Short-Term Financial Management Decisions: Working Capital Management

Short-term Financial
Management Decisions:
Working Capital Management
AE321: STRATEGIC BUSINESS ANALYSIS

Financial Management: Advanced Financial Statement Analysis
Working Capital, Defined
•the amount of current assets (financial
management view) or current assets net of
current liabilities (accounting view) used to
finance the firm’s short term operations.
•Sustains the normal operations of the
business.

Working Capital
•Current Assets, Defined •Current Liabilities, Defined
• Cash
• and those convertible to •Obligations to be paid
cash • To be settled within one
• For trading purposes year (non-operating), or
• To be realized within twelve • To be settled within the
months from report date
(non-operating) normal operating cycle
• To be realized, sold or (operating).
consumed within the normal
operating cycle (operating)
• to support the main operation of
the entity.

Working Capital
•Includes cash, marketable •Includes trade payables,
securities, receivables, accrued expenses, short
inventories and term debts and current
prepayments. portion of long term debts.

Working Capital
•May also be described as •May also be described as
either temporary or trade or nontrade.
permanent.

Working Capital
•Current Assets, Defined
a. Temporary current assets
–required to support
fluctuations of the firm’s
level of activity (volume
of operations).
b. Permanent current assets
–required to maintain
normal operations.

Working Capital Management, Defined
•Ways to achieve efficient and effective
utilization of working capital
•Directed to attain organizational objectives
related to:
a. Profitability of operations
b. Liquidity of financial resources
c. Minimization of risks and company costs
•Involves managing the company’s liquidity
which in turn involves managing.
a. The company’s investment in current assets
(cash, MS, receivables, inventories)
b. The company’s use of current liabilities (level &
mix of short term financing)

•Covers both
•Setting the working capital policy, and
•Carrying it out in daily operations.

Working Capital Policy: As to Investment:
Basics of Current Asset Investing:
Current Asset Liquidity Profitability
1. Cash Most liquid Idle (Generally non-income
generating)
2. Short-term Very liquid Low income
investments
3. Receivables Liquid Funds are tied up in receivables and
4. Inventory Less Liquid inventory. Analyzed together in the
operating income.
a. Relaxed Current Investment Policy
b. Restricted Current Investment Policy
c. Moderate Current Investment Policy
Asset Mix Decision

a. Relaxed Current Investment Policy
•Entity carries a relatively large amount of current
assets.
•Supported by:
•Liberal credit policy resulting to high level of
receivables.
•Carrying of large amount of inventory.

b. Restricted Current Investment Policy
•Current assets are minimized.
•Evidenced by:
•Tight credit policy though it means running the risk of
losing sales
•Holding of minimal stock of cash and inventory.
•Results to:
•Highest current asset turnover.
•Highest expected ROI but entails the greatest risk.
Working Capital Policy: As to Financing:
Basics of Financing: Short-term VS Long-term
Criteria Short-term Financing Long-term Financing
1. Flexibility of use Can be used with matching the timing Interest are paid for a fixed period
of needs of such funds. The business even if such funds are not
pays interest only during such period necessarily being beneficially used
funds are used beneficially. in such period.
2. Liquidity risk Greater. Debts are to be paid in Lesser. Debt are to be paid in the
shorter periods. longer periods.
3. Interest costs
a. Rate Generally lower (excluding Generally higher.
transaction costs)
b. Rate Fluctuations More unstable Fixed during the fixed period
Basics of Financing: Financing Requirements:
A. Permanent
• refers to property, plant & equipment (fixed assets) and
permanent current assets that must always be with the company
throughout the year.
B. Seasonal (Temporary)
• additional requirements arising from fluctuation in the volume of
activity (production & sales) arising from seasonal changes in
demand level for products during the year.

a. Conservative Policy
b. Aggressive Policy
c. Balanced Policy
d. Maturity Matching Policy
Financing Mix
Decision
a. Conservative Policy
•almost all investment assets are financed by long term
debts, resulting to lesser amounts of short term debts. It
reduces liquidity risk but also reduces profit due to
greater financing costs.

