RELATIONSHIP BETWEEN SA AND SL

OPTIMAL LEVELS
FINANCING WC AT LEAST COST

BUSINESS FINANCE
Session 6: Financial Planning - Working Capital Management
 Why do Firms Hold Cash?

SPECULATION PRECAUTION TRANSACTION

 WHAT NEW PRODUCTS ARE HOT?

HOW TO OBTAIN IT AT THE LOWEST COST?

DELIVERING IN A TIMELY MANNER.

 OBJECTIVES
At the end of the session, the learners are expected to be able to:
• Define Working Capital,
• Enumerate and differentiate the kinds of Working Capital Policy,
• Compute for the Cash Conversion Cycle,
• And Explain tools in managing cash, receivables, and inventory.
• Solve Basic to moderate probleams on Working Capital Management
Financial Planning Concepts
Financial planning is the most important concepts in various areas of
finance. It is applied in both public finance and business finance. All
entities - whether a business for profit or a non- profit organization-
undertake financial planning as an inherent activity for their existence
and survival.

Financial Control is the phase in which financial plans are

implemented; the feedback and adjustment process required to ensure
adherence to plans and modification of plans because of unforeseen
changes.

Financial Planning Tools are techniques used to forecast certain

variables.
COMMON FINANCIAL PLANNING TOOLS
• SHORT TERM PLANNING
(1) Working Capital Management
(2) Master Budgeting ALLOCATION OF RESOURCES

• LONG-TERM PLANNING
(1) Forecasting of Financial Statement, and PEP

(2) Additional Fund Needed (AFN) EXTERNAL FUNDS

 WORKING CAPITAL MANAGEMENT
Working Capital in some books are defined as current asset. But most books define
working Capital as the difference between current assets and current liabilities. For
purposes of consistency, we will use the latter definition.

Working Capital = Current Assets - Current Liabilities

Current Assets are cash, other assets convertible into cash, and assets utilizable
within one accounting period. Some assets, although are not utilizable in one year,
are still considered as current (e.g. Prepaid Rent).

Current Liabilities are short-term debts or debts payable within one year or a
normal business cycle. They are typically free in such a way that it does not bear
interest.

How a firm manages its short-term assets and short-term liabilities is its working
capital policy.
MMK

The term working Capital originated with the old

Yankee Peddler who would load up his wagon and go
off to peddle his wares. The merchandise was called
“working capital” because it was what he actually
sold, or “turned over”, to produce his profits. He
generally owned the horse and the wagon, but he
bought his merchandise on credit or with money
borrowed from the bank.
It is important to understand working capital
management to ensure the continuance of the
operations. Working Capital Policy is affected by the
firm’s operating cycle and the fact that cash receipts
and disbursements are rarely synchronized.
CURRENT ASSET INVESTMENT POLICIES

LARGE AMOUNT
RELAXED AND RESTRICTED
CONSTRAINED
 CURRENT ASSET INVESTMENT POLICIES
Relaxed Current Asset Investment Policy. The steepest which indicates
that the firm holds a great deal of cash, marketable securities,
receivables, and inventories relative to its sales. When receivables are
high, the firm has a liberal credit policy, which results in a high level of
accounts receivable
Effect on ROE (using DuPont equation):

Low level of Lower risk of

High Level Low
=> total asset => => experiencing
of Assets ROE
turnover shortage
 CURRENT ASSET INVESTMENT POLICIES
The Restricted Current Asset (or tight ot “lean-and-mean”) investment
policy, holdings of current assets are minimized.

Effect on ROE (using DuPont equation):

High level of Higher risk of

Low Level of High
=> total asset => => experiencing
Assets ROE
turnover shortage

Higher risk of shortage exposes the firm to work stoppages, unhappy

customers, and serious long-run problems.
CURRENT ASSET
INVESTMENT POLICIES

A Moderate Current Asset

investment policy lies
between the two
extremes.
CASH CONVERSION CYCLE (CCC)
All firms follow a “working capital cycle” in which
they purchase or produce inventory, hold it for a
time, and then sell it and receive cash. This process is
known as Cash Conversion Cycle (CCC).

