WORKING CAPITAL

For financial analyst, working capital equals current assets.

For accountants, working capital equals current assets minus current liabilities.

 CURRENT ASSETS – reasonably expected to be realized in cash or consumed or sold

during the normal operating cycle of the business. These include cash, marketable
securities, receivables, and inventory.
o TEMPORARY CURRENT ASSETS – Current assets such as cash, that fluctuate
with the firm’s operational needs
o PERMANENT CURRENT ASSETS – the portion of the company’s current assets
required to maintain the firm’s daily operations. It is the minimum level of current
assets required if the firm is to continue its operations.
 CURRENT LIABILITIES – their liquidation requires the use of current assets or incurrence
of other current liabilities. They include current accounts payable, unearned revenue,
accrued expenses, short-term debts and the current portion of the long-term debts.

WORKING CAPITAL FINANCING POLICIES

1. Conservative (relaxed) policy – operations conducted with too much working capital;
involves financing almost all assets investments with long-term capital.
a. ADVANTAGES
i. Reduces risk of illiquidity
ii. Eliminate the firm’s exposure to fluctuating loan rates and potential
unavailability of short-term credit
b. DISADVANTAGE
i. Less profitable because of higher financing cost
2. Aggressive (restricted) policy – operations are conducted on a minimum amount of
working capital; uses shirt-term liabilities to finance, not only temporary, but also part or
all of the permanent current asset requirement
a. ADVANTAGES
i. Increases return on equity (profitability) by taking advantage of the cost
differential between long-term and short-term debt
b. DISADVANTAGES
i. Exposure to risk arising from low working capital position
ii. Puts too much pressure on the firm’s short-term borrowing so that it may
have difficulty in satisfying unexpected need for funds
3. Matching Policy (also called self-liquidating policy or hedging policy) – matching the
maturity of a financing source with specific financing needs
a. Short-term assets are financed with short-term liabilities
 b. Long-term assets are funded by long-term financing sources
4. Balanced Policy – balances the tradeoff between risk and profitability in a manner
consistent with its attitude toward bearing risk

DECIDING ON AN APPROPRIATE WORKING CAPITAL POLICY

The amount of net working capital that a company should have depends on the amount of risk it
is willing to take. The primary consideration therefore is the tradeoff between returns
(profitability) and risk (risk of illiquidity) associated with:

1. Asset Mix Decision – appropriate mix of current and non-current asset

2. Financing Mix Decision – appropriate mix of short-term and long-term liabilities to
finance current assets

RISK RETURN TRADEOFF

 The greater the risk, the greater is the potential for larger returns
 More current assets lead to greater liquidity but yield lower returns (profit)
 Fixed assets earn greater returns than current assets
 Long-term financing has less liquidity risk than short-term debt, but has a higher explicit
cost, hence, lower return

MANAGEMENT OF CURRENT ASSETS

OBJECTIVES: Determination of the appropriate mix of the current assets components (cash,
marketable securities, accounts receivables, and inventories), considering safety and liquidity,
as well as profitability.

CASH CONVERSION (OR OPERATING CASH CONVERSION CYCLE) - the length of time it takes
for the initial cash outflows for goods and services (materials, labor, etc.) to be realized as cash
inflows from sales (cash sales and collection of accounts receivable)

DETERMINATION OF CASH CONVERSION CYCLE

CASH MANAGEMENT – involves the maintenance of the appropriate level of cash and
investment in marketable securities to meet the firm’s cash requirements and to maximize net
income on idle funds

OBJECTIVE: to invest excess cash for a return while retaining sufficient liquidity to
satisfy future needs

REASON FOR HOLDING CASH

1. Transaction Purposes – firms maintain cash balance that they can use to conduct the
ordinary business transaction; cash balances are needed to meet cash outflow
requirements for operational or financial obligation
2. Compensating Balance Requirements – a certain amount of cash that a firm must leave
in its checking account at all time as part of a loan agreement. These balances give
banks additional compensation because they can be relent or used to satisfy reserve
requirements
3. Precautionary Reserves – firms hold cash balance in order to handle unexpected
problems or contingencies due to the uncertain pattern of cash inflows and outflows
4. Potential Investment Opportunities - excess cash reserves are allowed to build up in
anticipation of a future investment opportunity such as major capital expenditure project
5. Speculation – firms delay purchases and store up cash for use later to take advantage of
possible changes in prices of materials, equipment, and securities, as well as changes in
currency exchange rates
THE CONCEPT OF FLOAT IN CASH MANAGEMENT

