you are the
owner, you probably will not steal from yourself and adjust the records?
Cash collections should be supported by official receipts which are summarized in a daily
collection report. The daily collection report is going to useful for the next control measure for
cash – depositing collections. A good internal control over cash is by depositing all collections
intact. The daily collection reports are now compared with the deposit slips to find out if all
collections are indeed deposited. If all collections need to be deposited, then payments must be
made through a check voucher system. There must also be two signatories in the check to
provide a check and balance. If the business is small then the entrepreneur’s signature may
suffice. For small payments like the fare given to a messenger, a petty cash fund is used. A petty
cash fund which should be minimal in amount, will be issued to a petty cash fund custodian, say
the office administrator. The petty cash fund may be PHP10,000 or PHP20,000. Disbursements
from this petty cash funds must be supported by a petty cash voucher signed by the recipient of
the petty cash. When the petty cash fund is almost depleted, the petty cash fund custodian will
get reimbursements. This reimbursement will go through the check voucher system where the
custodian gets a check with the petty cash vouchers as supporting documents. The check must
also be cross-checked by drawing two lines on the payee section of the check. This cross-
checking requires depositing of a check. It cannot be encashed. This makes it more difficult for
somebody who stole a check to get the money.

Motives for Holding Cash

The following are the reasons for holding cash:
A. Primary Reasons
a. Transactional. This is the cash used for paying expenses such as salaries, utilities, rent and
taxes, among others.
b. Compensating Balance. This is the cash held to meet bank requirements such as the
minimum cash balance you maintain for checking accounts and if you have existing loans, banks
may also require a minimum amount of deposit with them.
B. Secondary Reasons
a. Precautionary. This is the cash maintained for emergencies such as the additional cash you
keep during political and economic uncertainties. For example, if your business requires a
substantial amount of importation, a relatively higher amount of cash has to be maintained
when the exchange rate becomes highly volatile due to political instability such as what
happened during EDSA II.
b. Speculative. This refers to the cash held by the company to take advantage of opportunities
(e.g. buying stocks during major corrections such as what happened at the height of the global
financial crisis in 2008 and 2009 where stock valuations went down by as much as 80% for some
companies).

Budgeting Cash
The Cash Budget provides information regarding the company’s expected cash receipts
and disbursements over a given period. It is useful for identifying future funding requirements
or excess cash within a given period. This allows managers to find possible sources of financing
if the cash budget shows cash shortage or identify appropriate tenors for money market
placements for excess cash. Normally, a cash budget is prepared for a one year period broken
down into smaller intervals like months. This allows managers to see the seasonality of the
business which affects the cash flows.
Basically, cash budget has the following parts:
A. Cash Receipts
Cash Receipts - include all of a firm’s inflows of cash in a given financial period. The most
common components of cash receipts are cash sales, collections of accounts receivable, and
other cash receipts.
Illustrative Example:
B. Bugay Industries, a defense contractor, is developing a cash budget for October, November,
and December. Jungaya’s sales in August and September were PHP100,000 and PHP200,000
respectively. Sales of PHP400,000, PHP300,000, and PHP200,000 have been forecast for
October, November, and December respectively.
Historically, 20% of the firm’s sales have been for cash, 50% have generated accounts
receivable collected after 1 month, and the remaining 30% have generated accounts receivable
collected after 2 months. In December, the firm will receive a PHP30,000 dividend from stock in
a subsidiary.
Required: Prepare the cash receipts section of the cash budget.

