Lesson 4: WORKING CAPITAL MANAGEMENT

Working capital, being the lifeblood of an organization, needs to be efficiently and effectively managed so that
the organization may optimize its operations, maximize its growth potential, and attain its desired financial
position

Working Capital Management Defined

Working capital management refers to the efficient and effective utilization of working capital to attach
predetermined objectives of an organization relative to profitability of operations, liquidity of financial resources,
and minimization of risks and company costs. It may also be defined as the administration and control of current
assets and current liabilities to maximize a firm's value by achieving a balance between profit and risk.

Trade-off between Profitability and Risk. In managing working capital, there is a trade-off between the firm's
profitability and its risk. Too much working capital can reduce the firm's profitability because of additional
financing charges (or interest expense) and the opportunity cost of capital tied up in the firm's assets. On the
other hand, inadequate working capital exposes the firm to the risks of not being able to pay its bills as they fall
due.

Working Capital Defined; Its Concepts

Working capital, as defined in Chapter I, is the difference between current assets and current liabilities. In other
words, it is the amount of current assets left after providing for current liabilities. As such, it is the amount of current
assets (or the aggregate of cash, marketable securities, receivables, inventories, prepaid expenses, and other
current asset items)financed by long-term capital (long-term debt and stockholders' equity) of the business. Thus,
considering the above given definitions, it is the amount of long-term capital that is made to revolve in
conducting operations and serves as the lifeblood of a company.

Concepts of Working Capital. The term working capital is generally used to refer to the excess of current assets
over current liabilities (or net current assets). Sometimes it is used as referring to current assets. Under the latter
concept of the term, the difference between current assets and current liabilities is referred to as net working
capital.

Inasmuch as working capital is the excess of current assets over current liabilities, it must be equal to the amount
of current assets financed by long term sources of funds. In other words, current assets provided by short-term
sources of funds do not affect working capital.

Relevance of Working Capital

A business concern uses working capital in conducting operations, that is, in making goods and services available
to customers and clients and in paying for operating expenses (salaries, advertising, rentals, etc.). Working capital
is made to revolve from cash to inventories and services and then to receivables or directly back to cash.
Because of this, it is called the lifeblood of an organization. Plant, property and equipment provide the structure.

At the start of business operations, working capital may be wholly in the form of cash. Inasmuch as it is made to
revolve in conducting operations, at any point in time of an organization's existence, it would be partly in the
form of cash, receivables, inventories, prepaid expenses and other current asset items. However, short-term
liabilities are incurred and these are to be paid from current assets so that whatever is left after deducting these
liabilities must be considered as what is available for use in operations.

Analysis of Working Capital

Working capital, because of its relevance in an organization, requires careful analysis. That involves looking into
its appropriate level, structural health, circulation and comparative liquidity.

Appropriate Level of Working Capital

The appropriate level of working capital refers to the adequacy thereof to enable a business entity to operate
efficiently towards the attainment of its predetermined objectives considering the cost of money involved. The
level or amount of working capital at which it should be maintained depends on factors such as:

a). nature of operations

b). length of period required to manufacture or obtain goods for sale, production or purchase volume and unit
costs.
c). terms of purchase and sale, gross margin on sales and operating expenses.
d). inventory turnover
e). receivable turnover
f). seasonal variations
g). price fluctuations or possible loss from decline in value of current assets.
h). average number of days in the operating cycle.
i). expansion programs
j). dividend policies
k). taxation
1). variation in sales volume
m). operating efficiency of the business
n). credit standing of the company
o). competitive conditions

Inadequate working capital contributes to business failures because of inability to promptly pursue company
objectives, inability to take advantage of business opportunities, inability to avail of cash discounts, higher
product and service costs, reduced sales volume, loss of customers, and poor credit standing. All these result in
lower rate of return on investment and employee morale.

On the other hand, too much working capital may result in inefficient use thereof because it encourages
speculation and unnecessary expansion. There may be complacency among management people inasmuch
as they are not under pressure to carefully plan its allocation and follow-up on its actual usage and flow.

Adequate working capital enables a company to pursue its objectives promptly, take advantage of business
opportunities, meet its obligations, and conduct operations smoothly.

Structural Health of Working Capital

Structural health of working capital refers to its composition, that is, how much is in cash, receivables, inventories,
etc. and the ability of the business organization to meet financial requirements.

Circulation of Working Capital

Circulation of working capital refers to the flow thereof from one current asset item to another in the process of
conducting operations and the rate of such flow. In other words, into what items is cash converted and how long
does it take to convert the latter back into cash? How long does working capital remain in the form of inventory
before it is converted into receivables and how long does it take to convert receivables into cash?

Liquidity of Working Capital

Liquidity of working capital refers to the relative composition thereof with emphasis on cash and marketable
securities and how soon can the noncash items among the current assets be converted into cash. The
measurement of liquidity of working capital would require the use of component percentages of current assets,
acid test ratio (ne a supplement to the current ratio), aging of accounts receivable, analysis of the movement
of the different inventory items, and analysis of sales into cash sales and charge or installment sales.