Cash Conversion Cycle- the length of time where

funds are tied up in working capital or the length of
time between paying for working capital and
collecting cash from the sale of the working capital.
 CURRENT ASSET INVESTMENT POLICIES

Computation of cash collection cycle:

Cash
Inventory Average Payable
Conver
Conversion
Period
+ Collection
Period
- deferral
Period
= sion
Cycle
Number of Days Number of days on a Number of days
in a Year year in a year
Accounts
Inventory Accounts Receivable
Payable
Turnover turnover
Turnover
 CURRENT ASSET INVESTMENT POLICIES
The factors composing the Cash Conversion Cycle:

Inventory Conversion Period is the age of inventories before its sale. The other way of
computing it is through the formula below:
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐶𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑 = 𝑥 365
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑

Average Collection Period is the age of Trade Receivables before it is collected. This is
also known as Day Sales Outstanding (DSO). The other way of computing this is through
the formula below:
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑 = 𝑥 365
𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠
 CURRENT ASSET INVESTMENT POLICIES
Payable Deferral Period is the age of short-term liabilities
before it is paid. Accounts Payable Turnover is computed as
follows:

𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒
Payable Deferral Period may also be computed using the formula
below:
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒
𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝐷𝑒𝑓𝑒𝑟𝑟𝑎𝑙 𝑃𝑒𝑟𝑖𝑜𝑑 = 𝑥365
𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
Problem 1: Basic Problem of CCC
If the average age of accounts payable is 15
days, the average age of accounts receivables
is 60 days, and the average age of inventory is
10 days, what is the number of days in the
operating cash conversion cycle?
Problem 2: Calculating the CCC from Financial Statements
Desai Inc. has the following data, in thousands. Assuming a 360-day year, what
is the firm's cash conversion cycle?
Annual Sales (80% on credit) P56,250
Annual COGS P30,000
Purchases (75% on account) P29,000
Inventory, Beginning P5,500
Accounts Receivable, Beginning P2,500
Accounts Receivable, End P2,000
Accounts Payable, Beginning P1,850
Accounts Payable, End P2,500
(1) What is the Inventory Turnover and the Inventory Conversion Period?
(2) What is the Receivables turnover and the Average Collection Period?
(3) What is the Accounts Payable Turnover and the Payable deferral period?
(4) What is the Cash Conversion Cycle?
CURRENT ASSET INVESTMENT POLICIES
Alternative Formulas:

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐶𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝐷𝑎𝑖𝑙𝑦 𝐶𝑂𝐺𝑆

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝐷𝑎𝑖𝑙𝑦 𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒

𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝐷𝑒𝑓𝑒𝑟𝑟𝑎𝑙 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝐷𝑎𝑖𝑙𝑦 𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
Problem3: Calculating CCC from Financial
Statements using the alternative formula
Samaritan Supplies Inc. has P5,000,000 average
inventory and P2,000,000 in average accounts
receivable. Its average daily credit sales are
P100,000 and a gross profit margin of 30%. The
company has P1.5 million in average accounts
payable. Its average daily purchases are P50,000.
What is the length of the company’s cash
conversion period?
 MANIPULATING THE CASH CONVERSION CYCLE:
Businesses quickly learn that they can manipulate the cash conversion
cycle to their benefit. What you want to do is shorten the cash
conversion cycle so that your money is not tied up in the production
process any longer than necessary. You can shorten the cash conversion
cycle by reducing the inventory conversion period and the receivables
collection period. How do you do that?

Try to speed up the production process by processing and selling goods

more quickly and speed up the collection of receivables. Regarding
payables, slow down your payments but don't incur late charges.
Shortening the cash conversion cycle will free up more working capital
for your business.
 MANAGEMENT OF CASH
Cash flow can be managed by:
• Preparing Cash Budget
• Preparing the cash break-even chart
• Determine the optimal cash balance using the Baumol cash
management model.
 Cash Break-Even Chart

(1) It shows the cash break-even point- the amount of sales in pesos or
the number of units to be sold so that the total inflows equal the total
cash outflows.
(2) It also shows the amount of cash deficiency when sales is below the
cash break-even point, or the amount of excess cash when sales is
above the cash break-even point.

Fixed Costs – Non Cash Expenses

Cash Break-even =
Selling Price Per unit – Variable Costs
Problem 4: Cash Break-even
Suppose a company sells products for $25
each and has variable production costs of $15
to produce each unit. In addition, the
company has fixed costs of $50,000, which
includes $2,000 depreciation. What is the
cash break-even?
 Baumol Cash Management Model
EOQ type model which can be used to determine the optimal cash balance where the costs of maintaining and
obtaining cash are at the minimum.
Such costs are the:
1. Cost of securities transactions or cost of obtaining a loan.
2. Opportunity cost of holding cash which includes return forgone by not investing in marketable securities or the
cost of borrowing cash. (interest expense)
2𝑇𝐷
𝑂𝐶 =
𝑖
Where:
OC = Optimal Cash Balance
T = transaction Cost which is a fixed amount per transaction. It includes the cost of securities transactions or cost of
obtaining a loan.
D = total demand for cash over a period of a time.
i = interest rate on marketable securities or the cost of borrowing cash.

