MODULE 6 – LESSON 2 – WORKING CAPITAL

MANAGEMENT, ACCOUNTS RECEIVABLE MANAGEMENT

AND INVENTORY MANAGEMENT
WORKING CAPITAL MANAGEMENT
• Is the administration and control of the company’s working capital (see previous lesson to recall).
• Has the objective of achieving balance between profitability and risk.
• Has 3 types of working capital financing policies the management can choose from:
A) Maturity-matching working capital financing policy
B) Aggressive working capital financing policy
C) Conservative working capital financing policy

Managing working capital is important because failure to do so may result in the closure of the
business.

It must be noted that working capital requirements increase as the size or volume of the
business increases. For example, a company needs P10,000,000 working capital to support an
annual sales of P50,000,000. If the sales increase to P100,000,000, will the P10,000,000 working
capital be enough? Most likely, the answer is NO. Because with P100,000,000 sales, there will be
more cash needed for the operations, more accounts receivable, and if the company is a
merchandising or a manufacturing company, more inventories.

TYPES OF WORKING CAPITAL

1. Permanent or Fixed Working Capital is the minimum level of current assets needed by a
company to carry on its business operations.

2. Temporary or Fluctuating Working Capital is the additional or extra current assets needed by
a company to support its changing production and sales for temporary period.

Illustrative Example: Mr. De Guzman is managing the working capital of SR Ice Cream Company.
SR Ice Cream Company is a business engaged in the selling of different ice cream. The following are
the sales and the working capital needed during different quarter of the year:

Please note that:

• During the year, sales are not the same every month/quarter. That is why companies have
slack season and peak season. The company’s annual sales is not generated uniformly
throughout the year.
• The working capital during the slack season is lower than those during the peak season.
• The working capital needed during the slack seasons represents the permanent working
capital.
• The additional working capital needed during the peak season represents the temporary
working capital

Based on the table, what is the company’s permanent working capital? P120,000.
The working capital never goes below that amount. It is the minimum.
At what quarter or months is the peak season?
2nd Quarter, April to June. The sales level is at P900,000.

At the peak season, how much is the company’s temporary working capital?
P180,000. It is the difference between the P300,000 working capital and the P120,000
permanent working capital. P180,000 temporary working capital is added to the permanent
working capital to achieve P900,000 sales during 2nd Quarter, which is the peak season.

During the 4th quarter (October to December), a slack season, how much is the company’s
temporary working capital?
P30,000. It is the difference between the P150,000 working capital and the P120,000
permanent working capital. P30,000 temporary working capital is added to the permanent
working capital to generate P350,000 sales in 4 th Quarter.

Difference between Permanent Working Capital and Temporary Working Capital

PERMAMENT BASIS TEMPORARY
WORKING CAPITAL WORKING CAPITAL
For long term Period For short term
Can be used for fixed assets Use Used for temporary or seasonal
needs
Stable Nature Fluctuating; Sometimes
increasing and sometimes
decreasing
Always be the reserve capital for Needed at times Only for special needs
uncertain situations
Source: https://vyaparapp.in/blog/types-of-working-capital/

Permanent working capital and temporary working capital are financed based on different working
capital financing policies of a company.

DIFFERENT WORKING CAPITAL FINANCING POLICIES

1. MATURITY – MATCHING WORKING CAPITAL FINANCING POLICY

• Based on this policy, the permanent working capital should be financed by long-term
sources while the temporary working capital should be financed by short-term sources
• Long-term sources include long-term debt and equity such as common stock and preferred
stock.
• Short-term sources include short- term loans from a bank. These short-term loans are
called working capital loans which perfectly describe the reasons why these loans are
incurred.

2. AGGRESSIVE WORKING CAPITAL FINANCING POLICY

• Under this policy, some of the permanent working capital are financed by short –term
sources.
• Managers adopt this policy because long-term sources have higher costs as compared to
short-term sources. By financing some of the permanent working capital with short-term
sources, costs are minimized which in turn, improves net income.
 3. CONSERVATIVE WORKING CAPITAL FINANCING POLICY
• Based on this policy, even some of the temporary working capital are financed by long-
term sources.
• This policy minimizes liquidity risk but also reduces company’s profitability because long
–term sources entail higher costs.

Illustrative Example: Mr. De Guzman is managing the working capital of SR Ice Cream. SR Ice
Cream is a company engaged in the selling of different ice cream. The following are the sales and
the working capital needed:

The following banks offered the following loans and terms:

Which bank/s will be probably chosen by Mr. De Guzman?

If aggressive working capital financing policy is adopted by SR Ice Cream, what bank will
be probably chosen by Mr. De Guzman to finance the P120,000 permanent working capital?
He will probably choose PNB. The bank grants a loanable amount of P60,000-P200,000 at 9 months
term. The reason is probably to avoid the higher costs of long-term sources.

If SR Ice Cream will adopt the conservative working capital financing policy, what bank
will Mr. De Guzman probably choose to finance the P30,000 temporary working capital for
the 4th Quarter?
He will probably choose BPI. The bank offers a loanable amount of P40,000-P90,000 with 3 years
term. The reason is probably to minimize liquidity risk or to avoid the chance of not meeting their
short-term obligation.