Financing Requirements of a Firm

The financing requirements of a firm may be classified into permanent and seasonal (or temporary). Permanent
financing requirement refers to what should stay with the firm throughout the budget year. Seasonal financing
requirement refers to additional requirements arising from fluctuation in the volume of activity (production and
sales) arising from seasonal changes in the level of demand for products or services during the year. The
permanent capital would be plant, property and equipment (or fixed assets) and the portion of current assets
(permanent current assets) that must be always with the firm. Thus, the total financing requirement of a firm may
be computed as follows:

Total Financing Requirement = Permanent Financing Requirement + Temporary Requirement

= (Fixed Assets + Permanent Current Assets) + Temporary Current Assets

Example: The permanent financing requirement of DGC Corp. is 280,000 consisting of fixed assets (P50,000) and
current assets (P30,000). Because of seasonal changes in the demand for its product, the total current assets for
the first, second third and fourth quarters of 2020 have been estimated at P 38,000,P45,000, P30,000 and P42,000,
respectively.
In the given example, the total financing requirement of the firm for each quarter is analyzed as follows:
Permanent Financing Requirement Temporary Total
Fixed Assets Current Assets Current Assets
First Quarter P 50,000 P 30,000 P 8,000 88,000
Second Quarter 50,000 30,000 15,000 95,000
Third Quarter 50,000 30,000 0 80,000
Fourth Quarter 50,000 30,000 12,000 92,000

Throughout the year, the total financing requirement is P80,000 with additional financing requirement of P8,000,
P15,000 and P12,000 for the first, second and fourth quarters, respectively.

Aggressive and Conservative Financing Strategies

In financing total capital requirement, financing strategies may be classified into aggressive, conservative, and
a trade-off between the two.

Aggressive Financing Strategy. Under an aggressive financing strategy, operations are conducted on a minimum
amount of working capital. Permanent capital requirement is financed by using long-term sources of funds with
seasonal requirements financed by short-term sources. Aside from exposing the firm to the risks arising from a low
working capital position, this strategy puts too much pressure on the firm's short- term borrowing capacity so that
it may have difficulty in satisfying unexpected needs for funds. Aside from this, short-term refinancing can result
in significantly higher borrowing costs arising from changing interest rates and service charges.

Applying the aggressive financing strategy in the given example, the permanent financing requirement of
P80,000 must be from long-term sources with the temporary financing requirements (which range from zero to
P15,000) financed by short-term debt. Under this strategy, working capital is P30,000 only.

The tabulation would be as follows:

(A) (B) (C) (D) (E)
Total Long Term Short-term Working Excess
Requirement Funds Funds Capital Working
(FA + CA) (A – B) (B – FA) Capital
(D – CA)
First Quarter P 88,000 P 80,000 P 8,000 P 30,000* P-
Second Quarter 95,000 80,000 15,000 30,000 -
Third Quarter 80,000 80,000 0 30,000 -
Fourth Quarter 92,000 80,000 12,000 30,000 -
*(Long term funds, P80,000 - Fixed assets, P50,000)

Conservative Financing Strategy. The most conservative financing strategy provides long-term funds based on
the maximum requirement with unexpected needs financed by short-term sources. This strategy generally results
in more financing charges (inasmuch as cost of long-term funds is often higher than that of short-term funds)
aside from the opportunity cost of too much capital tied up in current assets.

The quarterly figures would be as follows:

(A) (B) (C) (D) (E)
Total Long Term Short-term Working Excess
Requirement Funds Funds Capital Working
(FA + CA) (A – B) (B – FA) Capital
(D – CA)
First Quarter P 88,000 P 95,000 P- P 45,000 P 7,000
Second Quarter 95,000 95,000 - 45,000 0
Third Quarter 80,000 95,000 - 45,000 15,000
Fourth Quarter 92,000 95,000 - 45,000 3,000

Applying this strategy in the given example, the maximum capital requirement of P95,000 would be made
available throughout the year, financed by long-term funds. Working capital would be P45,000 and during the
first, third and fourth quarters, there would be excess funds.

Semi-Aggressive (or Semi-Conservative Strategy)

As a trade-off between the aggressive and the conservative financing strategies, the semi-aggressive (or semi-
conservative) strategy may be adopted. Part of the seasonal financing requirement is funded using long-term
sources. Thus, long-term funds may be equal to the average between the highest and the lowest total
requirements. For the given example, the long-term funds would be P87,500 or ((P95,000 + 80,000/2). It may also
be computed as follows:
 Permanent financing requirement P 80,000
Average temporary financing requirement (15,000* + 0)/2 = 7,500
To be financed by Long-term funds P 87,500
*Highest temporary current asset requirement

For a given example, the semi-conservative strategy is applied as follows:

(A) (B) (C) (D) (E)
Total Long Term Short-term Working Excess
Requirement Funds Funds Capital Working
(FA + CA) (A – B) (B – FA) Capital
(D – CA)
First Quarter P 88,000 P 87,500* P 500 P 37.500** P-
Second Quarter 95,000 87,500 7,500 37,500 -
Third Quarter 80,000 87,500 - 37,500 7,500
Fourth Quarter 92,000 87,500 4,500 37,500 -
*(P 80,000 + P 95,000)/2 = P 87,500
** P 87,500 – P 50,000 = P 37,500

Seasonal Variation in Working Capital Requirement

As stated in the preceding section, seasonal fluctuation in the activities of a firm results in additional financing
requirement in the form of temporary current assets. When said additional current asset requirement can be
financed by short-term borrowing or by trade creditors, it does not bring about an increase in working capital
requirement. If it cannot be financed by creating current liabilities, it gives rise to additional working capital
requirement inasmuch as it must be financed by long-term equity (long-term debt and/or owner's equity).

