ELAINE KRYSTA S.

PONDO, MBA
Subject Instructor
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MODULE 4:
WORKING CAPITAL MANAGEMENT

Lesson
1

2
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Lesson 1: ADDRESSING WORKING CAPITAL POLICIES AND MANAGEMENT

OF SHORT-TERM ASSETS AND LIABILITIES

Learning Objectives

After studying Lesson 1, you should be able to:

Understand the concept and importance of working capital management

Identify and understand the factors affecting the firm’s working capital policy.
Distinguish the alternative policies as to the amount of investment in current
assets.
Know the alternative policies in financing investment in current assets.

Introduction

Working capital management is associated with short-term financial decision

making. Short-term financial decisions typically involve cash inflows and outflows that occur
within a year or less. For instance, short-term financial decisions are involved when a firm
orders raw materials or merchandise, pays in cash and anticipates selling finished goods in
one year for cash. In contrast, long-term financial decisions are involved when a firm
purchases a special equipment that will reduce operating costs over, say, the next five
years.

Working capital management also involves finding the optimal levels of cash,
marketable securities, accounts receivable and inventory and then financing that working
capital at the least cost. Effective working capital management can generate
considerable amounts of cash.

REASONS WHY WORKING CAPITAL MANAGEMENT IS IMPORTANT

1. Working capital comprises a large portion of the firm’s total assets. Although the level
of working capital varies widely among different industries, firms in manufacturing
and trading industries more often than not, keep more than half of their assets in
current assets.

2. The financial manager has considerable responsibility and control in managing the
level of current assets and current liabilities.

3. Working capital management directly affects the firm’s long-term growth and
survival because higher level of current assets are needed to support production
and sales growth.

4. Liquidity and profitability are likewise directly affected by working capital

management. Without sufficient liquidity, a firm may be unable to pay its liabilities as
they mature. The firm’s profitability is also affected because current assets must be
financed and financing involves interest expense.

FACTORS AFFECTING THE FIRM’S WORKING CAPITAL POLICY

1. The Nature of Operations. Working capital requirements differ greatly among

manufacturing, retailing and service organizations. For example, retailing firms have
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a high proportion of total assets in the current category because they earn their
return from current assets such as inventory.

2. The Volume of Sales. More current assets such as, accounts receivables and
inventories, are needed to support a higher level of sales.

3. The Variation of Cash Flows. The greater the fluctuations in the firm’s cash inflows and
outflows, the greater the level of net working capital required.

4. The Operating Cycle Period. The operating cycle is the length of time cash is tied up
in a firm’s operating process. For example, the operating cycle of a manufacturing
firm is the length of time required to purchase raw materials on credit, produce and
sell a product, collect the sales receipts and repay the credit. Shortening the
operating cycle reduced the amount of time funds are tied up in working capital
and thus lowers the level of working capital required.

Some questions that will fall under the general heading of working capital management
are:

1. What is a reasonable level of cash to keep on hand and in bank to pay bills?
2. How much credit should the firm extend to customers?
3. How much inventory should the company hold?
4. How much should the firm borrow in the short-term?

Working capital management has become particularly difficult in the declining

economic environment following the recent financial crisis. Some companies have been
stuck with unused inventory while others refrain from purchasing additional inventory until
they see sufficient evidence that consumers would start spending again.

Working capital management involves risk-return trade-offs because the level

composition and financing of working capital always affect both a firm’s risk and its
profitability.

TRACING CASH AND NET WORKING CAPITAL

To trace cash movement through the firm’s operation, we must measure the
operating cycle as well as the firm’s cash conversion cycle. Understanding the following
time periods is necessary in monitoring the working capital movement.

1. Operating Cycle. The length of time in which the firm purchases or produce
inventory, sell it and receive cash.

2. Cash Conversion Cycle. The length of time funds are tied up in working capital or
the length of time between paying for working capital and collecting cash from the
sale of inventory.

 Inventory Conversion Period. The average time required to purchase

merchandise or to purchase raw materials and convert them into finished
goods and then resell them.

 Average Collection Period. The average length of time required to convert

the firm’s receivables into cash, that is, to collect cash following a sale.
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 Payables Deferral Period. The average length of time between the purchase
of materials and labor or merchandise and the payment of cash for them.

HOW CAN OPERATING CYCLE BE REDUCED?

The aim of every management should be to reduce the length of operating cycle
or the number of operating cycles in a year in order to reduce the need for working capital.
It is therefore necessary that the financial managers be able to identify the reasons for
prolonged operation cycle and how it could be reduced.

