MANAGEMENT ADVISORY SERVICES

Working Capital Management

Working Capital Management

Working Capital Management involves managing the firm’s current assets and liabilities to achieve a balance between
profitability and risk that contributes positively to the firm’s value.

Trade-off between Risks and Returns

The management of working capital requires consideration for the trade-off between risk and returns. Holding more
current than long-term assets means greater flexibility and reduced liquidity risk. However, the rate of return will be less than with
current assets than with long-term assets. Long-term assets typically earn a greater return than current assets. Long-term financing
has less liquidity risk associated with it than short-term debt, but it also carries a higher cost. Consider the following:
Working Capital Policy
Conservative Aggressive
Level of Current Assets High Low
Reliance on Long-Term Financing High Low
Liquidity Risk Low High
Profitability and Returns Low High

Factors to Consider in Managing Working Capital

1. Appropriate Level This refers to Adequacy of working capital

 Consider: Nature of business and length of operating cycle
2. Structural Wealth This refers to composition of working capital
 Consider: Need for cash, accounts receivable and other current assets
3. Liquidity This refers to the relative transformation (and its rate) of current assets into more liquid current
assets (e.g., cash and marketable securities).

In general, sound working capital policy requires:

1. Managing cash and its temporary investment efficiently. (Cash and Marketable Securities Management)
2. Ensuring efficient manufacturing operations and sound material procurement. (Inventory Management)
3. Drafting and implementing effective credit and collection policies. (Receivable Management)
4. Seeking favorable terms from suppliers and other temporary creditors. (Short-Term Credit Financing)

Illustration: Working Capital

Given the following information of Saitama Company:

Cash P 12,000 Accounts payable P 10,000
Accounts receivable 18,000 Current tax liability 3,000
Inventory 20,000 Accrued payroll 7,000
Fixed assets 50,000 Bonds payable 80,000

The bonds will mature in 10 years. All amounts are correctly stated.

Required:
1. Net Working Capital 30,000 4. New Current Ratio (assuming all accounts payable are paid in cash)
4
2. Current ratio 2.5 5. New Current Ratio (assuming a P10,000 short-term loan is
obtained
3. Acid-Test Ratio 1.5 from a bank) 2

1) NWC = CA – CL
= 50,000 – 20,000
= 30,000

2) CR = CA / CL
= 50,000 / 20,000
 = 2.5

3) ATR = QA / CL
= 30,000 / 20,000
= 1.5

4) New CR =
= (50,000-10,000) / (20,000-10,000)
=4

A/P 10,000
Cash 10,000

5) New CR =
= (50,000+10,000) / (20,000+10,000)
=2

Cash 10,000
STL 10,000

Turnover Ratios, Conversion Periods and Cash Conversion Cycle

Income statement account

Turnover =
Average balance sheet account

Average age/ Conversion No. of days in a year

=
periods Turnover

Cash Conversion Cycle is the average length of time a peso is tied up in current assets. It runs from the date the company makes
payment of raw materials to the date company receives cash inflows thru collection of accounts receivable. It is also known as the
cash flow cycle.

Objective: To shorten the cash conversion cycle without hurting operations. The longer the cash conversion cycle, the greater the
need for external financing; hence, the more cost of financing.

Working Capital Activity Ratios (Efficiency Ratios)

It is the time required to complete one collection cycle

Receivables turnover Net (Credit) sales from the time receivables are recorded, then collected,
Average receivables to the time new receivables are recorded again.

Average age of receivables 360 days It indicates the average number of days during which
(Average collection period) Receivables turnover the company must wait before receivables are
(Days’ sales in receivables) collected.

Cost of goods sold It measures the number of times that the inventory is
Inventory turnover Ave. merchandise inventory replaced during the period.

Average age of inventory It indicates the average number of days during which
(Inventory conversion period) 360 days the company must wait before the inventories are
(Days’ sales in inventory) Inventory turnover sold.
OPERATING CYCLE

------------------------------------------------------------------30 DAYS------------------------------------------------------
1/1 1/11 1/16 1/31
PURCHASE----------------------PAYMENT-----------------------SALE---------------------------------------------------COLLECTION

INVENTORY A/P A/R CASH

A/P CASH SALES A/R
COGS
INVENTORY

------------------------------CASH CONVERSION CYCLE-------------

20 DAYS
15 DAYS
-------------------------AGE OF INVENTORY----------------------
10 DAYS 15 DAYS
-------AGE OF PAYABLES------- -----------AGE OF RECEIVABLES-------

OC = ICP + CP
= 15 DAYS + 15 DAYS
= 30 DAYS

CCC = NOC – PP
= 30 DAYS – 10 DAYS
= 20 DAYS

NO. OF CCC = 360 DAYS/20 DAYS

= 18 CYCLES

INVENTORY T.O. = 360 DAYS / 15 DAYS OR; ITO = COGS / AVE. INV.
= 24X

FG TO = COGS / AVE. FG

WIP TO = COGM / AVE. WIP

RM TO = RMU / AVE. RM

PAYABLES T.O. = 360 DAYS / 10 DAYS OR; APTO = NET CREDIT PURCHASES / AVE. AP
= 36X

RECEIVABLES T.O. = 360 DAYS / 15 DAYS OR; ARTO = NET CREDIT SALES / AVE. AR
= 24X

Illustration:

Rimuru Corporation purchases merchandise on 20-day term. Goods are sold, on the average, 15 days after they are received. The
average age of accounts receivable is 45 days. Rimuru pays its payable on due date. (Assume a 360-day year).

Required:
1. How long is the company’s normal operating cycle? 60
2. How long is the company’s cash conversion cycle? 40
3. What is the number of cash conversion cycles in one year 9
4. What is the accounts payable turnover ratio? 18x
5. What is the inventory turnover ratio? 24x
6. Assuming the average inventory amounts to P200,000, how much is the COGS? P4.8M
7. What is the accounts receivable turnover ratio? 8x
8. Assuming an average receivable balance of P700,000, how much is the net credit sales? P5.6M
1) NOC = ICP + CP
= 15 DAYS + 45 DAYS
= 60 DAYS

2) CCC = NOC – PP
= 60 DAYS – 20 DAYS
= 40 DAYS

3) NO. CCC = 360 DAYS / CCC

= 360 DAYS / 40 DAYS
=9

4) APTO = 360 / PP
= 360 DAYS/ 20 DAYS
= 18X

5) ITO = 360 / ICP

= 360 / 15
= 24X

6) ITO = COGS / AVE. INV.

24 = ? / 200,000
? = 4,800,000

7) ARTO = 360 DAYS / CP

= 360 / 45 DAYS
= 8X

8) ARTO = NET CREDIT SALES / AVE. AR

8 = ? / 700,000
? = 5,600,000