Fluctuations in production and sales and the consequent fluctuations in current asset and working capital
requirements can be anticipated in the process of budgeting. In budgeting, company plans are stated in
financial and quantitative terms such as those on planned sales and production volumes, costs and expenses,
cash inflows and outflows, the effects of transactions on financial resources and equities and the planned levels
of financial resources.

Example: The temporary current asset requirements for the first second, third and fourth quarters of 2021 are
expected at P8,000, P15,000, PO and P12,000, respectively. The company can make arrangements with its trade
creditors to extend their term of sale and a financing company is willing to grant short-term loans. The following
tabulation shows the increase in working capital requirement.

Temporary Current To be Financed by Additional Working Increase

Assets Requirement Short-term Debt Capital Requirement (Decrease)
First Quarter P 8,000 P 5,000 P 3,000 3,000
Second Quarter 15,000 7,000 8,000 5,000
Third Quarter 0 0 0 (8,000)
Fourth Quarter 12,000 0 12,000 22,000

The last column shows the required additions to working capital and the amount that may be released. For the
first quarter, only P3,000 need to be raised. For the second quarter, an additional P5,000 is required. Inasmuch as
the additional working capital requirement would be financed by increasing long-term equities, the release of
P8,000 from working capital requirement may be temporarily invested for one quarter. The expected earnings
therefrom can reduce the working capital requirement for the 4th quarter. Thus, if the temporary investment of
P8,000 for one quarter can earn P3,000 for the company, the amount of the temporary investment shall amount
to P11,000. With additional working capital requirement for the fourth quarter amounting to P12,000, the
company has to raise only P1,000 more to meet the additional requirement.

Minimizing Working Capital Requirement

Inasmuch as working capital is the difference between current assets and current liabilities, working capital
requirement may be minimized by efficiency in cash and raw material management, in making collections and
in the manufacturing processes, by effective credit and collection policies, reduction of time lag between
completion and shipment of finished goods, and favorable terms from suppliers.

For a trading concern, working capital requirement for inventory acquisition may be reduced by accepting
deliveries on consignment.
Working Capital and Cash Provided by Operations

Instead of immediately looking for additional sources of funds from outside a firm, it would be worthwhile to
determine how much working capital and cash can be provided by operations.
Operations of a company result in outflows and inflows of working capital and canh. When inflows exceed out
hows, the difference must be working capital or cash from operations. The income statement of a business entity
includes charges (such as depreciation and amortization of intangibles) that do not require outflow of funds, so
that oven if the company's operations result in a net loss, there could still be a net innow or working capital or
cash.

Cash Management

Cash management refers to the efficient and effective utilization of cash to attain company objectives. Cash is
the most liquid of all current asset items and is used to meet financial requirements so that its flow must be carefully
planned and controlled. In cash management, the following are some of the questions that must be answered
considering company objectives and planned operations:

o How long is the cash cycle?

o How much should be its minimum balance? (In other words, what should be its lowest balance
considering average cash requirements per day and availability of sources thereof on short notice?)
o How much are the expected cash inflows and outflows during the next twelve months, quarter, month,
week and day? (This requires preparation of a master budget with quarterly and monthly details.)
o In how many days does the company collect its receivables! Are collections made promptly are discounts
granted to customers for prompt payment?
o How long does it take the company to convert inventory to receivables or directly to cash
o What are the objects of disbursements and when are they to be paid to avail of discounts and or minimize
costs? What are the terms of purchases?
o Is there an effective control system within the company?
o What cost-cutting measures may be adopted to minimize cash requirements?
o In case the company has temporarily idle funds, in what kind of investments may they be placed?

Although most of the foregoing questions are on items or transactions that directly affect cash, it should be
emphasized that cash is ultimately affected by other business transactions and changes in balance sheet items
so that the management of the latter ultimately affect cash also.

Number of Days in Cash Cycle and Cash Cycles in One Year

The number of days in cash cycle refers to the length of time that elapses from the point cash payment is made
for purchases to the point of collection from customers/clients to whom the goods services have been sold.
Example: XYZ Corp-pays for its purchases 22 days after they are received. On the average, goods are sold 15
days after they are received and collections are made 25 days from date of sale. The length of the cash cycle
is computed as follows:

No. of days in cash cycle:

Number of days' sales in (or average age of) inventory 15 days

Average collection period (or number of days' sales in receivables) 25
Average age of payables (or number of days' purchases in payables). (22)
Number of days in cash cycle 18 days

Number of Cash Cycles in One Year. The number of cash cycles in one year is computed by dividing the number
of days in one year by the number of days in a cash cycle. For XYZ Corp. in the given example, it is computed as
follows:

No. of cash cycles in one year = 360 days/18days = 20 times

Minimum Cash Balance

A primary objective of cash management is to see to it that cash is available whenever there is a need for it. This
brings about the question of what should be its minimum balance. A cash balance that is too high gives rise to
lost income from alternative uses thereof (opportunity cost) and more interest charges (in case of borrowed
funds). On the other hand, a cash balance that is too low is apt to hamper operations, increase costs and
expenses, and demoralize employees. These may be due to inability to procure goods and services promptly, to
avail of discounts, and pay salaries and wages on due date.
The minimum cash balance may be set based on the desired number of days' of operations to be covered. The
latter may vary under different circumstances considering the relative liquidity of current assets and willingness
of suppliers to deliver goods and services under extended terms of payment.