•uses short term debts to finance, not only temporary
but also part or all of the permanent current asset
requirements. Thus, leading to greater amounts of short
terms debts & lesser amount of long term debts. It
increases profits due to lesser financing costs of short
term debts but also exposes the firm to liquidity risks
due to low working capital position.

c. Balanced Policy
•balances the trade-off between risk and profitability in a
manner consistent with its attitude toward bearing risk.

a. Conservative Current liabilities
Policy finance even the
noncurrent assets
Current assets are
mainly financed
through noncurrent
c. Balanced Policy liabilities

a. Conservative
Policy
b. Aggressive Policy Temporary assets

are financed
through current
liabilities
c. Balanced Policy

a. Conservative
Policy
c. Balanced Policy
???
d. Maturity Matching Policy – (Hedging
Principle/Self-liquidating debt Principle)
•It matches the maturities of obligations to the income
(cash flow) generating characteristics of the assets
financed. Long term debts are used to finance long term
assets (permanent working capital) requirements while
short term debts to finance short term assets.

Management of Current
Assets

Inventory Management
•the overall way a company oversees its
inventory and uses its control system to
manage the benefits against the cost of
carrying inventory.

•Tools, Techniques and Models
1. Inventory Planning
•Fixed Order Quantity System
•How much? Economic Order Quantity
•How often? Reorder Point
•Fixed Reorder Cycle System
•Just in Time

2. Inventory Control
•ABC System
•Two-bin System
3. Inventory turnover
4. Average age of inventories
5. Cost-benefit analysis

Reorder Point: Illustration: Basic: Place +3 DAYS +New
Chart: order - 90 KG Stock
Average daily demand in kg 30 = 0 Stock
Average lead time in days 3
ROP
Required: Reorder Point: What
should be the reorder point in +1 DAY
kilograms? - 30 KG
Computation: +1 DAY
- 30 KG
+1 DAY
- 30 KG
Notes: Assumes that daily demand and lead time are constant.
What if the entity sold more than the average daily demand?
What if the supplier delivers beyond the 3rd day?

Reorder Point: Illustration: Advanced:
Chart: Max daily demand and max lead time
Average daily demand in kg 30
Average lead time in days 3 +5 DAYS +New
ROP - 200 KG Stock
Maximum daily demand in kg 40 +1 DAY
= 0 Stock
Maximum lead time in days 5 - 40 KG
+1 DAY
Required: Reorder Point: What - 40 KG
Place +1 DAY
should be the reorder point in
order - 40 KG
kilograms? +1 DAY
Computation: - 40 KG
+1 DAY
- 40 KG

Chart: Average daily demand and average lead time
+New
Stock
ROP
Maximum daily demand in kg 40
Maximum lead time in days 5

Place
order
kilograms?
Computation: +3 DAYS Safety
- 90 KG Stock
= 110 Stock

Maximum daily demand in kg 40

kilograms? Safety stock?

Economic Order Quantity: Illustration: Basic:
Working days in a year 300
Annual carrying cost per unit P 5
Cost per order 100
Required: Economic Order Quantity:

1. Annual demand in kg
2. Economic order quantity
3. Average orders per year
4. Average ordering cost per year
5. Average inventory level
6. Average annual carrying cost of the inventories
7. Total annual inventory-related costs at EOQ

Average daily demand in kg 30 Computation:
Cost per order 100


Cost per order 100


Cost per order 100


Cost per order 100

7. Total inventory-related costs at EOQ

Cost per order 100


Cost per order 100


Cost per order 100


Average daily demand in kg 30 SUMMARY:
Cost per order 100


Economic Order Quantity: Illustration: With Safety Stock:
Working days in a year 300 ✔
Annual carrying cost per unit P 5 ✔
Cost per order 100 ✔
✔
Safety stock in kg 110

✔

✔

✔

✔

Receivable Management
•formulation and administration of plans and
policies related to sales on account, and
• ensuring maintenance & collectability of
receivables at predetermined levels.

•Levels of Credit Policy
•Policy Level – relates to customers – credit
and collection policies.
•Administration Level – procedures and
techniques to simplify and lower cost of
implementing the credit and collection policy.