B. Cash Disbursements
Cash Disbursements - include all outlays of cash by the firm during a given financial period. The
most common cash disbursements are:
• Cash purchases
• Purchasing fixed assets
• Payments of accounts payable
• Interest payments
• Rent (and lease) payments
• Cash dividend payments
• Wages and salaries
• Principal payments (loans)
• Tax
It is important to recognize that depreciation and other noncash charges are not
included in the cash budget, because they merely represent a scheduled write-off of an earlier
cash outflow.
Illustrative Example:
Jungaya Industries has gathered the following data needed for the preparation of a cash
disbursements schedule for October, November, and December.
- Purchases - The firm’s purchases represent 70% of sales. Of this amount, 10% is paid in cash,
70% is paid in the month immediately following the month of purchase, and the remaining 20%
is paid 2 months following the month of purchase.
- Rent Payments - Rent of PHP5,000 will be paid each month.
- Wages and Salaries - Fixed salary cost for the year is PHP96,000, or PHP8,000 per month. In
addition, wages are estimated as 10% of monthly sales.
- Tax Payments - Taxes of PHP25,000 must be paid in December.
- Fixed Assets - New machinery costing PHP130,000 will be purchased and paid for in
November.
- Interest Payments - An interest payment of PHP10,000 is due in December.
Answer Key:

C. Net Cash Flow, Ending Cash, Financing, and Excess Cash

The firm’s net cash flow is found by subtracting the cash disbursements from cash
receipts in each period. Then we add beginning cash to the net cash flow to determine the
ending cash for each period. Finally, we subtract the desired minimum cash balance from
ending cash to find the required total financing or the excess cash balance. If the computed
amount is negative, the company needs financing. Otherwise, the company has excess cash.
The cash budget is part of planning. It helps managers anticipate future funding
requirements in order to obtain proper financing even before the need arises. This will help
them avoid usurious rates. On the other hand, if the company has excess cash, managers are
able identify the investment instruments that will maximize the returns on the excess cash.
Accounts Receivable Management
Accounts receivables spring out of the need to sell merchandise. An excellent business
proposition is to generate sales without offering a credit facility to customers. However, this
concept is theoretically sound, but not sustainable. Consider a real estate company which sells
condominium units at PHP5 million per unit. How many units can the property developer sell if
he sells the units only on cash basis? Do you think he can sell a lot? Probably not as many as
compared to providing instalment payments. Credit management strategically defines the
quality of account receivables collection. The collectability of accounts receivables depends
largely on the quality of customers. The quality of customers depends on the standards or
credit policies set up and used by an organization. Credit policies are an integral part of the
credit evaluation and there are 5C’s used in credit evaluation. These are:
- Character –the willingness of the borrower to repay the loan
- Capacity – a customer’s ability to generate cash flows
- Collateral – security pledged for payment of the loan
- Capital – a customer’s financial resources
- Condition – current economic or business conditions
Proper management of accounts receivable entails having a good billing and collection
system. A good system should lead to the sending of statements of account to customers on
time. Follow-ups through phone calls or any form of gentle reminders should be made if
customers fail to pay on time. These follow-ups can also serve as the management’s way of
validating if the contact details given by customers are still valid and if the customers still
occupy the same office.
Aging of receivables is also a control measure to determine the amount of receivables
that are still outstanding and past due.
 Accounts which have been past due for more than 90 days have higher probability to
default. The aging of receivables is useful in determining the allowance for doubtful accounts.

