FINANCIAL MANAGEMENT

THEORIES
Group 9 & 10

Submitted by:
Adrian Alvin Amoroso | 202065088
Grace Cervantes Fabor | 202065086
Caroline Mercado Maranan | 202065084
Imelda Oballo | 202065090
Aaron Dale Villanueva | 202065068
Working Capital Management

Working capital management refers to the set of activities performed by a company to make sure it got
enough resources for day-to-day operating expenses while keeping resources invested in a productive way.
It is one of the strongest indicators regarding the health of a company. It is the difference between your
firm’s available assets and its liabilities and includes cash, unpaid invoices, existing inventory, current
accounts payables, and liabilities.

Working Capital Management is affected by various assets and liabilities management such as, Liquidity
Management, Accounts Receivable Management, Inventory Management, Accounts Payable Management
and Short-term Management.

Ensuring that the company possesses appropriate resources for its daily activities means protecting the
company’s existence and ensuring it can keep operating as a going concern. Scarce availability of cash,
uncontrolled commercial credit policies, or limited access to short-term financing can lead to the need for
restructuring, asset sales, and even liquidation of the company.

Components of Working Capital

Working capital is computed as current assets less current liabilities, but there are 4 major components
which needs to be efficiently managed not only to ensure the profitability of the business but also ensures
the smooth running of business.
1. Cash and Cash Equivalent – It is needed for performing all activities of a business. Managing the
inflows and outflows in order to maintain adequate cash because companies need to meet routine
payment such as wages, purchases, operating expenses, etc., to meet unexpected demands for cash,
and to take advantage of favorable market conditions.
2. Receivables - The term account receivable represents sundry debtors of a company. Credit sale and
debt collection policy significantly influence receivable management. Therefore, cost and benefits
associated with those policies is an important task for a finance manager.
3. Inventory – Efficient management of inventory results in maximization of earnings of the
shareholders. Efficient inventory management consists of managing two conflicting objectives:
Minimization of investment in inventory on the one hand; and maintenance of the smooth flow of
raw materials for production and sales on the other. Hence, the objective is to maintain sound level
of inventory.
4. Accounts Payable – Payables provide a spontaneous source of financing of working capital. Payable
management is very closely related with the cash management. Effective payable management leads
to steady supply of materials to a firm as well as enhances its reputation.

Gross Vs. Net Working Capital

Gross working capital is the sum of a company's current assets (assets that are convertible to cash within a
year or less). Gross working capital includes assets such as cash, accounts receivable, inventory, short-term
investments, and marketable securities. Net working capital is the difference between the current assets and
the current liabilities of a company.

Determinants of Working Capital

Determinants of working capital are items that have a direct impact on the amount invested in current
assets and current liabilities. Managers like to keep a close watch over these factors, since working capital
can absorb a large part of the funding that an organization has at its disposal. Accordingly, managers are

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always trying to adjust the manner in which operations are run in order to pare back on the working capital
investment.

There are a number of determinants of working capital, which include the following:
1. Credit policy - If a business offers easy credit terms to its customers, the company is investing in
accounts receivable that may be outstanding for a long time. This investment can be reduced by
tightening the credit policy, but doing so may drive away some customers.
2. Growth rate - If a business is growing at a rapid rate, it is likely increasing its investments in
receivables and inventory. Unless profits are extremely high, it is unlikely that the entity can
generate sufficient cash to pay for these receivables and inventory, resulting in a steady increase in
working capital. Conversely, if a business is shrinking, its working capital requirements will also
decline, which spins off excess cash.
3. Payable payment terms - If a company can negotiate longer payment terms with its suppliers, it can
reduce the amount of investment needed in working capital, essentially by obtaining a free loan
from its suppliers. Conversely, short payment terms reduce this source of cash, which increases the
working capital balance.
4. Production process flow - If a company estimates its production needs, what it manufactures will
likely vary somewhat from actual demand, resulting in an excess amount of inventory on hand.
Conversely, a just-in-time system produces goods only to order, so the investment in inventory is
reduced.
5. Seasonality - If a company sells most of its goods at one time of the year, it may need to build its
inventory asset in advance of the selling season. This investment in inventory can be reduced by
outsourcing work or paying overtime to manufacture goods at the last minute.

