Ateneo de Zamboanga University

School of Management and Accountancy

Accountancy Department

LEARNING PACKET
FINMAN2 –FINANCIAL MANAGEMENT
Session 1, First Semester, SY 2020-21

LEARNING PACKET NO. 2 DATE: August 24 – September 4,

TOPIC: WORKING CAPITAL MANAGEMENT AND FINANCING 2020
Week No.: 3-4
Session: 1

INTENDED LEARNING OUTCOME:

At the end of this learning units, the learners shall:

1. Discuss fundamental decision issues in the management of working capital, determining trade-
off between decisions, and how to determine optimal level and combination of current assets
and short-term credits using different approaches.
2. Develop strategies on how to effectively manage cash and marketable securities using different
cash and marketable securities management approaches and analyze its impact to the
company’s liquidity and profitability position.
3. Develop strategies on how to effectively manage inventories using different inventory
management approaches and analyze its impact to the company’s liquidity and profitability
position.
4. Explain how the level of investment in accounts receivable is affected by the firm’s credit
policies.
5. Critically evaluate proposed changes in credit policy, including changes in credit standards,
credit period, and cash discount.
6. Evaluate various sources of short-term credit and develop decisions by analyzing the effect of
each credit source type to the overall profitability and risk of the company.

I. CONCEPT NOTES
Fundamental Decision Issue
 Optimal Level of Investment
 Appropriate Mix of Financing

Trade-off between Profitability and Risk

• Profitability-relationship between revenues and costs
• Risk-probability that a firm is unable to pay its bills when it comes due

Current Assets versus Fixed Assets

 Assessed using:
• Nature of business
• Profitability-risk trade off

Temporary versus Permanent Current Assets

 Based on the seasonality

Investment Policies:
 Relaxed (relatively large amount of current assets)
 Restricted (holdings for current assets are constrained)
 Moderate (between relaxed and restricted policies)

Level of Financing
1. Conservative
 Fixed assets, Permanent Current Assets, and some of the temporary current assets are
being financed by long-term capital
 Excess temporary assets are obtained by short-term financing
 Lesser risk, more liquid, but less profitable
2. Aggressive
 Fixed assets and only some of the permanent current assets are being financed by long-
term capital
 All temporary current assets and excess permanent current assets are obtained by short-
term capital
 More profitable, but less liquid and more risky

3. Maturity Matching
 Fixed Assets and all of the permanent current assets are being financed by long-term capital
 All temporary current assets are being financed by short-term capital
 Balanced between profitability and risk and liquidity

Working Capital
• Gross working capital- essentially your current assets
• Net working capital – Excess of current assets over current liabilities

Working Capital Management

-process of administration of current assets and financing using current liabilities to achieve balance
between profitability and risk that contributes positively to the firm’s value

Key concept of Operating Cycle and Cash Conversion Cycle

Operating Cycle- the time from the beginning of the production process to collection of cash from the
sale of finished product

OC= Average Age of Inventory + Average Collection Period

Cash Conversion Cycle- length of time required for a company to convert cash invested in its operations
to cash received as a result of its operations

CCC= OC – Average Payment Period; or

CCC= Ave Age of Inventory + Ave Collection Period – Ave Payment Period

Note:
* All balance sheet accounts should be on an average basis, unless indeterminable and in that case, the
ending balance will be used.

Cash and Marketable Securities Management

Cash Management
• Management of cash inflows and outflows, as well as the stock of cash on hand
• Monitoring our cash needs through cash forecasting (analyzing how much and when cash is
needed and how much and when to generate it)

Reasons for holding Cash:

1. Transaction motive (cash needed to meet the day-to-day transactions)
2. Precautionary motive (for uncertainties in the day-to-day transactions)
3. Speculative motive (amount of cash or securities that can be easily turned into cash above what
is needed for transactions and precaution, takes advantage of investment opportunities on short
notice and to meet extraordinary demands for cash)
4. Compensating balance (cash balance required by banks in exchange for its services)

Goal in cash management:

 Get cash from those who owe it to you as soon as possible and pay it out to those you
owe as late as possible.
 Have enough cash on hand for immediate needs, but not too much as to waste any
opportunity to earn from securities

Strategy
 Speeding up cash receipts
  Slowing down cash disbursements
 Management of costs associated with cash

Cash Management- Speeding Cash Receipts

• Addressing Collection Float
 Collection Float-The total time that it takes from the moment a customer mails a check
until its availability as cash to the receiving firm; its is composed of the following:
 Mail float- the time that the check is in the mail and not yet received by the firm
 Processing float- the time that it takes to process the check for validity until its
delivery to the firm’s bank
 Availability/clearing float- the time it takes to deposit the amount of check to the
designated account