If asked for the average cash balance under this model, it is just equal to the Optimal Cash divided by 2.
Problem 5: Baumol Cash Management Model
Ben Corporation uses Baumol Cash Management Model to
determine its optimal cash balance.
For the coming year, the expected cash disbursements total
P432,000. The interest rate on marketable securities is 5% per
annum. The fixed cost of selling marketable securities is P8 per
transaction.
1) Using the Baumol Cash Management Model, What is the
company’s optimal Cash Balance?
2) Using the Baumol Cash Management Model, what is the
average cash balance?
 CASH BUDGET
A cash budget is a schedule showing cash receipts, cash disbursements,
and cash balances for a firm over a specified time period;

The Target ( minimum) cash balance is the minimum cash balance that
a firm desires to maintain while conducting business;

Disbursements and receipts method ( Scheduling) is where the Net

Cash Flow is determined by estimating the cash disbursements and the
cash receipts expected to be generated each period;
 CASH BUDGET
A Cash Budget:
Cash, Beginning xx
Forecasts cash inflows, outflows, Add: Receipts xx
and ending cash balances.
Total Cash available, before
Used to plan loans needed or current financing xx
funds available to invest. Less: Disbursements xx
Excess (deficiency) of cash xx
available over disbursements
Can be daily, weekly, or monthly,
Financing xx
forecasts (Monthly for annual
planning and daily for actual cash Cash Balance, Ending xx
management)
Problem 6 Basic Cash Budget (Cash Inflow)
A business just opened and had the sales for the first quarter:
January February March
P1,000,000 P2,000,000 P1,500,000
The sales is 30% cash Sales

The pattern of the collection of receivables is:

50% on the month of sales
30% on the subsequent month
20% on the month after the next

1) How much is the Cash collection on January? On

February? March?
2) How much is the balance uncollected as of March?
Problem 7 Basic Cash Budget (Cash Outflow)
The other costs incurred during January and February:
Jan February
RM Purchases P1,000,000 P2,000,000
DL Costs P1,000,000 P1,200,000
MOH Cost P700,000 P840,000
Selling and Admin P300,000 P400,000

The purchases is 50% on Credit

The pattern of the payment of Accounts payable is:
60% on the month of sales
40% on the subsequent month

The other manufacturing costs are paid 70% in the current month and 30% in the
subsequent month.
The Selling and Administrative Costs are all paid in the same month as they are
incurred.

How much is the cash disbursements for the month of January? February?
 Management of Accounts Receivable
This is 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.

Man objective: to have both the optimal amount of accounts receivables

outstanding and the optimal amount of bad debts.

Trade off between (1) the benefits of more credit sales; and (2) the costs of
accounts receivable such as collection, interest, and bad debts.
 Management of Accounts Receivable
Factors in determining accounts receivable policy
(1) Credit Standards- The criteria that determine which customers will be
granted interest, and bad debts cost.

Factors in establishing credit Standards (The 4 Cs of Credit)

a. Character (customer’s willingness to pay)
b. Capacity (Customer’s ability to pay)
c. Capital (Customer’s Financial sources such as collateral)
d. Conditions (current economic or business conditions)
(2) Credit terms- define the credit period and any discount offered for early
payment.
 Management of Accounts Receivable
Ways of accelerating collection of receivables
1. Shorten credit terms.
2. Offer special discounts to customers who pay their accounts within a specified
period.
3. Speed up the mailing time of payments from customers to the firm.
4. Minimize float, that is, reduce the time during which payment received by the firm
remains uncollected
 Management of Accounts Receivable
Aids in Analyzing Receivables
1. Ratio of receivables to net credit sales.
2. Receivable turnover
3. Average collection period
4. Aging of Accounts receivables
Ratio of Receivables to Net Credit Sales
Ratio of Receivables Average Accounts Receivable
=
to Net Credit Sales Net CREDIT Sales

Receivable Turnover
Receivable Turnover Net Credit Sales
=
(x) Average Accounts Receivable

Average Collection Period

Receivable turnover
Average Collection
= Number of days in a year
Period (days)
(360or 365)
Problem 8 on Ratio of Accounts Receivables
Net Sales P1,500,000
Cash Sales ratio 20%
Accounts Receivable, beg P100,000
Collection of ReceivablesP300,000
1) What is the Net Credit Sales?
2) What is the Average Accounts Receivable?
3) What is the ratio of Receivables to Net Credit Sales?
4) What is the Receivable Turnover?
5) What is the Average collection period (use 360 days)?
 Management of Accounts Receivable
Aging of Accounts Receivables
Stratify the receivables based on age (age bracket eg. 31 days to 60 days). Through
this, you will know which receivables demand attention. Also, this is mostly used in
determining the allowance for doubtful accounts. Allowance for doubtful accounts
is Assign rate of uncollectible per bracket.