Example: Assume that XYZ Corp. in the preceding example desires to have its minimum cash balance equal to
10 days' requirement. Annual cash requirement is P720,000. It would be computed as follows:

Cash balance to cover 10 days' requirement:

𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡 𝑜𝑓 𝑃 720,000

x 10 days = P20,000
360 𝑑𝑎𝑦𝑠

Dividing the annual cash requirement of P720,000 by 360 days, the average daily usage must be P2,000 so that
the requirement for 10 days on the average must be P20,000.

Inasmuch as cash requirements fluctuate during the year, the minimum cash balance may be set as a
percentage of planned cash outlays for the next month or quarter. Thus, if the planned cash disbursements for
the next quarter is P180,000 and man agreement desires a 10% minimum balance, it should be set at 18,000.

Cash Float

Cash float refers to temporarily unclaimed funds because of time lag between issuance and subsequent clearing
of checks. Upon issuance of checks, the amount thereof is subtracted from the Cash account balance per books
of the company but it is only upon clearance with the depository bank that the amount is deducted by the bank
from the account of the issuing company. In other words, while the check is still not cleared with the depository
bank, the company's cash balance remains intact.

Example: On January 10, 19B, ABC Corp. issues a check for P10,000 in favor of Simon de Leon. The check is mailed
on the same date and is received by the payee on January 14th. The check is recorded by the payee on January
15th and deposited on the 16th. It takes three days to have the check cleared so that it is deducted from the
account of ABC Corp. on January 19th.

The total float in the above-given example is equal to 9 days broken down as follows:

Mailing float 4 days

Processing (recording) float 2
Clearing float 3
Total float 9 days

Finance managers sometimes make use of the cash float when there is an immediate need for additional funds.
In the given example, the amount of P10,000 remains as part of the company's cash per bank's books up to
January 18th. Should the finance manager decide to issue checks against the cash float, he should see to it that
additional deposits are made before the P10,000 check is cleared.

Cash Management Strategies

The following are the basic strategies in managing cash:

1. Collect receivables as quickly as possible without resorting to high-pressure collection techniques.

2. Stretch accounts payable. Pay bills as late as possible without adversely affecting credit rating.
3. Turn over inventory as quickly as possible (or even go to the extent of eliminating inventories in some
cases so that upon manufacture or purchase, they are automatically sold).

Accelerating Collection of Receivables

One way of reducing operating cash requirements is by speeding up or accelerating collection of receivables.
This may be effected by shortening credit terms and offering special discounts to customers who settle their
accounts within a specified period.

Example: XYZ Corp. collects its receivables after 25 days on the average so that they amount to P75,000. A
proposal has been made to shorten the credit term to 20 days or by 5 days. Said proposal will reduce receivables
(or reduce cash requirement) by P15,000 computed as follows:
 Receivables with collections after 25 days P 75,000
Receivables with collections after 20 days:
Average sales per day (175,000/25 days) = P 3,000
Multiply by 20 Days 60,000
Decrease in receivables (and in operating cash requirement) P 15,000

Assuming 15% as cost of money, the company must be expected to save P2,250 (P15,000 x 15%) in financing
charges. However, this advantage should be equated with the possible decline in sales volume arising from
shorter credit terms. Instead of shortening credit terms, the firm may opt to reduce its collection float.

Collection Techniques

It has been mentioned before that cash management involves collection of receivables as quickly as possible.
Customers may be paying their accounts promptly but there may be delays in the conversion of their payments
to spendable form so that the objective now must be to shorten the collection float, specifically the processing
portion. The following are some of the techniques used to effect the shortening of the collection float.

➢ Direct Sends. Checks received as part of collections are sent directly to the banks on which they are drawn
by customers. This reduces the clearing float for the said checks for the drawee banks pay immediately to
the company that is making the collection.

➢ Concentration Banking. Bank accounts are maintained for provincial sales outlets so that they may collect
from customers and deposit their collections with the local banks. The provincial or regional banks may then
be instructed to transfer funds periodically to the main office. This practice reduces both mailing and clearing
floats.

➢ Lockbox System. Customers are instructed to send remittances to a post office box which is serviced by the
company's bank. The latter opens payment envelopes, deposits remittances received to the account of the
company that is making the collection, and sends the latter the corresponding deposit slip together with any
enclosures. Lockboxes are geographically dispersed so that this system shortens mailing, processing and
clearing floats.