The following could be the reasons for longer operating cycle period:

1. Defective purchasing policy and practices that could lead to

 Purchase of raw materials or merchandise in excess/short of
requirements
 Buying inferior, defective materials thus lengthening the production
time
 Failure to get credit from suppliers
 Failure to get trade/cash discount
 Inability to purchase goods due to seasonal swings

2. Lack of proper production planning, coordination and control that could

result to protracted manufacturing cycle.

3. Defective inventory policy.

4. Use of outdated machinery, technology as well, poor maintenance and

upkeep of plant, equipment and infrastructure facilities.

5. Defective credit policy and receivable collection procedures.

6. Lack of proper monitoring of external environment.

Remedies that may be adopted to reduce the length of operating cycle period
are as follows:

1. Production Management
 There should be proper production planning and coordination at all
levels of activity. Also, a continuing assessment of the manufacturing
cycle, proper maintenance of plant, equipment and infrastructure
facilities and improvement of manufacturing system, technology
would help shorten manufacturing cycle thus shortening the operating
cycle.

2. Purchasing Management
 The purchasing manager should ensure the availability of the right
type, quantity and quality of materials/merchandise obtained at the
right price, time and place through proper logistics management.
Further, efforts exerted towards lengthening the credit period of the
suppliers, increasing the rates of trade discount and cash discount
would certainly bring favourable outcome to the company’s deferral
payment period.

3. Marketing Management
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 The sale and production policies should be synchronized. Production

of quality products at lower costs enhance their marketability and
saleability. Storage costs would likewise be minimized. The marketing
people should strive to continually develop effective advertisement,
sales promotion activities, effective salesmanship and appropriate
distribution channels.

4. Credit and Collection Policies

 Sound credit and collection policies will enable the finance manager
to minimize investment in working capital particularly on inventory and
receivables.

5. External Environment
 The length of operating cycle is equally influenced by external
environment. The financial manager should be aware and sensitive to
fluctuations in demand, entrants of new competitors, government
fiscal and monetary policies, price fluctuations, etc. to be able to
anticipate and minimize any adverse impact of the changes to the
company.

SOME ASPECTS OF SHORT-TERM FINANCIAL POLICY

The working capital or short-term financial policy that a firm adopts involves
answering two basic questions.

1. What is the appropriate size of the firm’s investment in current assets?

2. How should the current assets be financed?

ALTERNATIVE POLICIES AS TO THE SIZE OF INVESTMENT IN CURRENT ASSETS

1. Relaxed Current Asset Investment Policy

 This is a policy under which relatively large amounts of cash,
marketable securities and inventories are carried and under which
sales are stimulated by granting liberal credit terms resulting in a high
level of receivables. In this policy, marginal carrying costs of current
assets will increase while marginal shortage costs will decrease.

2. Restricted Current Asset Investment Policy

 This is a policy under which holdings of cash, securities, inventories and
receivables are minimized. Marginal carrying costs of current assets will
decrease while marginal shortage costs will increase.

3. Moderate Current Asset Investment Policy

 This is a policy that is between the relaxed and restricted policies. This
policy dictates that the firm will have just enough current assets so that
the marginal carrying costs and marginal shortage costs are equal,
thereby minimizing total cost.

WHICH FINANCING POLICY SHOULD BE CHOSEN?

On the question as to what is the most appropriate financing working capital

strategy? There is no definitive answer. However, the following should be considered in
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analysing the advantages/disadvantages of the alternative financing policy for working

capital.

1. Maturity Hedging. Most firms attempt to match the maturities of assets and liabilities.
They finance inventories with short-term bank loans and long-term assets with long-
term financing. Firms tend to avoid financing long-lived assets with short-term
borrowing. This type of maturity mismatching would necessitate frequent
refinancing and is inherently risky because short-term interest rates are more volatile
than longer-term rates.

2. Cash Reserves. The flexible financing policy implies surplus cash and a little short-
term borrowing. This policy reduces the probability that a form will experience
financial distress. Firms may not have to worry as much about meeting recurring,
short-run obligations. However, investments in cash and marketable securities are
zero net present value investments at best.

3. Relative Interest Rates. Short-term interest rates are usually lower than long-term
rates. This implies that it is, on the average, more costly to rely on long-term
borrowing as compared to short-term borrowing. If we expect rates to rise in the
future, the firm may want to lock in fixed rates for a longer time by shifting towards
a flexible financing policy. With falling rates, the opposite would of course hold true.

4. Availability and Costs of Alternative Financing. Firms with easy and sustained access
to alternative sources will want to shift toward more restricted policy.

5. Impact on Future Sales. A more restricted short-term financial policy probably

reduce future sales to level that would be achieved under flexible policy. It is also
possible that prices can be charged to customers under flexible working capital
policy. Customers may be willing to pay higher prices for the quick delivery service
and lore liberal credit terms implicit in flexible policy.
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ASSIGNMENT:

R E V I E W Q U E S T I O N S

Direction: Answer comprehensively the following questions.