Example: How much should be the allowance for doubtful accounts on December
31, 2018.
Customer name Date of Invoice Amount
Rate of uncollectible: Rain Co. September 1, 2018 P500,000
0-30 days 0% Karl Co. December 5, 2018 P200,000
DaHegs Co. November 21, 2018 P300,000
31-60 days 5%
Basty Co. November 5, 2018 P150,000
61-90 days 10% Aimee Co. October 1, 2018 P200,000
91-120 Days 20% Eric Co. October 18, 2018 P350,000
 Management of Accounts Receivable
Aging of Accounts Receivables
Rate Uncollectable
Answer:
0-30 days
Karl Co. P200,000 0% 0
31-60 days
Basty Co. P150,000
DaHegs Co. P300,000
TOTAL P450,000 5% P22,500
61-90 Days
Aimee Co. P200,000
Eric Co. P350,000
TOTAL P550,000 10% P55,000
91-120 days
Rain Co. P500,000 20% P100,000
Allowance for doubtful accounts P177,500
 Management of Inventory
A basic inventory model exists to assist in two inventory questions:
1. How many units should be ordered?
2. When should the units be ordered?

Other than the Purchase cost of the inventories, additional costs (Ordering Cost and Carrying Cost) are
incurred before its sale.

Ordering cost is the cost of placing an order, which includes shipping, brokerage, and processing costs. These
costs decline (are lower per unit) as the inventory increases.
𝐷
𝑂𝐶 = 𝑥𝐹
𝑄
Where:
OC= Ordering Cost
D= Annual Demand or Sales
Q= Quantity of inventory per order
F= Cost of Placing an order
 Management of Inventory
Example: Computation of Ordering Cost
If annual Sales are 10,000 units and the size of each inventory order is 1,000 units, and the cost of
placing an order is P50. How much is the total ordering cost?
10,000
𝑂𝐶 = 𝑥 50 = 𝑷𝟓𝟎𝟎
1,000

Note: D/Q is the number of times that the company ordered inventories. Multiplying it with the
Ordering Cost per order will give a product equal to the total ordering cost.

The second set of cost is carrying cost which include insurance, storage, and the cost of financing
the inventory.
𝑄
𝐶𝐶 = 𝑥 𝐶
2
Where:
Q= Quantity of inventory per order
C= Carrying Cost per unit
 Management of Inventory
Example: Computation of Ordering Cost
If annual Sales are 10,000 units and the size of each inventory order is 1,000 units, and the cost of
placing an order is P50. How much is the total ordering cost?
10,000
𝑂𝐶 = 𝑥 50 = 𝑷𝟓𝟎𝟎
1,000

Note: D/Q is the number of times that the company ordered inventories. Multiplying it with the
Ordering Cost per order will give a product equal to the total ordering cost.

The second set of cost is carrying cost which include insurance, storage, and the cost of financing
the inventory.
𝑄
𝐶𝐶 = 𝑥 𝐶
2
Where:
Q= Quantity of inventory per order
C= Carrying Cost per unit
 Management of Inventory
Example: Computation of Carrying Cost
• Continuing the previous example, if the firm orders 1,000 units with a per-
unit carrying cost is P10. What is the carrying Cost?
 Management of Inventory
Example: Computation of Carrying Cost
Continuing the previous example, if the firm orders 1,000 units with a per-unit carrying cost is P10.
What is the carrying Cost?

1,000
𝐶𝐶 = 𝑥 10 = 𝑷𝟓, 𝟎𝟎𝟎
2
Note: Q/2 is the average inventory carried by the business. Beginning inventory being equal to the
inventory ordered, and the ending inventory being zero.

The Total Cost of the inventory will be computed as follows:

TC= OC + CC
TC= P500 + P5,000
TC= P5,500
 Management of Inventory
Economic Order Quantity is the quantity to be ordered, which minimizes the sum
of the ordering and the carrying costs. The total inventory cost function includes:
Formula:

2𝐹𝐷
𝐸𝑂𝑄 =
𝐶
Where:
F = cost of placing one order (or ordering cost)
D = annual demand in units
C= annual costs of carrying one unit in inventory for one year.
 Management of Inventory
Problem 10: Computation of EOQ
A firm uses 10,000 of inventories each year which costs
P100 per unit, and the percent cost of carry is 10%. The cost
of an order is P50.
(1) How many units should be ordered?
(2) What is the total Cost at EOQ?
(3) How many times will the business order from the
supplier?
(4) What is the duration of the EOQ?