➢ Direct Payment to Depository Banks. Special arrangements are made with banks to accept payments from
customers/clients with collections directly credited to the collecting company's bank account. This practice
eliminates mailing and processing floats.

➢ Direct Deposit to Company's Bank Account. With the prevalence of computerized system in banking,
customers may be allowed to make deposits to the main office bank account through the bank's provincial
branches provided the latter are "on line". This eliminates the mailing and processing floats and shortens the
clearing float.

Stretching Payables

Stretching payables, that is, postponing payment of bills to their due dates (or last date of discount period)
shortens the cash cycle.

Example: Despite the fact that suppliers give XYZ Corp. 30 days to pay for its purchases, the latter pays after 22
days so that its payables average 766,000. By delaying payments to the 30th day, XYZ Corp. is expected to
increase its payables by P24,000 or to P90,000 computed as follows:

Average payables with payments made after 22 days P 66,000

Average payables with payments to be made after 30 days:
Average purchases per day P66,000/22 days P 3,000
Multiply by 30 days 90,000
Increase in payables (decrease in cash requirement) P 24,000

Assuming that cost of money is 15%, the company must be expected to save P3,600 (T24.000 x P15%) or earn said
amount in other forms of investment.

Accelerating Inventory Turnover

Another way of minimizing operating cash requirement is by accelerating inventory turnover. This may be
effected by reducing inventory level in proportion to sales volume.

Erample: XYZ Corp. maintains its inventory at a level equal to 15 days' sales. This means that on the average
goods purchased remain in the form of inventory for 15 days before they are sold. Cost of sales amount to P68,000
per annum so that its inventory must be P19,500 (that is P168,000/360 days x 15 days). Should the company decide
to reduce inventory level to take care of 12 days' sales (or reduce it by 3 days' sales), the decrease in inventory
must be equal to P 3,900 computed as follows:

P 468,000/360 days x 3 days = P 3,900

The P3,900 decrease in inventory requirement would also release an equal amount from operating cash
requirement thereby saving the company the corresponding financing charges (or eliminate the corresponding
opportunity cost) and a proportionate amount of handling cost. On the other hand, the finance manager should
also consider the possibility of stockouts should inventory level be drastically reduced.

Marketable Securities

When a business entity has temporarily idle funds, the finance manager looks for ways and means of earning on
this funds without exposing the company to unnecessary risk. The excess funds are invariably invested in
marketable securities.

The term marketable securities has generally been used in referring to short-term money market instruments that
can be easily converted to cash. To be truly marketable, two requisites have to be met, namely: (a) existence of
n ready market and (b) safety of principal. The popular marketable securities are:

Government Securities (GS)

Treasury bills. These are debt instruments representing obligations of the National Government issued by
the Central Bank and sold at a discount thru competitive bidding. The investor's profit is the difference
between face value and purchase price.

CB bills or Central Bank Certificates of Indebtedness (CBCI's.) These represent indebtedness by the Central
Bank.

Commercial Papers (CP's)

These are short-term, unsecured promissory notes issued by corporations with very high credit standing.
They are issued based on approval by the SEC.

Receivable Management

Receivable management refers to the formulation and administration of plans and policies related to sales on
account and ensuring the maintenance of receivables at a predetermined level and their collectability as
planned.

Objective of Receivable Management

The objective of receivable management is to maintain receivables at a level that will result in a combination of
turnover and profit rates that will maximize the over-all return on investment in a business entity. A High level of
receivables exposes a company to greater risk from uncollectible accounts, more financing charges and greater
opportunity cost arising from the capital tied up in receivables. On the other hand, a very low level of receivables
may have its adverse effects on sales volume and gross margin. This is because longer credit terms attract more
customers and the gross margin on credit sales far exceeds that on cash sales.

Determinants of the Size of Receivables

The size of investment in receivables is affected by the following factors:

1. Terms of sale
2. Paying practices of customers
3. Collection policies and practices
4. Volume of credit sales
5. Credit extension policies and practices
6. Cost of capital

Aids in Analyzing Receivables

The following are the aids in analyzing receivables:

a) Ratio of receivables to net credit sales.
b) Receivable turnover
c) Average collection period or number of days' sales in accounts receivable.
 d) Aging of accounts.

The above-enumerated aids in analyzing receivables may be used in determining the adequacy, over-or
underinvestment in receivables and the effectiveness of the company's credit and collection policies.
Receivables are expected to fluctuate in proportion to the changes in credit sales provided sales terms and
credit and collection policies remain the same so that the given ratios invariably use the comparison between
credit sales and receivables. Aging of accounts show in detail how old are the different accounts (such as by
classifying them into current, 31 to 60 days old, 61 to 90 days old, etc.). The older are the accounts the greater is
the exposure of the company to bad debts so that closer attention must be made by the collection department
to big and older accounts.