•Elements of Credit Policy
1. Credit Standards
2. Credit Terms
3. Collection Programs

1. Credit Standards
•Establish acceptable levels of the 5 Cs
• Character (willingness to pay)
• Capacity (ability to pay)
• Capital (buffer to the ability to pay)
• Collateral (committed buffer to the ability to pay)
• Conditions (other external factors)

2. Credit Terms
•Credit Period
•Cash Discount

3. Collection Programs
•strategies, organization and procedures for
collection of receivables.
•Collection agencies, salesman, billing, follow-up
procedures

•Ways of Accelerating Collection of
Receivables
1. Shorten credit terms.
2. Offer special discounts to customers for
early payment.
3. Minimize collection float. (see cash
management)
1. Receivable turnover
2. Average collection period (Age of A/R)
3. Aging of Accounts

Receivable Turnover and Average Collection Period
Industry
Annual Data Entity
Ave.
Credit Sales P18.00M
Average Accounts Receivable Bal. 2.25M
Collection Period ? 36
Credit Policy 2/10, n/40 2/10, n/30
Required: Using 360 days in a year, compute the ff:
1. Entity’s receivable turnover
2. Entity’s average collection period
3. In comparison to the industry average, does the entity
have a lenient or strict receivable policy?
4. How many days can the entity decrease the collection
period by through improved collection programs?
Industry Computation:
Annual Data Entity
Ave.
Annual Data Entity
Ave.
Annual Data Entity
Ave.
3. In comparison to the industry average, does the
entity have a lenient or strict receivable policy?
period by through improved collection programs? The entity has a lenient receivable policy.
Annual Data Entity
Ave.
4. How many days can the entity decrease the
collection period by through improved collection
programs?
Industry SUMMARY:
Annual Data Entity
Ave.
✔1. Receivable turnover
✔2. Average collection period (Age of A/R)
✔3. Aging of Accounts

Cost Benefit Analysis: Basic: Changing the Credit Policy: Relaxing
The sales director suggests that certain credit terms be
modified. He estimates the following effects:
Sales will increase by at least 20%.
Receivable turnover will be reduced to 8 times from the
present turnover of 10 times a year.
Bad debts, now at 1% of sales, will increase to 1.5%.
Sales before the proposed changes is at P900,000.
Variable cost ratio is 55%.
The desired rate of return is 20%.
Required:
Should the firm allow the revision of the credit terms?
Support your answer with a cost-benefit analysis.

The sales director suggests that certain credit terms be Computation:
Sales P 900,000.00
Multiplied by: Percent Increase 0.20
present turnover of 10 times a year. Increase in Sales P 180,000
Increase in Sales P 180,000
Multiplied by: Variable Cost Ratio 0.55
The desired rate of return is 20%. Increase in cost P 99,000
Required: Increase in Sales P 180,000

Should the firm allow the revision of the credit terms? Less: Increase in Cost 99,000
Support your answer with a cost-benefit analysis. Increase in contribution margin P 81,000

Short-cut:
Sales P 900,000.00
present turnover of 10 times a year. Multiplied by: Percent Increase 0.20
Bad debts, now at 1% of sales, will increase to 1.5%. Increase in Sales P 180,000
Sales before the proposed changes is at P900,000. Multiplied by: Contribution Margin 0.45
Variable cost ratio is 55%. Ratio (1.00-0.55)
The desired rate of return is 20%. Increase in Contribution Margin P 81,000
Required:

Old New
Sales will increase by at least 20%. Sales (New=900k+180k) P900k P1,080k
Receivable turnover will be reduced to 8 times from the Divided by: Receivable Turnover 10 8
Ave. AR Balance P 90k P 135k
Ave. AR Balance – new P 135,000
Less: Ave. AR Balance – old 90,000
The desired rate of return is 20%. Increase in Ave. AR balance P 45,000
Multiplied by: Variable Cost Ratio 0.55
Required: Increase in required capital invested in AR P 24,750
Should the firm allow the revision of the credit terms? Multiplied by: Desired rate of return 0.20
Cost of carrying add’l receivables P 4,950
Old New
Sales P900k P1,080k
Multiplied by: Bad Debt Rate 0.01 0.015
Ave. AR Balance P 9k P 16.2k
Sales before the proposed changes is at P900,000. Bad Debt Expense – new P 16,200
Variable cost ratio is 55%. Less: Bad Debt Expense – old 9,000
The desired rate of return is 20%. Increase in Bad Debts P 7,200
Required:

