CHAPTER 3: MANAGEMENT OF WORKING CAPITAL

3.0 Current Asset Management

Current asset management deals with three important parts of current asset components:
i. Cash (Cash in hand & Cash in bank)
ii. Inventories
iii. Account Receivables
iv. Marketable Securities

3.1 Cash
Cash is important in the hospitality organizations to ease the day-to-day payment and receipts
of transactions. The motives for holding cash are:

i) Transaction
Cash is needed especially for paying the short-term debts such as installment payment
to creditors or supplier. Other than that, a firm must have sufficient cash to pay for the
day-to-day operational activities for example salaries, utility bills, rental, maintenance,
and other expenses. The cash inflow or outflow of a firm depends on the frequency of
transactions that occurs in the business. Business with high frequency of transactions
such as budget hotel or fast food restaurant need much cash to ensure the transactions
can be settled immediately. Lack of cash will result in cancellation of transactions.

ii) Precautionary
Organization must keep/maintain cash for unexpected expenditure. Customer
purchasing pattern is not consistent from time-to-time. For example; for chalet
operators; sometimes they expect that the tourist arrival is lower because of natural
climate but when the expectation is reversed, tourist might come and stay and we need
cash to pay for the foods, extra allowance or other operational expenditures. Other
example; Banquet department; cannot trust the historical data alone. Sometimes
people organize event at unexpected date.

iii) Speculative
This purpose is deals with trying to reverse the market expectation. It means a firm goes
against expectation of other industry player in deciding future transaction especially in
investment purposes. But it can be applied to any business in buying its raw materials or
inventories. A firm can hold the buying activities of its asset or inventories when it
expects that the producer or supplier of the assets or inventories lower the price in the
future. For example; most of the market participants expect the stock price to increase
in the future but if we confident that the stock price remain lower, so we can buy in the
future in a large amount. Speculative is a risk-taking activities.
3.1.1 Cash Flow Cycle
Managing cash is important for firm’s growth. Therefore every firm must make sure that they:
i. Collecting payment from customer as soon as possible
ii. Delaying cash outflows on the due date
iii. Investing surplus cash to earn instant rate of return
iv. Borrowing cash at the lowest interest rate
v. Maintaining an optimum level of cash

Cash inflows usually happen from payment of account receivables. However some firms established
transaction with immediate cash in exchange with less credit agreement. Credit agreement usually takes
3 to 60 days to be settled. But it can be extended with mutual agreement from both parties. Cash inflow
cycle for the account receivable can be illustrated from the following example:

3.2 Perpetual Inventory Method

3.2.1 Purposes

(a) To ensure that quantities purchased are sufficient to meet anticipated need without being
excessive, and
(b) To provide effective control over those items that are being stored for future use.

3.2.2 Par Stock

The perpetual inventory card provides for a par stock figure for each item in stock. Par stock is defined
as the quantity of any item required to meet anticipated needs in some specific upcoming period. With
nonperishables, that quantity can be determined only after carefully weighing the following
considerations:

(a) Storage space

(b) Limits on total value of inventory prescribed by management
(c) Desired frequency of ordering
(d) Usage
(e) Purveyors’ minimum order requirements

3.2.3 Reorder Quantity

Reorder quantity is the amount that will be ordered each time the quantity of a particular item
diminishes to the reorder point. The quantity ordered should be sufficient to bring the total inventory up
to the par stock level.

Calculation of Reorder Quantity

Par stock 32
- Reorder point 15
= Subtotal 17
+ Normal usage until delivery 8
= Reorder quantity 25

3.3 Economic Order Quantity (EOQ)

This is one of the financial tools to ensure optimum order and usage of inventories in the company. In
hospitality the inventories are perishable for F&B. And we need a better management of inventories.

3.3.1 Why EOQ important?

EOQ is planning for future order of inventories. It will help to minimize the cost of production because
the company orders the inventories when it is necessary. The components of EOQ are:

i. Annual demand of the product (expected sales of the product)

ii. Purchase cost per unit (The price of the product in single unit)
iii. Fixed cost per order (Transportation, allowance, telephone or facsimile bill)
iv. The order quantity
 v. Holding cost of the product (Warehousing including rental and utility bills, wages for product
movement, and maintenance of machine)

3.3.2 Safety Stock

Safety stock is the minimum inventories level that need to be maintained at all time to avoid insufficient
inventories in any circumstances. It is not compulsory for the company to maintain safety stock
especially for the perishable items.