Processing float and availability float total the deposit float, which is the time it takes for the bank to
deposit the account to the receiving firm
 Lockbox System- system where customers of the firm can send their payments directly to
a post office controlled by the firm’s bank
 Addresses two floats: mail float and processing float
 Will be accepted if the benefit from the lockbox system (collection per day times
number of reduction of days in float times opportunity cost of funds per year)
outweighs the cost of the lockbox system (fees charged by the bank
 Some drawbacks include:
 Recording of payments of customers paid takes longer
 Confusion on the part of customers
 Detailed study of strategic locations for the lockboxes

Other ways to speed up collection:

 Selection of banks with unique features
 Clearinghouse is a location where banks meet to exchange checks drawn with
each other
 Check processing within the firm
 Electronic collection and preauthorized debit
 Avoiding the use of paper checks and dealing only with electronic entries
 Some banks allow pre-authorized debit, where customer signs an agreement
where it would allow the firm to automatically debit the customer’s bank account
at a specific date for recurring and fixed payments
 Concentration banking
 Aids the use of lockbox system, where all deposits shall be moved to one central
location that (1) improves the control of inflows and outflows of cash, (2) reduces
idles balances, and (3) allows for more efficient investments

Cash Management- Slowing Disbursements

• Controlled Disbursement
 Minimizes the amount that you hold in bank balances to pay what you owe
 Extreme method is referred to as: Zero-balance account
 Where you keep absolutely nothing in the account and you simply deposit funds
as the check you wrote are presented for payment
• Remote Disbursement
 Paying what is owed with checks drawn on a bank that is not readily accessible to the
payee, increasing the check processing float

Investment in Cash
• Determination of the optimal cash to hold for the day-to-day operations
• Comparison of cost of holding too much cash and cost of converting cash from marketable
securities
 Holding Costs
 Opportunity cost that is lost by not investing cash to marketable securities and
thereby losing some returns (such as interest, dividends, fair value changes)
 Computed by multiplying the opportunity cost per peso of cash to the average
cash balance
 Conversion/Transaction Costs
  Costs of converting marketable securities to cash
 Computed by multiplying the number of transactions to the cost per transaction

Analysis: Converting too much marketable securities into cash decreases holding costs, but increases
transaction costs (because of the increase in number of transactions); however, keeping too much cash
increases opportunity cost even if number of transactions is decreased.

• Models used to determine optimal amount of cash to be held:

 Baumol Model
 Uses the formula:
2(Cost per Transaction)( Annual Demand for Cash)
Optimal Transaction Size (OTS) =
√ Opportunity Cost of holding Cash

 Indicates the maximum level of cash that is controlled before it is invested in

marketable securities
 Assumes that cash is used uniformly throughout the period

 Miller-Orr Model
 Uses the same concepts for Baumol but considers any possible fluctuations in the
cash requirements
 Uses three levels of cash in its management, including:
 Lower Limit (safety stock of cash, determined by management)
 Upper Limit (amount determined mathematically, threshold where any
cash above it can be invested in marketable securities)
 Return Point (amount determined mathematically, where it would be the
target amount if actual cash reached either limits)

Investment in Marketable Securities

• Portfolio of Marketable Securities:
 Ready-cash Segment (for probable deficiencies)
 Controllable cash Segment (for knowable outflows)
 Free cash segment (unassigned purpose)

• Factors in Marketable Securities Selection:

 Safety
 Marketability
 Yield
 Maturity

• Common Marketable Securities

 Treasury Securities
 Repurchase Agreements
 Banker’s Acceptance
 Commercial Papers
 Negotiable Certificates of Deposit

Inventory Management
• Objective is to turn over inventory as quickly as possible without losing sales from stockouts
• Focus in Inventory Management:
 Control of Inventory
 Minimization of Inventory Costs

Control of Inventory
• ABC Inventory System
 Technique that divides all inventory into three groups:
 Group A are items of inventory with the cumulatively largest peso investment
 Group B are items that consists the second largest in peso investment (cheaper
than units in Group A)
 Group C are items that consists of relatively smallest peso investment
 The system dictates
 the level of control and monitoring that should be in place for every group of
 items of inventory
 the type of inventory system that would be appropriate for each group

Minimization of Inventory Costs

 Assumes that the relevant costs can be divided into two:
 Order Costs- these are costs incurred in placing orders, including shipping fees
and other related costs
 Order Cost = (Fixed Cost per order) (Number of orders per period)