The Operating Cycle Approach

Operation cycle method considers total cycle of operations, from raw materials to finished goods, from
accounts payable to net cash. The times taken to complete these operations are called operating cycle time.
If the operating cycle is long then, requirement of working capital is larger, if the operating cycle is less then,
requirement of working capital is less.

Formulas:

Working capital = CGS(E)* D/365 + CB Finished goods = P(E)*CGSp*(HPfg/365) * P(E) =

* CGS (E) = estimated cost of goods sold, D = days in production estimated. CGSp = unit cost of goods produced,
operating cycle, CB = Cash/Bank balance HPfg= holding period of finished goods

RM Stock = PU(E) * Cu * (HP/365) Accounts receivables = P(E) * SP *(CP/365)

* PU(E) = production units estimated, Cu = cost per unit, HP = * P(E) = production estimated, SP = selling price, CP =
holding period of RM Collection period

WIP = P(E) * {Cu – RM + L+OH} * {WIP/365} Accounts payables = P(E)* RMu * (PP/365)
* P(E) = production estimated, Cu = unit cost, RM (100%), * P(E) = production estimated, RMu = RM cost per unit, PP =
L(50%) =Labor, OH (50% = overheads), payment period
WIP = work in progress

Operating cycle = IP + ARP

* IP = Inventory period, ARP = Accounts receivable period

Planning of Working Capital

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In planning the working capital, management should consider the following steps:
1. Assess future fund requirements – Evaluate the short-term funding need of the business. Matching of
cash inflows and outflows, due dates of cash outflow may not correspond to cash inflows.
Management must consider also long-term fund requirements such as purchase of fixed assets.
2. Compute the working capital requirement – Determine whether the current working capital is
adequate or inadequate.
3. Evaluate the current access to working capital and alternatives – Review current access to various
funding sources, such as working capital lines of credit, cash and investment accounts, accounts
receivable and inventory.
4. Review payables and receivables processes to maximize working capital – decreasing the time when
cash can be received and increasing the time payables can be paid would help in maximizing working
capital.
5. Use of borrowing or credit facilities - a positive cash position will improve a company’s access to
capital. Having a favorable liquidity position reduces the company’s cost of capital.
6. Test and update the working capital plan – a formal working capital plan should be updated annually
or as need arises to adjust and implement corrective measures to maintain the working capital
requirements.

Financing of Working Capital through Bank Finance and Trade Credits

Bank Finance
Commercial bank is a business organization which deals in money i.e., lending and borrowing of money.
They perform all types of functions like accepting deposits, advancing loans, credit creation and agency
functions. Besides these usual functions, one of the important functions of banks is to finance working
capital requirements of firms. Commercial banks are the most important source of short- term capital. The
different forms in which the banks normally provide loans and advances are as follows:
a) Loans - When a bank makes an advance in lump sum against some security, it is called a loan. In case
of a loan a specified amount is sanctioned by the bank to the customer. The entire loan amount is
paid to the borrower either in cash or by credit to his account. The borrower is required to pay
interest on the entire amount of loan from the date of sanction.
b) Cash Credit - Cash credit is an arrangement by which a bank allows his customer to borrow money
up to a certain limit against some tangible securities. A customer can withdraw from his cash credit
limit according to his need and interest is calculated on the daily balance and not on the entire
amount.
c) Overdraft - Overdraft is an arrangement by which a current account holder is allowed to withdraw
more than the balance to his credit up to a certain limit. The interest is charged on daily over drawn
balances.
d) Discounting of Bill of Exchange - Purchasing and discounting of bills of exchange is the most
important form in which the banks lend money without any collateral security.

Trade Credit
Trade credit refers to the credit extended by the supplier of goods in the normal course of business. The
trade credit arrangement of a firm with its suppliers is an important source of short-term finance. The credit
worthiness of a firm and the confidence of its supplier are the main basis of securing trade credit. Every firm
must utilize this source to the fullest extent because this source is cost free. i.e., borrower need not pay any
interest.

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 Example: Goods are sold on credit by the supplier to one of its customers amounting to P20,000.00.
The credit granted as per the term of sale with the terms of 3/15 net 40 or credit is given to
customer for 40 days from the date of the invoice issued.

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