Reason for maintaining safety stock:

i. Late delivery of raw materials
ii. Unexpected demand especially during peak season or random events

Formula for EOQ:

S – Sales volume, usage in units per period

O – Order cost per order

C – Carrying cost/Holding cost per unit per period

SS – Safety stock

i) EOQ = 2SO
√ C

ii) Number of orders = S

EOQ

iii) Order Cost = Number of orders x Cost per order

iv) Average Inventory = EOQ

+ SS
2

v) Carrying Cost = Average inventory x Carrying cost per unit

vi) Total Cost a year(for ordering = Order Cost a year + Carrying cost (average)
and holding only)

Exercises: For the following questions, calculate EOQ, Number of orders, Order Cost, Average Inventory,
Carrying Cost, and Total Cost.

Question 1
Dawood Restaurant is recently upgraded its kitchen equipment. The owner, Dawood Baharoom is trying
to improve its inventory control management by using the economic order quantity. He anticipates sales
for the next year of 50,000 units, cost per order is RM 1.50, and carrying cost per order is RM 0.50 per
unit. The safety stock is targeted at 50 units.

Answers:

EOQ = v 2 x 50,000 units x RM1.5 / RM0.5 = 548 units

Number of orders 50,000 units / 548 units = 91 times

Ordering frequency 365 / 91 = once every 4 days

Order cost a year 91times x RM1.5 = RM136.5 a year

Average inventory 548 units / 2 + 50 units = 274 units + 50 units = 324 units

Carrying cost (Holding cost) 324 units x RM0.5 = RM162

Total cost a year (for ordering and holding only) RM136.5 + RM162 = RM298.5
Question 2
Kasih Hotel would like to assess the new level of inventory. The owner, Kasih Binti Waja estimates that
the next year sales would be 20,000 units per month. Price of the room is estimated at RM 110.
Ordering cost is estimated at 10% of annual sales. The carrying cost is 2% of the room price. The hotel
maintains its minimum inventory at 100 units.

Question 3
Nizam Bin Karim, operation manager of Mancongkam Theme Park, would like to estimate the future
inventory level of the theme park. The current sales are 300,000 units with the price of RM 50 per unit.
The cost per order is 15% of the annual sales while carrying cost is 0.5% of the price per unit. He
estimates that the next year sales and price per unit will increase by 15%. Cost is estimated to increase
by 20%.

Question 4
Sarip Dol Masak Lemak Restaurant is a new restaurant that will operate at the new shopping complex
near to the old Uptown Shah Alam. The owner would like to assess the inventory control system before
the actual operation. The financial controller anticipates sales of 300,000 units per year, an ordering cost
of RM 3.50 per order, and carrying costs of RM 1.50 per unit. The restaurant would like to maintain
safety stock at 100 units.

Question 5
Reveal Recipe is trying to improve its inventory control system and has installed an on-line computer at
its retail store. The company anticipates sales of 126,000 units per year, an ordering cost of RM 4 per
order, and carrying costs of RM1.10 per unit.

Question 6
Fahrin Restaurant would like to estimate the future inventory level of the restaurant. The current level
of sales is 80,000 units with the average price of RM 110 per unit. The cost per order is 15% of the price
per unit while carrying cost is 11% of the price per unit. The safety stock is maintained at 300 units. The
company estimates that the next year sales and price per unit will be reduced by 20%. Cost is estimated
to be increased by 20%.

Question 7
Linda Nasi Ayam current level of sales is average at 10,000 units per month with the average price of RM
15 per unit. The cost per order is 25% of the price per unit while carrying cost per unit is 70% of the cost
per order. The safety stock is maintained at 300 units. The company estimates that the next year sales
and price per unit will be increased by 20%. Cost is estimated to be increased by 10%.
3.4 Accounts Receivable

Accounts receivable is the total of all credit extended by a firm to its customers; therefore this balance
sheet account represents unpaid bills owed to the firm. As is true of other current assets, accounts
receivable should be thought of as an investment. The level of accounts receivable should not be judged
too high or too low based on historical standards of industry norms, but rather the test should be
whether the level of return we are able to earn from this asset equals or exceeds the potential gain from
other investments. For example, if we allow our customers five extra days to clear their accounts, our
accounts receivable balance will increase – draining funds from marketable securities and perhaps
drawing down the inventory level. We must ask whether we are optimizing our return, in light of
appropriate risk and liquidity considerations.

3.4.1 Credit Policy Administration

In considering the extension of credit, there are three primary policy variables to consider in conjunction
with our profit objective.