Increase in Contribution Margin P 81,000
Cost of carrying add’l receivables ( 4,950)
Increase in Bad Debts ( 7,200)
Benefit of the revision of credit term P 68,850
Variable cost ratio is 55%. Yes, the firm should allow the revision of the credit term
The desired rate of return is 20%. because this will provide the entity an additional income
of P68,850
Required:

Cash Management
•involves the maintenance of cash &
marketable securities (MS) investment level
which enhances the ability of the company
to meet its cash requirements while
maximizing the income on idle funds.

Cash Management
•Reasons for Holding Cash
•Transactional motive – to facilitate normal
transactions of the business
•Contractual motive – to meet bank (creditor)
requirements contained in a financing
agreement.

Cash Management
•Precautionary motive (safety stock) – to
provide buffer against contingencies like
unexpected delay in collection of receivables
& unexpected increases in disbursements due
to inflation.

Cash Management
•Speculative motive – to take advantage of
special income opportunities like:
•Purchase of large volume of inventories or fixed
assets at much lower prices (bargain)
•To avail purchase discounts
•Purchase of high yielding securities

Cash Management
•Strategies
1. Managing (Accelerating) Collections
2. Controlling (Delaying) Disbursements*
3. Synchronize inflows and outflows
4. Reduce the need for precautionary balance
*More computations under the current liability

management portion.
Cash Management
•Strategies
•Modes of Payment
•Cash basis
•Credit cards
•Checks
•Bank Transfers

Cash Management
•Strategies
•Delays (Float) Faced
•Mail Float – from customer to entity
•Processing Float – from entity to bank
•Clearing Float – from bank acceptance to bank credit

Cash Management
•Strategies
2. Controlling (Delaying) Disbursements
•Defer cash payments (paying on the last day of
the cash discount or of the credit term)
•Play the float

Cash Management
•Strategies
2. Controlling (Delaying) Disbursements
•Remote disbursement account
•Zero balance accounts
•Use of different bank from that of the payee
•Less frequent payroll
•Scheduled issuance of checks to suppliers

Cash Management
•Strategies
3. Synchronize inflows and outflows
4. Reduce the need for precautionary balance
• Increasing forecast accuracy
• Negotiating a line of credit
• Holding marketable securities

Cash Management
1. Cash Budget
2. Playing the float
3. Optimizing the Cash Balance through
a. Baumol Model
b. Control Limit Model

Cash Management - Net Float
•Net cash stuck in the clearing process
•Computed as
•Disbursement float, LESS
•Collection float

Which is BETTER?
Collection Float > Disbursement Float

OR
Disbursement Float > Collection Float
Cash Management
Net Float: Illustration:
The daily collections of ABC is P50,000 while its Collection float in pesos
daily disbursement is P30,000. The collection Daily collections P 50,000
float is 3 days and the disbursement float is 4 Multiplied by: Collection float in days 3
days. Cash would have earned 3% interest Collection float in pesos P 150,000
income if it remains in the bank account.
Required:
1. Collection float in pesos Disbursement float in pesos
2. Disbursement float in pesos Daily disbursements P 30,000
3. Net Float Multiplied by: Disbursement float in days 4
4. Net benefit/ cost of the float Disbursement float in pesos P 120,000

The daily collections of ABC is P50,000 while its Disbursement float in pesos P 120,000
daily disbursement is P30,000. The collection Collection float in pesos ( 150,000)
float is 3 days and the disbursement float is 4 Net float in pesos (P 30,000)
days. Cash would have earned 3% interest
Required: Float = D E L A Y
1. Collection float in pesos
2. Disbursement float in pesos
3. Net Float
4. Net benefit/ cost of the float
-
Collection Float
Disbursement Float
+
= cash received
= cash disbursed
does not earn
earns income
income
Which is BETTER?
Collection Float > Disbursement Float