Example: Total sales of XYZ Corp. amount to P 1200000 with credit sales equal to P 1080000 Receivables average
P75,000. The computations using the first three aids in analyzing receivables would be as follows:

𝑃 75,000
Ratio of receivables to credit sales = = 6.9%
𝑃 1,080,000

𝑝 1,080,000
Receivable turnover = = 14.4 times
𝑃 75,000

360 𝑑𝑎𝑦𝑠 360 𝑑𝑎𝑦𝑠

Average collection period = = = 25 days
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 14.4

If the ratio of receivables to credit sales fluctuates significantly, the finance manager should look into its possible
causes and their effects on the results of operations. The turnover rate of 14.4x means that on the average,
receivables of P75,000 are collected 14.4 times in one year (because when using average receivables, it is
assumed that net credit sales are equal to collections). Thus, on the average, receivables are collected after 25
days. If it is the practice of the company to grant credit only for 20 days, it may be concluded that receivables
are 5 days overdue on the average.

Relaxing Terms of Sales

One way of relaxing credit is by prolonging the terms of sales. It is an alternative that management may consider
in order to increase sales volume, However, this is generally expected to bring about an increase in receivables
and inventory and variable costs and expenses. Should there be a need to increase property and equipment,
there must also be an increase in fixed costs and expenses.

In analyzing a proposal to prolong terms of sales, incremental income arising therefrom must be compared with
the incremental capital requirement considering the actual and opportunity costs of money.

Example: The following data are given on current operations of XYZ Corp.:

Sales volume (units) 108,000

Unit selling price P 10
Unit variable costs and expenses 4
Fixed costs and expenses per annum 320,000
Gross profit rate 40%
Terms of sales 25 days charge
No. of days' sales in inventory 15 days
Minimum desired rate of return 30%

A proposal has been presented to the effect that the terms of sales be prolonged to 30 days at the current selling
price in order to increase sales volume by 25%. There are objections to the said proposal because of possible loss
from bad debts estimated at 2% of increased sales and an expected increase in inventory requirement despite
the plan to maintain it at its current level, that is, equal to 25 days' sales.

The incremental income from the proposal is computed as follows:

Increase in sales (25% x 108,000 units x P 10) P 270,000

Increase in variable costs and expenses (25% x 108,000 units x P4) (108,000)
Bad debts (2% x (108,000 units x 125% x P 10)) (27,000)
Incremental income from proposal P 135,000

The proposal must be expected to increase working capital requirement computed as follows:
Increase in working capital requirement:
Increase in receivables
Per proposal: (P 1,350,000*/360 days) x 30 days = P 112,500
At present: (P 1080000/360 days) x 25 days = 75,000 P 37,500

Increase in inventory
Per proposal: ((P 1,350,000 x 60%)/360) x 25 days = P 56,250
At present: ((P 1,080,000 x 60%)/360) x 25 days = 45,000 11,250
Increase in working capital requirement P 48,750
*P 1,080,000 x 125%

With minimum desired rate of return at 30%, the incremental working capital requirement must bring in
incremental income of at least 14,625. The incremental income of P135,000 far exceeds this amount so that based
on the minimum desired rate of return criterion, the proposal must be approved.

In the foregoing illustration, nothing was mentioned about expected changes in minimum cash balance and
payables. Changes in these items would also affect analysis of proposals that affect working capital requirement.

Inventory Management

Inventory management refers to the formulation and administration of plans and policies to efficiently and
satisfactorily meet manufacturing and merchandising requirements and minimize costs relative to inventories.

Objective of Inventory Management

"The primary aim of inventory management is to maintain inventory at a level that best reconciles turnover and
profit considerations and consequently, maximizes return on investment.

The size of inventory is related to the size and frequency of purchase orders. When purchases are made less often
but in bigger volumes, inventory must be at a higher level so that less ordering costs but more handling costs are
incurred. When purchases are made more often and in smaller volumes, inventory must be at a lower level
thereby giving rise to more ordering costs but less handling costs. This is not mentioning the greater possibility of
stockouts and the corresponding stockout costs.

Aids in Analyzing Inventory

The following ratios are used in determining adequacy of inventory level:

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
a). Ratio of average inventory to sales =
𝑆𝑎𝑙𝑒𝑠

𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑

b). Inventory turnover =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑂𝑛𝑒 𝑌𝑒𝑎𝑟

c). Number of days' sales in inventory =
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

Example: DEF Corp. provides you with the following data:

Sales P 1,080,000
Cost of sales 648,000
Inventory, Jan. 1 38,000
Inventory, Dec. 31. 34,000

(𝑃 38,000+𝑃 34,000)/2
Ratio of average inventory to sales = = 3.3%
𝑃 1,080,000

𝑃 648,000
Inventory turnover = = 18 times
(𝑃 38,000+𝑃 34,000)/2

No. of days' sales in inventory = 360 days/18 times = 20 days

Per foregoing computations, inventory is 3.3% of sales, inventory turnover is 18x in one year and that it is equal to
20 days' sales. These ratios may be compared with chosen standards to determine over- or underinvestment in
inventory.
Inventory Level

The different managers in an organization have different viewpoints about inventory levels. A production
manager would prefer high inventory level for raw materials to avoid delays in production and bigger volume for
production runs to minimize production costs. A marketing manager would prefer large inventories to be able to
fill customers' orders promptly. On the other hand, a financial manager would like to keep inventory levels at a
minimum to reduce working capital tied up in inventory and the consequent handling costs and opportunity cost
of capital.