1. Credit standards
2. Terms of trade
3. Collection policy

Credit Standards
The firm must determine the nature of the credit risk on the basis of prior records of payment, financial
stability, current net worth, and other factors. When an account receivable is created, credit ha been
extended to the customer who is expected to repay according to the terms of trade. Bankers sometimes
refer to the 5 Cs of credit (character, capital, capacity, conditions, and collateral) as an indication of
whether a loan will be repaid in time, late, or not at all. Character refers t the moral and ethical quality
of the individual who is responsible for repaying the loan. Capital is the level of financial resources
available to the company seeking the loan and involves an analysis of debt to equity and the firm’s
capital structure. Capacity refers to the availability and sustainability of the firm’s cash flow at a level
high enough to pay off the loan. Conditions refer to the sensitivity of the operating income and cash
flows to the economy. The more sensitive the cash flow to the economy, the more the credit risk of the
firm. Collateral is determined by the assets that can be pledged against the loan. The better the quality
of the collateral, the lower the risk of the loan has.

Terms of Trade
The stated terms of credit extension will have a strong impact on the eventual size of the accounts
receivable balance. If a firm averages RM 5,000 in daily credit sales and allows 30-day terms, the average
accounts receivable balance will be RM 150,000. If customers are carried for 60 days, we must maintain
RM 300,000 in receivables and much additional financing will be required.

In establishing credit terms the firm should also consider the use of a cash discount.
Trade Discounts

Trade discounts are reductions to those prices indicated on a vendor’s price list. Vendors sometimes use
trade discounts as a convenience in making price changes without printing new catalogs or price lists.

Trade discounts are never recorded as such. The amount paid is entered without indicating that it is a
trade discount. Trade discounts do not depend upon payment within a given time period.

Vendor’s invoices normally show the gross amount, trade discount and net billing. Therefore,
computation of trade discounts is generally not required.

For example, kitchen equipment with a list price of RM5,000 purchased at a 40% trade discount will be
billed at a net invoice price of RM3,000. The purchase of this asset is recorded as RM3,000. Any
applicable cash discounts are computed on the RM3,000 net price.

Cash Discounts

Some vendors offer a discount for payment of an invoice before its due date. Early collection from
customers provides a vendor with one clear benefit: better cash flow to cover expenditures or to make
investments. To encourage prompt payment, vendors may offer an incentive called “Cash Discount” or
“Purchase Discount”.

Unlike trade discounts, cash discounts are only offered if payments are made within a specified time
period. Cash discount involves either ordinary dating terms (from receipt of invoice) or extended dating
terms (receipt of goods & end of month).

Cash discount terms are usually shown in abbreviated form such as:

2/10, n/30

2(note 1) / 10 (note 2) , n (note 3) / 30 (note 4)

(note 1)- Discount %

(note 2)- Maximum number of days where the discount is allowed after
invoice date

(note 3)- No discount

(note 4)- Maximum number of days after invoice date where the invoice
must be paid fully

There are three dating systems used in computation of cash discounts.

(a) Ordinary Dating Payment Term

 The payment period under ordinary dating payment terms begin with the receipt of
an invoice.

Example:

A RM100 invoice dated Oct. 16 with cash discount terms of 2/10, n/30 may be paid
anytime between Oct. 16 and Oct. 26 to take advantage of the 2% discount.

Calculation:

Invoice amount RM100

- 2% Cash Discount 2
Check amount RM 98
=====

(b) Receipt of Goods (ROG)

Cash discount ending period is computed from the date goods are received, not
from the invoice date. This form of dating is used by vendors when goods are
delivered a relative long time after the invoice has been sent.

Example:

Assume an invoice is dated March 5 with terms of 2/10, n/30 ROG. If the goods are
received on March 10, the discount period is from March 10 to March 20 (10 days
after goods are received).

Example:

Assume a delivery of goods is received on August 15. The invoice amount for
merchandise is RM700. The invoice date is August 2 and terms are 1/10, n/30 ROG.
Payment is made on August 24 (the cash discount is valid until August 25).

Calculation:

Invoice amount RM700

- 1% discount 7
Check amount RM693
=====

(c) End of Month (EOM)

Cash discount period begins after the end of the month I which the invoice is dated.

Example:
An invoice is dated June 8 with terms of 2/10, n/30 EOM. The discount period ends
on July 10.

The month of invoice in this case is June. There are 10 discount days. The following
month is July. The discount period is good until July 10.

Sometimes, the abbreviation “Prox.” is used in offering extended dating terms. Prox.
stands for proximo, which means “next month” in Latin. The procedures for
computing discounts with credit terms of Prox. are identical to those used for EOM.