OR
Disbursement Float > Collection Float ✔
The daily collections of ABC is P50,000 while its Net float in pesos (P 30,000)
daily disbursement is P30,000. The collection Multiplied by: Interest rate 3%
float is 3 days and the disbursement float is 4 Net Benefit/(Cost) of float (P 900)
days. Cash would have earned 3% interest
Required:
1. Collection float in pesos
2. Disbursement float in pesos
3. Net Float
4. Net benefit/ cost of the float
%

Cash Management
Baumol Model: Illustration:
Average daily cash demand P3,000 Answers:
Return on money marketable securities 5%
Transaction Cost 100
Required:
1. Annual cash demand
2. Optimal cash balance
3. Average transactions per year
4. Average transaction cost per year
5. Average cash level
6. Average annual opportunity cost of holding cash
7. Total annual cost of holding and maintain cash

Marketable Securities Management
•Complements cash management
•Improves profitability by placing excess cash
into short-term income-generating
marketable securities.

•Marketable Securities, Inclusions
1. Government securities
a. Treasury bills – represents obligations of the
national government, issued by the Bureau of
Treasury
b. Central bank bills – represents indebtedness of BSP.
2. Commercial papers – short term unsecured
promissory note issued by corporations w/
very high credit standing.
•Marketable Securities, Inclusions
3. Certificate of time deposits in commercial
banks.
4. Mutual funds

•Marketable Securities, Reasons for Holding
1. To serve as substitute for cash balances
2. To serve as temporary investment
3. To meet financial requirements that are
becoming due – such as tax payments,
maturing bond issue, etc.

•Marketable Securities, Factors to Consider
1. Liquidity Risk
2. Investment Risk
3. Profitability
4. Term of maturity
5. Minimum lot size and transaction cost

1. Liquidity Risk
- Can the investment be easily sold?

2. Investment Risk
a. Default Risk: Consider:
a. Accreditation
b. Single borrower’s limit
c. Security
a. Grade of security is acceptable.
b. Collateral is sufficient.
2. Investment Risk
a. Default Risk
b. Settlement Risk
c. Interest Rate Risk
a. Price risk
b. Inflation risk

3. Profitability
4. Term of maturity
5. Minimum lot size and transaction cost

Cash Management
Control Limit Model: Illustration:
Minimum cash balance set by management P40,000 Required:
1. Spread
2. Optimal Return Point
Return on money marketable securities 6% 3. Upper Cash Limit
Transaction Cost P 100 4. Average Cash Balance
Variance of daily net cash flows P 20,000 Computation:
Formula:

Cash Management
1. Spread
Formula:

Cash Management
1. Spread
Formula:

Cash Management
1. Spread
Variance of daily net cash flows P 20,000
Formula: Computation:
OR

Cash Management
Formula: Summary: Sample Graph:
Source: Kaplan Knowledge Bank

Short-term Financial
Management Decisions:
Working Capital Management
-End of Part 1-

Short-Term Financial Management Decisions: Working Capital Management

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Short-term Financial

AE321: STRATEGIC BUSINESS ANALYSIS

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Asset Mix Decision

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

b. Aggressive Policy Temporary assets

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Required: Reorder Point: What

Financial Management: Advanced Financial Statement Analysis

Required: Reorder Point: What

Financial Management: Advanced Financial Statement Analysis

Required: Economic Order Quantity:

Financial Management: Advanced Financial Statement Analysis

Required: Economic Order Quantity:

Financial Management: Advanced Financial Statement Analysis

Required: Economic Order Quantity:

Financial Management: Advanced Financial Statement Analysis

Required: Economic Order Quantity:

Financial Management: Advanced Financial Statement Analysis

Required: Economic Order Quantity:

Financial Management: Advanced Financial Statement Analysis

Required: Economic Order Quantity:

Financial Management: Advanced Financial Statement Analysis

Required: Economic Order Quantity:

Financial Management: Advanced Financial Statement Analysis

Required: Economic Order Quantity:

Financial Management: Advanced Financial Statement Analysis

Required: Economic Order Quantity:

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Financial Management: Advanced Financial Statement Analysis

Required: Increase in Sales P 180,000