 Carrying/Holding Costs- cost of keeping your inventory, including storage,

depreciation, obsolescence and the opportunity costs of tying up funds in the
inventory
 Carrying Cost = (Average Quantity) (Carrying Cost per unit)

• EOQ Model
 Determines the level of inventory that should be ordered in order that total inventory
costs will be at its minimum
 Assumes that:
 Inventory is used uniformly over the period.
 Inventory shortages are not desirable.
 Formula:
2∗(Cost per Order )(Annual Demand for Inventory)
Economic Order Quantity (EOQ) =
√ Carrying Cost per units

• Re-order Point
 Determines the amount of inventory which will be set as threshold for when the
company needs to order
 Reflects the number of days of lead time that the firm needs to place and receive the
order and the firm’s daily usage of inventory plus any safety stock (additional level of
inventory for any uncertainties)
 Minimizes the cost of losing customers because of unavailability of products, and at the
same time, only order when there is already a need to
 Formula:
Reorder point = Days of lead time * Daily usage + Safety Stock

• JIT System
 The goal is to cut down on the firm’s need to keep inventory on hand, coordinating the
supply of raw materials with the production and marketing of the goods
 Idea is to have zero or nearly zero inventory as possible without adversely affecting
production or sales, therefore:
 Minimizing storage costs
 Coordinating with suppliers to also minimize the cost of reordering inventory
 To work, it should apply with the other management principles:
 Total Quality Control
 Employee Involvement

Receivables Management

Objective:
 Collect accounts receivable as quickly as possible without losing sales
 Minimize bad debts
 3 Points of Consideration
 Credit Policies
 Collection Policies
 Credit Monitoring

Credit Policy
• Credit Standards and Selections
 5 C’s of Credit (for large-peso requests)
 Character (record of past obligations)
 Capacity (ability to repay obligation)
  Capital (debt relative to equity)
 Collateral (assets used in securing the debt)
 Conditions (surrounding the transaction)

 Credit Scoring (small-peso requests)

 Application of statistically derived weights to credit applicant’s scores on key
financial and credit characteristics that will be used to decide whether to accept
or reject applications

• Credit Period
 Length of time given to customers to pay their obligations
 Setting up a period depends on the following:
 Nature of business and industry practices
 Riskiness of customers
 Changing credit standards – to improve returns and create value for its owners
 Possible circumstances:
 Lengthening the period
 Shortening the period
 Considerations:
 Change in sales volume
 Change in investment in A/R
 Change in Bad debts Expenses
 Change in cash discounts given

Collection Policy
• Refers to procedures used to collect accounts including the toughness and laxity used in the
process
• Few Strategies include:
 Including Cash Discounts
 Adding or removing cash discounts affect:
 Cost or savings from cash discounts
 Sales volume
 Investment in A/R
 Bad debts
 Reminders (letters, phone calls)
 Collection Agencies
 Legal Actions

Credit Monitoring
1. Using financial ratios
 Overall picture of how fast we collect on accounts receivables
 Includes:
 Number days of credit (AR/Credit Sales per day)
 Indicates the number of days’ worth of sales that have not been paid
 Compared to the net credit period allowed for effectiveness in collection,
but subject to seasonality
2. Aging schedule
 Breakdown of the accounts by how long they are around to help get a more detailed
picture of collection efforts
 Gives you the information as to:
 Estimate of extent of customers’ compliance with credit period
 Estimate of cash inflows in the near future
 Identify accounts that are most overdue

Payables Management

Spontaneous Liabilities
• Financing that arises from normal course of business
 Accounts Payable
 For the raw materials and other inventory acquired from suppliers
 Accruals
  From wages as the required labor increases
 Taxes because of increased earnings
• Considered as unsecured short-term financing
 No collateral required
 Relatively smaller in amount
 Does not need a long time to be paid
 Can be with small stated interest or non-interest bearing

Accounts Payable Management

• Credit Period
 The amount of time given to the firm before the liability becomes due for payment
 To be strategic, the firm must pay on the last day of credit period
 Increases the average payment period
 Any cash that should be tied up can still be used in other circumstances

• Cash Discount
 Discount given by the supplier as inducement to pay on an earlier date
 As financial managers, the decision-making lies on whether to take advantage of the cash
discount or not
 Cost of giving up the cash discount – amount that is additionally paid by the firm
because of not taking advantage of the cash discount
 Approximate Annual Cost = [CD/(100% - CD)] x (360/N)
 Effective Annual Cost = [1 + (CD/100%-CD)]360/N – 1
 where: CD = Cash discount percentage and N = Number of days
payment can be delayed by giving up the cash discount