Example:

An invoice with an amount of RM600 is dated May 25, terms are 4/15, n/30 Prox.
and the invoice amount for merchandise period extends to June 15.

If payment is made on or before June 15, it is calculated as follows:

Calculation:

Invoice amount (merchandise) RM600

- 4% discount RM 24
Check amount RM576
=====

According to business practice, if an invoice with EOM term is dated on or after the
26th of the month, the cash discount period extends to the second month after the
invoice date.

Example:

May 26, received of invoice, credit terms are 4/15, n/30 EOM and the invoice
amount is RM600. The month of the invoice is May but the date is on the 26 th day of
the month. In this case, the invoice is treated as a June 1 billing; the cash discount
period extends to July 15 (15 days into the next month of billing period). If the
payment is made any time up to July 15, it is calculated as follows:

Calculation:

Invoice amount (merchandise) RM600

- 4% discount RM 24
Check amount RM576
=====

Transportation Charges
 Discounts on freight charges are generally not permitted. Cash discount should be
calculated on the invoice amount exclusive of any freight (delivery) charges.

Example:

Assume a RM271.95 invoice consisting of merchandise (RM250) and freight charges

(RM21.95) is dated October 17 with discount terms of 2/10, n/30. If payment is
made during the discount period, it is calculated as follows:

Calculation:

Invoice amount RM271.95

- Cash discount (2% x RM250) RM 5.00
Amount of check RM266.95
=======

Exercises:

Question 1

A RM200 invoice for storeroom food provisions is received with terms of 2/10, n/30. The invoice is paid
within the discount period. Calculate the amount of cash discount.

Answers:

2% x RM200 = RM4

Question 2

A hospitality operation purchases new tables and chairs at a list price of RM12,000 and a trade discount
of 25%. Calculate the amount that will be recorded in the Furniture and Equipment account.

Question 3

Give the latest date that the discount may be taken for each of the following invoices:

(a) Dated April 27, terms 3/15, n/30 EOM

(b) Dated April 20, terms 2/10, n/30 ROG, goods received May 31

(c) Dated September 26, terms 5/10, n/30 Prox.

Question 4

Calculate the amount of the check remitted to pay for each of the following invoices:

(a) Dated June 7, terms 2/10, n/30, invoice amount RM200, payment made on June 17
 (b) Dated June 8, terms 1/10, n/30, invoice amount RM200, payment made on June 20

(c) Dated July 14, terms 2/10, n/30 EOM, invoice amount RM500, payment made on August 4

(d) Dated August 26, terms 2/10, n/30 EOM, invoice amount RM60, payment made on October
10

(e) Dated September 5, terms 5/10, n/60, invoice amount RM150, payment made o September
14

(f) Dated July 14, terms 3/10, n/30 Prox., invoice amount RM400, payment made on August 4

Collection Policy
In assessing collection policy, a number of quantitative measures may be applied to the credit
department of the firm

Average collection period = Accounts receivable / Average daily credit sales

An increase in the average collection period may be the result of a predetermined plan to expand credit
terms or the consequence of poor credit administration.

Ratio of bad debts to credit sales

An increasing ratio may indicate too many weak accounts or an aggressive market expansion policy.

Aging of accounts receivable

Aging of accounts receivable is one way of finding out if customers are paying their bills within the time
prescribed in the credit terms. If there is a buildup in receivables beyond normal credit terms, cash
inflows will suffer and more stringent credit terms and collection procedures may have to be
implemented. An aging schedule is presented to illustrate the concept.

Age of Receivables, May 31, 2009

Age of Percent of
Month of Sales Account (days) Amounts Account due

May 0 – 30 RM 60,000 60%

April 31 – 60 25,000 25%
March 61 – 90 5,000 5%
February 91 – 120 10,000 10%
Total receivable RM100,000 100%

If the normal credit terms are 30 days, the firm is doing something wrong because 40 percent of
accounts are overdue with 10 percent over 90 days outstanding.

3.5 Marketable Securities

3.5 Marketable Securities

Marketable Securities are the financial instrument which a firm can raise short-term funds in the money
market. It is called short-term fund because it is highly liquidity which means the maturity period is less
than a year. A firm will invest the excess cash to the marketable securities to gain lower returns but it
provides safe investment.