1. What are some of the characteristics of a firm with a long operating cycle?

2. What are some of the characteristics of a firm with a long cash cycle?

3. Miracle Manufacturing has recently installed just-in-time (JIT) inventory system.

Describe the effect this is likely to have on the company’s carrying costs, shortage
costs and operating cycle.

4. Is it possible for a firm’s cash cycle to be longer than its operating cycle? Explain why
or why not.

P R O B L E M S O L V I N G

Problem 4.1 (Cash Equation)

Corona Corporation has a book net worth of Php 10,380. Long term debt is Php 7,500. Net
working capital, other than cash is Php 2,105. Fixed assets are Php 15,190. How much cash
does the company have? If current liabilities are Php 1,450, what are the current assets?

Problem 4.2 (Working Capital)

Vaxine Manufacturing Company

Statement of Financial Position
As of December 31, 2021

Cash Php 20,000 Current liabilities (10%) Php 200,000

Marketable securities 30,000 Long-term liabilities (15%) 300,000
Accounts receivable 150,000 Total liabilities Php 500,000
Inventory 200,000
Total current assets Php 400,000 Stockholders’ equity Php 500,000
Net fixed assets 600,000 Total Liabilities and
Total assets Php 1,000,000 Owners’ equity Php 1,000,000

During 2022, the firm’s earnings before interest and taxes were 20 percent of Php 800,000 in
sales. The income tax rate is 34 percent.

Required:
a. Determine the level of working capital, net working capital and current ratio.
b. Calculate the return on equity (net income/stockholders’ equity)
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Use the following information about Vaxine Manufacturing Company to solve for (c) and
(d).

Vaxine Manufacturing Company decides to examine its working capital policy. In addition
to its current strategy of maintaining current assets at 50 percent of sales, Vaxine is
considering two other strategies based on current assets at 30 or 70 percent of next year’s
sales. Projected net sales and fixed assets for next year are Php 1,000,000 and Php 600,000,
respectively. Vaxine plans to maintain its existing capital structure of 50 percent debt and
50 percent equity. Current liabilities are to be 40 percent of projected total liabilities.

Required:

c. CalculateVaxine’s net working capital and current ratio

d. Explain what effect these strategies would have on Lockdown’s liquidity.
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Lesson 2: CASH AND MARKETABLE SECURITIES MANAGEMENT

Learning Objectives

After studying Lesson 2, you should be able to:

Understand the concept of cash management

Learn the objectives of cash management
Identify the reasons for holding cash balances
Understand the other factors that influence the target cash balance
Know the cash management techniques to manage properly the cash flows of
the firm
Understand the objective of marketable securities management
Realize the reason for holding marketable securities
Identify the factors influencing the choice of marketable securities
Learn the types of marketable securities

Introduction

Managing cash is becoming even more sophisticated in the global and electronic
age of the 21st century as finance managers try to squeeze the last peso of profit out of their
cash management strategies. Despite whatever lifelong teachings about the virtues of
having cash, the corporate financial manager actively seeks to keep this nonearning asset
to a minimum. Minimizing cash balances as well as having accurate knowledge of when
cash moves into and out of the company can improve overall corporate profitability.
However, a business firm would not want to get caught without cash when it is needed.
Cash management involves control over the receipts and payments of cash as to minimize
nonearning cash balances.

CASH MANAGEMENT

OBJECTIVE OF CASH MANAGEMENT

The basic objective in cash management is to keep the investment in cash as low as
possible while still keeping the firm operating efficiently and effectively.

A financial officer can use the following strategies in monitoring cash balances:

1. Accelerate cash inflows by optimizing mechanisms for collecting cash

2. Monitor the cash disbursement needs or payments schedule
3. Minimize the amount of idle cash or funds committed to transactions and
precautionary balances
4. Avoid misappropriation and handling losses in the normal course of business

To achieve the above objectives, proper planning of cash flows is needed. Effective
cash management generally encompasses proper management of cash flows which
entails among others the following:

a. Improving forecasts of cash flows

b. Using floats
c. Synchronizing cash inflows and outflows
d. Accelerating collections
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e. Controlling disbursements
f. Obtaining additional funds when and where they are needed

REASONS FOR HOLDING CASH BALANCES

A business enterprise may keep part of its capital tied up in cash for several reasons. These
are:

1. Transaction Facilitation
 This involves the use of cash to pay for planned business expenditures such as
supplies, payrolls, taxes, suppliers’ bills, and interest on debts, cash dividends
and acquisition of long-term fixed asset.