FLOAT – difference between the bank’s balance for a firm’s account and the balance that the
firm shows in its own books

TWO ASPECTS OF FLOAT

1. The time it takes a company to process its checks internally

2. The time consumed in clearing the check through the banking system

TYPES OF FLOAT

1. NEGATIVE FLOAT – book balance exceeds the bank balance, which means that there is
more cash tied up in the collection cycle and it earns a 0% rate of return
 Mail float – peso amount of customers’ payments that have been mailed by a
customer but not yet received by the seller
 Processing float – peso amount of customers’ payments that have been received
by the seller but not yet deposited
 Clearing float – peso amount of customers’ checks that have been deposited but
not yet cleared

 GOOD CASH MANAGEMENT DICTATES THAT ABOVE FLOATS MUST BE

MINIMIZED, IF NOT ELIMINATED
2. POSITIVE FLOAT (DISBURSEMENT FLOAT) – the firm’s bank balance exceeds its book
balance [example: checks written/issued by the firm that has not yet been cleared].
Management should increase this type of float

CASH MANAGEMENT STRATEGIES

1. ACCELERATE CASH COLLECTION – reduce negative float

a. Bill customers promptly
b. Offer cash discounts for prompt payment
c. Establish local collection office
d. Request customers to makes direct payment to the firm’s depository bank
e. Use of automatic fund transfer or Electronic Fund Transfer (EFT)
2. CONTROL (SLOW DOWN) DISBURSEMENTS
a. Stretch payables by paying as late as possible within the credit period
b. Maintain zero-balance account (ZBA) – checks are written from special
disbursement accounts having zero peso balance (no minimum maintain cash
 balance required). Funds are automatically transfers from a master account when a
check drawn from a ZBA is presented
c. Play the float – increase the positive float
d. Less frequent payroll schedule issuance of checks to suppliers
3. REDUCE THE NEED FOR PRECAUTIONARY CASH BALANCE
a. More accurate cash budgeting
b. Have ready lines of credit
c. Invest idle cash in highly liquid, short-term investments instead of holding idle
precautionary cash balance

CASH FLOW MANAGEMENT

Cash flow can be managed by:

1. Preparing cash budgets

2. Preparing the cash break-even chart
3. Determining the optimal cash balance using the Baumol Cash Management Model

 CASH BREAK-EVEN CHART

1. It shows the cash break-even point – the mount of sales in pesos or the number of
units to be sold so that the total cash inflows are equal to the cash outflows
2. It shows the amount of cash deficiency when sales are below the cash break-even
point, or the amount of excess cash when sales is above the cash break-even point

 BAUMOL CASH MANAGEMENT MODEL – EOQ-type model which can be used to

determine the optimal cash balance where the cost of maintaining and obtaining cash
are at the minimum

Such Costs are the:

 1. Costs of securities transaction or costs of obtaining a loan
2. Opportunity cost of holding cash which includes the return foregone by not investing iin
marketable securities or the cost of borrowing cash

MANAGEMENT OF MARKETABLE SECURITIES

MARKETABLE SECURITIES – short-term money market instruments that can easily be

converted to cash

Examples:

1. Government Securities
 Treasury Bills – debt instruments representing obligations of the national
government issued by the Central Bank and sold at a discount through
competitive bidding
 CB Bills or Central Bank Certificates of indebtedness (CBCIs) – represent
indebtedness by the Central Bank
2. Commercial Papers (CPs) – short-term, unsecured, promissory notes issued by
corporations with very high credit standing

REASONS FOR HOLDING MARKETABLE SECURITIES (MS):

1. MS serves as substitute for cash (transactions, precautionary, and speculative)

balances.
2. MS serves as temporary investment that yields return while funds are idle
3. Cash is invested in MS to meet known financial obligations such as tax payments and
loan amortizations