3.5.1 Banker’s Acceptance

A Banker’s Acceptance (BA) is a short-term credit investment created by non-financial companies and
guaranteed by a bank to make a specified payment when it is due. BA usually useful for international
trade which an exporter draws a draft on a specific bank in order to obtain payment for goods shipped
to a customer in another country. The maturities on acceptance normally range from 30-180 days.
However, a banker’ acceptance need to be held until maturity. Upon maturity, it can be sold in the
secondary market. BA is traded at discounts rate on top of its face value. For example:

Face value of Banker’s Acceptance RM 1,000,000

Less: 2% commission for one year RM 20,000
Amount received by exporter in one year RM 980,000

3.5.2 Treasury Bills

Treasury Bills or popularly known as T-Bills are another type of marketable securities. They are issued
with three-month, six-month, and one-year maturities. The bills issued by the government in order to
raise fund in short run. T-Bills are issued at discount rate from the face value. When T-Bills mature, the
government pays the holder the full par value. The returns are calculated from the differences between
the maturity value and issue price. Malaysia T-Bills are issued on weekly basis and auction is held one
day before the issue date. The successful bidders are determined according to the most competitive
yield offered. The standard trading amount is RM 5 million. Example of T-Bills calculation:

Issue Value of 90-day T-Bills RM 1,000,000

Maturity Value RM 1,200,000
Return on investment in T-Bills (1,200,000 – 1,000,000) RM 200,000

3.5.3 Certificates of Deposit

A Certificate of Deposit (CD) is a form of savings. The certificate shows that the account holder has
deposited a sum of money for a specific period of time at a pre-determined interest rate. The interest
rate is fixed and stated at the initial stage of the CD issuance. This certificate can purchased directly from
commercial bank s or other financial institutions that provide loan facilities. CD is non-tradable securities
and not available in the secondary market. CD is a relatively low-risk marketable securities. The interest
rate is not fixed and therefore the interest rate is depends on current interest rate environment, the
amount of CD, the maturity period, and the bank policy in issuing the CD.

Issue Price of 270-day CD RM 1,000,000

6% Coupon (1,000,000 x + (6%/365) x 270] RM 44,384
Price at maturity RM 1,044,384
3.5.4 Commercial Paper
Commercial Paper (CP) is an unsecured, short-term loan or promissory note issued by corporations with
very high credit standing. The issuing companies use the proceeds of commercial paper sales to finance
their working capital. The investor pays the face value and, at maturity, receives the face value plus
accrues interest. The interest rates on commercial paper are quoted on discount basis. CP’s maturities
are usually very short and not more than 9 months. It is issued by banks for a fee on behalf of companies
and other borrowers to raise funds from investors with idle cash. It is an alternative to bank loans. CP
issuers are able to raise large funds quickly and at relatively low cost. It can be sold directly or through
dealers to a large pool of institutional buyers. Usually the credit rating agency assesses and rates the
quality of commercial paper. The yield earned by the owner of commercial paper is similar to the rate of
return earned by the owner of certificate of deposit. CP is considered as safe investment because the
financial situation of a company can easily be predicted over a few months.

Issue Price of 90-day CP RM 1,000,000

4% Discount rate (1,000,000 x 4% x 90/360) RM 10,000
Price at maturity RM 990,000
SHORT TERM FINANCING

Short-term financing is a method of acquiring small loan with a repayment period of less than a year. It
is required by a firm to fund the shortage/sufficient of cash flow from operations. Firms may need to
borrow immediately for buying the raw materials or other short-term assets rather than wait until
amount of saving is sufficient. Firms may prefer short-term financing because:
 Availability
 Lower cost
 Urgent need of current assets

3.1 Sources of short term financing:

 Short-term loans – loan from banks and other financial institutions
 Trade credit – borrowing from suppliers
 Commercial paper – large amount of loan usually made by corporations.

3.2 Types of short-term loans:

3.2.1 Promissory Note
A legal agreement that bound two parties the mutual understanding in terms of loan
amount, term of loan, and the interest rate. It requires the borrower to pay the principal
plus interest at the end of the loan period. It is usually made with bank and financial
institutions.

3.2.2 Line of Credit

This is an arrangement set with bank for the types of loan can be borrowed after
reviewing the cash budget of a firm. After the arrangement is agreed by both parties,
the amount can be borrowed with fewer problems, since it is pre-approved. This type of
short-term financing is needed for peak demand times where the firm needs additional
fund to buy excess raw materials.

3.2.3 Trade Credit

This is the act of obtaining funds by deferring payments to suppliers, which usual period
of credit covers 30 days. The cost of trade credit is the charges imposed to the unpaid
balance of the credit purchase. Some suppliers make is it as practice to give cash
discount and therefore if the firm pays earlier, it will result in loss of discount.