If SR Ice Cream observes maturity –matching working capital financing policy, what bank
will Mr. De Guzman probably choose to finance the P120,000 permanent working capital of
the company?
He will probably choose AUB. The bank offers a loanable amount of P90,000-P150,000 with 4
years term.

ACCOUNTS RECEIVABLE
• Accounts receivables spring out of the need to sell merchandise.
• An excellent business proposition is to generate sales without offering a credit facility to
customers. However, this concept is theoretically sound, but not sustainable.
• Credit management strategically defines the quality of account receivables collection.
• The collectability of accounts receivables depends largely on the quality of customers. The
quality of customers depends on the standards or credit policies set up and used by an
organization. Credit policies are an integral part of the credit evaluation and there are 5C's
used in credit evaluation. These are:
 • Character -the willingness of the borrower to repay the loan
• Capacity - a customer's ability to generate cash flows
• Collateral - security pledged for payment of the loan
• Capital - a customer's financial resources
• Condition - current economic or business conditions

INVENTORY MANAGEMENT
• Inventory management involves the formulation and administration of plans and policies to
efficiently and satisfactorily meet production and merchandising requirements and minimize
costs relative to inventories.
• Proper inventory management involves the determination of reasonable levels of inventories
considering the size and nature of business.

Three Types of Inventory

• Raw materials – these are purchased materials not yet put into production.
• Work in process – these are goods and labor put into production but not yet finished.
• Finished goods – these are goods put into production and finished. These are ready to be
sold.

The ABC Analysis

• One way to control inventory is to classify inventory into a classification system called ABC
Analysis.
• Inventories classified as “A” are high valued items which should be safeguarded the most.
• B items, on the other hand, are average-cost items that should be safeguarded more than C
items but not as much as A items.
• While C items have low cost and is the least safeguarded.
ACTIVITY 1
Part I Study the table below and answer the questions that follow.

CDO is a company that manufactures holiday ham. Its 2019 sales and working capital are as
follows:
Quarter Sales (in pesos) Working Capital
1st (January-March) P26,000,000 P3,900,000
2nd (April-June) P8,000,000 P1,200,000
3 (July-September)
rd P18,000,000 P2,700,000
4th (October-December) P57,000,000 P 8,550,000

1. What quarter of the year is considered the peak season? ___________

2. How about the slack season? __________
3. How much is the permanent working capital of the company? ____________
4. How much is the lowest temporary working capital of the company? ____________
5. How about the maximum temporary working capital of the company? _____________

Part II Answer the questions in not less than 3 sentences each.

1. Say you are the financial manager and your company doesn’t want to finance its working
capital through short term and long term sources. What specifically are you going to do to
meet your company’s working capital requirements?
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2. What are the effects on the company if the financial manager’s working capital management
fails? Cite at least 2 possible effects.
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ACTIVITY 2
Answer the questions in not less than 3 sentences each.

1. Why is it important for a company to make a good credit policy?

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2. What is FIFO policy? How can it help in the management of inventories?
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ASSESSMENT
Analyze the below-given situation and information. Then answer the 10-item multiple choice test
that follows.

Ms. Castillo handles M & M Toy Company’s working capital. The following are the sales and the
needed working capital:

Ms. Castillo is looking at different short-term and long-term sources to finance the working capital.
The following banks offer the following loans:

1. The required permanent working capital of the M & M’s Toy Company is
_____________ .

A. P180,000
B. B. P200,000
C. C. P260,000
D. P300,000

2. If aggressive working capital financing policy will be adopted, Ms. Castillo should choose
_______________ to finance the company’s permanent working capital.
A. BPI
B. BDO
C. AUB
D. PNB
3. The quarter when consumers buy toys the most is ________________.
A. 1st
B. 2nd
C. 3rd
D. 4th
4. In your answer in #3, the temporary working capital (the additional working capital
requirement) is _______________ .
A. P20,000
B. P80,000
C. P100,000
D. P120,000
5. Based on conservative working capital financing policy, even some of the temporary working
capital requirement are financed by long-term sources. So, the company’s required temporary
working capital in #4 is BEST to be financed by ________________.
A. BPI
 B. BDO
C. AUB
D. PNB
6. The quarter that requires the least temporary working capital is ________________
A. 1st
B. 2nd
C. 3rd
D. 4th
7. If M & M’s Toy Company observes maturity-matching working financing capital policy, Ms.
Castillo should choose ________________ to finance the company’s temporary working capital
requirement in #6.
A. BPI
B. BDO
C. AUB
D. PNB
8. During period in which there is highest sales, the required working capital _______________
A. Becomes lower
B. Becomes higher
C. Remains the same
D. Turns zero
9. A lower days sales of inventory (DSI) indicates that a company has inventory that is
______________ to sell.
A. Easy
B. Difficult
C. Impossible
D. None of the above
10. When calculated, a company that is taking longer to pay its vendors and suppliers has
______________ DPO.
A. Higher
B. Lower
C. Same
D. Zero