Inventory Management
Inventory Management - involves the formulation and administration of plans and policies to
efficiently and satisfactorily meet production and merchandising requirements and minimize
costs relative to inventories.
Effective inventory management becomes critical when the nature of the products are
either perishable (e.g. fruits, vegetables), fragile (e.g. glasses), or toxic (e.g. bleaching agent).
Proper inventory management involves the determination of reasonable levels of
inventories considering the size and nature of business. Maintaining too much inventories has
costs such as carrying or holding costs, possible obsolescence or spoilage. On the other hand,
too low inventory can result to stockout, and eventually lost sales.
Inventory In A Manufacturing Company
In a manufacturing company, there are three types of inventory:
Raw Materials – these are purchased materials not yet put into production.
Work in Process – these are goods and labor put into production but not yet finished.
Finished Goods – these are goods put into production and finished. These are ready to be sold.
The ABC Analysis
One way to control inventory is to classify inventory into a classification system called
ABC Analysis. Inventories classified as “A” are high valued items which should be safeguarded
the most. B items, on the other hand, are average-cost items that should be safeguarded more
than C items but not as much as A items. While C items have low cost and is the least
safeguarded.
III. SUMMARY OF LESSON
 Working Capital is the company’s investment in current assets such as cash, accounts
receivable, and inventories.
 Net Working Capital is the difference between current assets and current liabilities.
 Operating cycle is the sum of days of inventory and days of receivables.
 Cash Conversion Cycle also called the net operating cycle, is computed as the operating
cycle less days of payable.
 Working Capital Management is the administration and control of the company’s working
capital. The primary objective is to achieve a balance between profitability and risk.
 Cash Budget provides information regarding the company’s expected cash receipts and
disbursements over a given period.
 Proper management of accounts receivable entails having a good billing and collection
system.
 Inventory Management involves the formulation and administration of plans and policies to
efficiently and satisfactorily meet production and merchandising requirements and
minimize costs relative to inventories.

IV. ENRICHMENT
Planning
Direction: Read Maria’s financial situation. The suggest one way for Maria to better manage her
cash balance. Answer on a separate sheet. (10 pts. each; Correctness of Ideas - 7, Organization
of Ideas - 3)
- Maria Luna, a 25-year-old nurse, works at a hospital that pays her every 2 weeks by direct
deposit into her checking account which pays no interest and has no minimum balance
requirement. She takes home about PHP9,000 every 2 weeks or about PHP18,000 per month.
- She maintains a checking account in the bank that does not earn any interest income with a
balance of around PHP7,500. Whenever it exceeds that amount she transfers the excess into
her savings account, which currently pays 1.5% annual interest.
- She currently has a savings account balance of PHP85,000 and estimates that she transfers
about PHP3,000 per month from her checking account into her savings account.
- Maria pays her bills immediately when she receives them. Her monthly bills average about
PHP9,500, and her monthly cash outlays for food and transportation cost total about PHP4,500.
- An analysis of Maria’s bill payments indicates that on average she pays her bills 10 days early.
Bank Time Deposit are currently yielding about 4.2% annual interest. Maria is interested in
learning how she might better manage her cash balances.

V. EVALUATION
Multiple Choice
Direction: Choose the letter of the best answer. Write your answers on a separate sheet. (2 pts.
each)
1. The _________ inventory consists of all items currently in the production process.
a. raw materials
b. work-in-process
c. finished goods
 d. apital goods
2. The _________ inventory consists of items that have been produced but not yet sold.
a. raw materials
b. work-in-process
c. finished goods
d. capital goods
3. The three basic types of inventory are all of the following EXCEPT
a. raw materials
b. work-in-process
c. finished goods
d. capital goods
4. The _________ inventory contains the basic components of the production process.
a. raw materials
b. work-in-process
c. finished goods
d. capital goods
5. The credit applicant’s _________ is the amount of assets the applicant has available for use
in securing the credit.
a. character
b. capacity
c. capital
d. collateral

B. Cash Conversion Problem Solving

Direction: Read and answer the problem. Answer and show your solution on a separate sheet.
For number 3, answer briefly. (5pts. each)
Philippine Products Company is concerned about managing cash efficiently. On the
average, inventories have an age of 90 days and accounts receivable are collected in 60 days.
Accounts payable are paid approximately 30 days after they arise. The firm has annual sales of
about PHP30 million. Assume there is no difference in the investment per peso of sales in
inventory, receivables, and payables and that there is a 360-day year.
1. Calculate the firm’s operating cycle.
2. Calculate the firm’s cash conversion cycle.
3. Discuss how management might be able to reduce the cash conversion cycle.

VI. RESOURCES
DepEd Business Finance Teaching Guide
http://simplestudies.com/what-are-the-types-of-working-capital
Cayanan and Borja. Business Finance. 2016.
Gitman, L. (1976). Principles of managerial finance. New York: Harper & Row.