Inventory Control Systems

To meet production and/or sales requirements and at the same time keep investment in inventory to a minimum,
various systems and technique have been developed. Among these are the following:

a) Two-bin System. For each inventory item, two bins or containers are provided. One contains enough
stocks to cover requirements from the time an order is placed until the goods are received. The other bin
contains the expected requirements before orders are placed. As soon as the second container
becomes empty, the order for replenishment is placed.

b) Min-max System. Minimum and maximum inventory levels are established for each item. in inventory. The
minimum balance is expected to take care of the requirement for the period from the time an order is
placed up to the receipt of the goods.

c) ABC System (or Usage-Value Analysis Technique). Items in the inventory are classified into three classes,
A, B, and C, based on their usage value. Varying degrees of control are adopted with the strictest control
adopted for the Class A items.

d) Order cycling System. Inventory items are reviewed one at a time at periodic intervals to determine when
replacement should be made.

e) Budgetary Control System. Actual usage and inventory levels are monitored to ensure their conformity
with what have been budgeted.

f) Explosion Method. Inventory requirements are determined in advance based on planned production
volume and purchases are made in advance to meet production schedules.

g) Perpetual Inventory Control System. Perpetual records are maintained to facilitate inventory
management. Information on these records includes pending orders, reserved quantities, minimum and
maximum balances.

h) Turnover Rates. This system is adopted to ensure that actual flow and levels of inventory are kept within
limits of the predetermined standard turnover rates.

i) Statistical Inventory Control System. Statistical or mathematical mod els such as economic order quantity
and reorder point are employed in in inventory management.

Relevant Costs in Inventory Management

The relevant costs in inventory management are those that vary with inventory levels, frequency of orders and
order sizes. They are the ordering cost, carrying costs and stockout costs.

A high inventory level implies that orders are placed less often but in bigger quantities so that more carrying costs
are incurred with ordering and stockout costs minimized. On the other hand, when inventory is maintained at a
lower level, the implication is that orders are in smaller quantity so that they are placed more often thereby
bringing about more ordering and stockout costs and less of carrying costs.

Ordering costs are those incurred everytime an order is placed. Examples are clerical costs involved in the
preparation of purchase requisitions and purchase orders, in following up on orders and in receiving the goods,
cost of man hours expended on canvassing of prices, and differential freight-in costs arising from small and
frequent orders. For manufacturing firms, set-up costs are incurred instead of ordering costs and these are in the
form of all costs incurred in preparing machinery and equipment everytime there is a change in the products to
be processed. Plates and/or dies have to be changed and adjustments to machinery and equipment have to
be made.
Carrying costs are the costs of maintaining inventories. Examples are warehouse ing and storage costs, property
taxes, insurance on inventory, cost of capital tied up in inventory (interest expense and opportunity costs), losses
from obsolescence and spoilage, clerical cost of keeping inventory records, and handling costs.

Stockout costs refers to the total effect of a company's failure to service customers or fill their orders or conduct
operations smoothly arising from stock outs (or non-availability of raw materials, supplies and merchandise).
Examples are cost of idle time and overtime and imputed value on lost customers' goodwill and non-realization
of contribution margin on lost sales.

Economic Order Quantity

With the trade-off between ordering costs and carrying costs, an organization must make its purchase orders
based on the point at which these two kinds of costs can be minimized. The order size at this point is called the
economic order quantity (or the quantity to order in order to minimize relevant costs). Economic order quantity,
therefore, refers to the order size that will minimize the total of relevant costs, namely, ordering and carrying costs.
For a manufacturing firm, it is called the optimum production run (or economic lot size) and the relevant costs
are set-up costs and carrying costs. The formulae are as follows:

𝟐 𝒙 𝑨𝒏𝒏𝒖𝒂𝒍 𝑼𝒔𝒂𝒈𝒆 𝒙 𝑶𝒓𝒅𝒆𝒓𝒊𝒏𝒈 𝑪𝒐𝒔𝒕 𝒑𝒆𝒓 𝑶𝒓𝒅𝒆𝒓

Economic order quantity = √
𝑪𝒂𝒓𝒓𝒚𝒊𝒏𝒈 𝑪𝒐𝒔𝒕 𝒑𝒆𝒓 𝑼𝒏𝒊𝒕

𝟐 𝒙 𝑨𝒏𝒏𝒖𝒂𝒍 𝑼𝒔𝒂𝒈𝒆 𝒙 𝑺𝒆𝒕−𝒖𝒑 𝑪𝒐𝒔𝒕 𝒑𝒆𝒓 𝑶𝒓𝒅𝒆𝒓

Optimum production run = √
𝑪𝒂𝒓𝒓𝒚𝒊𝒏𝒈 𝑪𝒐𝒔𝒕 𝒑𝒆𝒓 𝑼𝒏𝒊𝒕

Example: Annual Usage is 10,600 units, ordering cost per order is P15.90. Carrying cost is 10% and unit cost is P 3.
The economic order quantity and optimum number of orders are computed as follows:

2 𝑥 10,600 𝑥 𝑃 15.90
Economic Order Quantity = √ = 1,060
10% 𝑥 𝑃 3

𝐴𝑛𝑛𝑢𝑎𝑙 𝑈𝑠𝑎𝑔𝑒 10,600

Optimum No. of Orders = = = 10
𝐸𝑂𝑄 1,060

The total relevant costs based on 12, 10 and 8 orders are computed as follows:
Number of orders 12 10 8
Order size (annual usage/no. of orders) 883 1,060 1,325
Average inventory (order size/2) 442 530 662
Ordering cost (No. of orders x P15.90) 191 159 127
Carrying cost (Ave. Invty. X P 30) 133 159 199
Total relevant cost 324 318 326

Lead Time, Lead Time Usage, Safety Stock, and Reorder Point

Lead time refers to the length of period it takes to order and receive goods. It is also called the reorder period.