Accruals
• Wages
 Can be manipulated in some extent (frequency)
 Governed by union regulations (Labor Code)
• Taxes
 The frequency cannot be manipulated by the firm
 However, since anticipated, any expected payments can be invested first in marketable
securities before due for payment

Short Term Financing

• Unsecured Loans
 Bank Loans
 Single Payment Notes
 Line of Credit
 Revolving Credit Agreement
 Commercial Paper (Promissory Notes)
 International Loans
• Secured Loans
 Collateral
 Accounts Receivable-backed Loans
 Inventory-backed Loan

Cost of Borrowing
Total Periodic Payments
Cost of Borrowing=
Total Usable Funds

Periodic Payments:
• + Interest from the stated rate
• + Commitment fees (in case of revolving credit agreement)

Usable Funds:
• Total Amount Loaned
• - Compensating Balance
• - Discounted Interest
• - Other outright payments
 • + Net Interest Income from compensating balance

Sources:
 Fundamentals of Financial Management by Van Horne, 13th edition
 Fundamentals of Financial Management by Brigham and Houston, 11th Edition
 Fundamentals of Corporate Finance by Berk, DeMarzo, and Harford, 4 th Edition

II. CHECKING FOR UNDERSTANDING

OPERATING CYCLE AND CASH CONVERSION CYCLE

Exercise 1. American Products is concerned about managing cash efficiently. On the average, inventories
have an age of 60 days, and accounts receivable are collected in 35 days. Accounts payable are paid
approximately 30 days after they arise. Assume a 365-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.

Exercise 2. The following accounts are picked from the financial statements of a company (Assume a
365-day year):
Credit Sales, P7,000,000
Credit Purchases, P3,000,000
Cost of Goods Sold, P6,000,000
Average Inventory, P360,000
Average Receivables, P700,000
Average Payables, P150,000

1. Compute for the operating cycle.

2. Compute for the cash conversion cycle.

CASH MANAGEMENT
Exercise 3. Third Company uses a continuous billing system that results in average daily receipts of
P500,000. The company's treasurer estimates that a proposed lock-box system could reduce its collection
time by 3 days.
1. How much cash would the lock-box system free up for the company?
2. What is the total amount of benefit derived from the lock-box system if it can earn 5 percent on
available short-term funds?
3. If the lock-box system could be arranged at an annual cost of P50,000, what would be the net gain
or loss from instituting the system?

Exercise 4. The management of Rica Co. anticipates P45,000,000 in cash outlays during the coming year.
The firm has determined that it costs P30 to convert marketable securities to cash and vice versa. The
marketable securities portfolio currently earns a 6% annual rate of return.
 
Required:
1. Suppose the management currently converts marketable securities to cash 2,000 times, how much
is the total costs associated with the current policy?
2. Suppose the management proposes that the company only now converts securities into cash
twice, how much is the total cost of investment in cash?
3. Using the Baumol model, what is the optimal transaction size (OTS)?
4. Compute the total cost of cash at optimal transaction size. Which is the least costly between the
three scenarios?

INVENTORY MANAGEMENT
Exercise 5. Contex, Inc. uses 800 units of a product per year on a continuous basis. The product has
carrying costs of P50 per unit per year and order costs of P300 per order. It takes 30 days to receive a
shipment after an order is placed and the firm requires a safety stock of 5 days usage in inventory.
1. How much is the total inventory costs when the management currently orders only once a year for
all its annual demand?
 2. How much is the total inventory costs when a proposal was provided where 10 units will be
ordered every time?
3. Calculate the economic order quantity (EOQ) and the total inventory costs at EOQ.
4. Determine the reorder point at EOQ.

RECEIVABLES MANAGEMENT
Exercise 6. Caren’s Canoes is considering relaxing its credit standards to encourage more sales. As a
result, sales are expected to increase 15 percent from 300 canoes per year to 345 canoes per year. The
average collection period is expected to increase to 40 days from 30 days and bad debts are expected to
double the current 1 percent level. The price per canoe is P850, the variable cost per canoe is P650 and
the average cost per unit at the 300-unit level is P700. The firm’s required return on investment is 20
percent.
1. How much is the total benefit from the proposed change in policy?
2. How much is the total additional costs from the proposed change in policy?
3. Based on the circumstance, should the proposed change in credit policy be accepted or rejected?

Exercise 7. Krug Gold Coin, Inc. is considering shortening its credit period from 30 days to 20 days and
believes, as a result of this change, its average collection period will decrease from 36 days to 30 days.
Bad debt expenses are also expected to decrease from 1.2 percent to 0.8 percent of sales. The firm is
currently selling 300,000 units but believes as a result of the change, sales will decline to 275,000 units.
On 300,000 units, sales revenue is P4,200,000, variable costs total P3,300,000, and fixed costs are
P300,000. The firm has a required return on similar-risk investments of 15 percent.
1. How much is the total benefit from the proposed change in policy?
2. How much is the total additional costs from the proposed change in policy?
3. Based on the circumstance, should the proposed change in credit policy be accepted or rejected?

Exercise 8. Gardner Company currently makes all sales on credit and offers no cash discount. The firm is
considering offering a 2% cash discount for payment within 15 days. The firm’s current average
collection period is 60 days, sales are 40,000 units, selling price is P45 per unit, and variable cost per unit
is P36. The firm expects that the change in credit terms will result in an increase in sales to 42,000 units,
that 70% of the sales will take the discount, and that the average collection period will fall to 30 days. If
the firm’s required rate of return on equal-risk investments is 25%, should the proposed discount be
offered? (Note: Assume a 365-day year.)

PAYABLES MANAGEMENT
Exercise 9. Compute the cost of foregoing the cash discount (approximate and effective) for each of the
following:
• 3/5, net 15 days.
• 2/10, net 40; The firm issues check on the 15th day
• 2/10, net 40; The firm pays on the 55 day.

Exercise 10. Sixth Company is negotiating with Island City Bank for a P1 million, 1-year loan. Island City
Bank has offered Sixth Company the following alternatives. Calculate the effective annual interest rate for
each alternative. Which alternative is the most attractive?
• An 8 percent annual rate on a simple interest loan, with no compensating balance required and
interest due at the end of the year.
• A 6.25 percent annual rate on a simple interest loan, with a 20 percent compensating balance
required and interest again due at the end of the year.
• A 5.50 percent annual rate on a discounted loan, with a 25 percent compensating balance.

III. ANALYSIS

1. What dictates the investment policy to be employed in a company?

2. What dictates the financing policy to be employed in a company?
3. What is the difference in the value of knowing the operating cycle and the cash conversion cycle?
a. Knowing Operating Cycle: Because the goal is shorter time to sell inventory and collect
receivables
b. Knowing the Cash Conversion cycle: knowing how much time is wasted in your cash
payments tied up in your operations before you can recover the money you spent
i. Your goal is to shorten the cash inflow to outflow journey
 ii. Strategy: To shorten the time of the cash conversion cycle, make the outflow of cash
longer
4. Explain how the strategies in cash management add value to the company.
a. To know how much cash we need to pay for expected operational expenses
5. How does each factor in selecting the selection of marketable securities affect the decision-maker?
6. What are the challenges in applying the EOQ model and JIT system?
7. What is the role of the financial analyst in establishing the credit and collection policies of the
company?
8. How does credit monitoring add benefit to the company?
9. Do we always need to analyze whether or not to give up the cash discount? Why or why not?
10. Aside from the cost of borrowing, what other factors should one consider in choosing a source for
the short-term financing?

IV. INTEGRATION

1. If you have excess cash, where do you put it and why?

2. When someone borrows money from you, what factors do you consider before lending the
money?
3. If you were to evaluate all your personal belongings using ABC system, but instead of monetary
value, they are grouped by importance and sentimental value, what items belong to Group A? How
about Group C?

V. INDEPENDENT LEARNING
1. For the next 2 synchronous meeting, the whole class will be divided into 10 groups. The task is to
provide a discussion for one of the 10 questions in the ANALYSIS Part.
2. The discussion should contain:
a. Context of the specific topic covered by the question
b. Answer and explanation
c. Real-life examples applying the answer to the question
3. The assignment of the question to the group shall occur in the synchronous meeting by the
instructor.
4. In addition, one other group shall provide a follow up question/different answer, also chosen by
the instructor every after each group’s discussion. The group shall address the follow up question
or defend their answer after.
5. Regardless of the speaker(s), the group is evaluated jointly, both on the discussion part, and the
follow up part. Discussion will be 60%, while the follow up is 40% of the grade for this activity.

PREPARED BY:

MR. JOHN CARLOS S. WEE, CPA MBA CMITAP

MR. ROMEL W. DELOSA, CPA CMA
MR. ROMMEL REGOR D. ONG, CPA
FINMAN2 Instructors