Lead time usage refers to the normal usage during lead time.

Safety stock refers to the additional quantity of goods in stock at the time an order is placed to minimize the
probability of stockouts.

Reorder point is the inventory level at the time an order is placed. It is equal to lead time usage plus safety stock.

Example: Normal usage for Material X Is 5 units per day. Maximum usage is 8 units per day. It takes one week to
order and receive the material,

Lead time is 7 days, Lead time usage is 35 units (or 5 units x 7 days). Based on the maximum usage of 8 units per
day, safety stock would be 21 units (that is, the additional 3 units per day x 7 days). Reorder point is 56 units, which
is equal to the lead time usage of 35 units plus safety stock of 21 units (or 8 units per day x 7 days).

Determining Safety Stock Level. The level of safety stock may be computed based on maximum usage (as
observed in the above-given example) and on frequency distribution for usages. The relevant costs are stockout
cost and safety stock carrying cost.
Frequency Distribution Method of Determining Safety Stock Level

Under this method, the safety stock level is determined based on desired safety percentage from stockouts
considering the frequency distribution for usages during lead time.

Example: For Material X, normal usage during lead time of 7 days is 35 units. However, usage during lead time
varies as follows:

Usages during lead time Frequency

10 8
25 25
35 40
45 20
56 ___7__
100

The different usages are assumed to be possible reorder points. The percentages of safety from, and risk of
stockouts are as follows:
Usages during lead time Frequency Safety % Risk %
10 8 8% 92
25 25 33 67
35 40 73 27
45 20 93 7
56 __7__ 100 0
100

The safety percentages are arrived at by adding the frequencies downward. If reorder point is 25 units and usage
happens to be 10 or 25 units, the firm would not experience stockouts Thus, the safety percentage for 25 units is
the cumulative frequency for 10 and 25 units. For 35 units, it must be the total of the frequencies for 10, 25 and 35
units.

The risk percentage is the difference between 100% minus the risk percentage (or I safety %) It is also the total of
the frequencies for usages higher than the ROP being considered It may also be computed by starting from the
highest usage (or moving upward) Thus, for ROP-56 units, the risk percentage must be zero because there is no
usage higher than this number For ROP-45 units, the risk percentage is the frequency (or probability) for 56 units.
For 35 units, it is the total of the frequencies for higher usages (or 7% + 20%)

Optimal Safety Stock

Optimal safety stock is the quantity of safety stock that is expected to minimize the total of the relevant costs (or
the total of stock out cast and safety stock carrying cost). The following formulae are used for these items

Stockout cost = Risk % x Maximum No. of stockouts x Stock Out cost per occurrence.
Safety stock carrying cost = Safety stock x Carrying cost per unit

Example: Use the data given in the preceding example. Assume that for Material X, carrying cost per unit is P6 stockout cost
per occurrence is P50, annual usage is 1,600 and EOQ is 200 units. Thus, the optimum number of orders is eight (8). This is used
as the maximum number of stockouts. Thus, if there is a 7% risk (or probability for stock us to occur), the number of stockouts
must be .56 (or 7% x 8 orders). Stockout cost is therefore equal to 56 x P50 or P28. With 7% risk from stockouts, reorder point
must be 45 units with safety stock equal to 10 units (that is, 45 minus normal usage during lead time of 35 units). Safety stock
carrying cost must be equal to P60 (or 10 units of safety stock x P6 carrying cost per unit)

The frequency distribution method may be used in estimating the optimal safety stock. The different usages during lead time
are assumed to be the reorder point (ROP) for which the total relevant costs are computed. Based on the example given in
the preceding section, the total relevant costs at the given reorder points are arrived at as shown below.
Reorder Normal Usage Stock Safety Stockout Cost Safety Stock Total Relevant
Point Carrying Cost Cost
10 35 - 92% x 8 x P 50 = P 368 0xP6= P0 P 368
25 35 - 67% x 8 x P 50 = 268 0xP6= 0 268
35 35 - 27% x 8 x P 50 = 108 0xP6= 0 108
45 35 10 7% x 8 x P 50 = 28 10 x P 6 = 60 88
56 35 21 0% x 8 x P 50 = 0 21 x P 6 = 126 126

Inasmuch as total relevant cost is minimized at ROP-45, the optimal safety stock must be 10 units (that is. 45 units minus normal
usage during lead time of 35 units). This means that when the stock level goes down to 45 units, the reorder maybe done for
200 units, the EOQ.