2. Precautionary Motive
 Although the firm expects cash to come in from day-to-day operations and
other financing activities, the inflows and outflows are not usually perfectly
synchronized. It will need to keep enough cash for emergency purposes.

3. Compliance with Creditors’ Covenant

 Another major reason for holding cash is to be able to comply the
requirement of lending institutions and other creditors of keeping a certain
percentage of borrowed funds in their bank accounts

4. Investment Opportunities
 Having excess cash may allow firm to take advantage of investment
opportunities that would otherwise be impossible to transact
 Example: a block of raw materials is offered at discounted prices if purchased
on cash basis

CASH MANAGEMENT TECHNIQUES

Although cash management activities are performed jointly by the firm and its
depository bank, the financial manager is primarily responsible for the effectiveness of the
cash management program.

Effective cash management encompasses the proper management of cash inflows

and outflows, which involve:

1. Synchronizing Cash Flows

 Synchronized cash flows is a situation in which inflows coincide with outflows
thereby permitting a firm to hold low transactions balances. If the firm is able
to reduce its cash balance, bank loans will be reduced together with the
corresponding interest expense, thus boosting profits.

2. Using Floats
 Float is defined as the difference between the balance shown in a firm’s
books and the balance on the banks record. It arises from the delays in
mailing, processing and clearing checks through the banking system.
 Once a check is received and a deposit is made, the deposited funds are
not available for use until the check has cleared the banking system (about
3 to 6 days) and credited to the corporate bank account. This means float
can be managed to some extent through a combination of disbursement
and collection strategies.
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a. Disbursement Float
 Represents the value of the checks the firm has written but which
are still being processed and thus have not been deducted from
the firm’s account balance by the bank

Example:

Suppose a firm writes on the average, checks amounting to Php 50,000

each day, and it takes 5 days for these checks to clear and to be deducted
from the firm’s bank account. This will cause the firm’s own checkbook to
show a balance of Php 250,000 smaller than the balance on the bank’s
records

b. Collections Float
 Represents the amount of checks that have been received but
which have not yet been credited to the firm’s account by the
bank

Example:

Suppose that the firm also receives checks in the amount of Php 50,000
but it loses four days while they are being deposited and cleared. This will
result in Php 200,000 of collection float.

In total, the firm’s net float, the difference between Php 250,000 positive
disbursement float and the Php 200,000 negative collection float, will be Php 50,000. If the
net float is positive, that is, disbursement float is more than collection float, then the
available bank balance exceeds the book balance.

ACCELERATING CASH COLLECTIONS

The finance manager should take steps for speedy recovery from debtors and for
this purpose, proper internal control should be installed in the firm. Once the credit sales
have been effected, there should be a built-in mechanism for timely recovery from the
debtors such as:

1. Prompt billing and periodic statements prepared to show the outstanding bills.

2. Incentives such as trade and cash discounts offered to customers for

early/prompt payments. These should be well communicated to them.

3. Prompt deposit. Once the checks/drafts are received from customers, no delay
should occur in depositing these receipts with the bank.

4. Direct deposit to firm’s bank account. Customers may also be advised to deposit
their checks or cash directly into the bank account of the firm and furnish details
to the firm.

5. Electronic depository transfer or payment by wire. With the developments taking

place in the computer technology, the present booking system is also being
switched over to the computer network of banks to offer efficient banking
services and cash management services to their customers. The network will be
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linked to the different branches, banks and the transfer of funds will take place
very fast that will result to substantial reduction of float.

6. Maintenance of regional collection office.

The above techniques can minimize the time lag between the time the customers
send the checks to the firm and the time when the firm can make use of the funds. This
system of cash collection will accelerate the cash inflows of the firm.

SLOWING DISBURSEMENTS

Any action on the part of the finance officer which slows the disbursement of funds
lessens the use for cash balance. This can be done by:

1. Centralized processing of payables. This permits the finance manager to evaluate

payments coming due for the entire firm and to schedule the availability of funds to
meet these needs on a company-wide basis. Care however should be taken so as
not to create ill will among suppliers of goods and services or raise the company’s
cost if bills are not paid on time.

2. Zero balance accounts (ZBA). These are special disbursements accounts having a
zero peso balance on which checks are written. As checks are presented to a ZBA
for payment, funds are automatically transferred from the master account.

3. Delaying payment. Of one is not going to take advantage of any offered trade
discount for early payment, pay on the last day of the credit period.

4. “Play the float”. This involves taking advantage of the time it takes for the company’s
check to clear the banking system.

5. Less frequent payroll. Instead of paying the workers weekly, they may just be paid
semi-monthly.

REDUCING THE NEED FOR PRECAUTIONARY BALANCE

Since the transaction and precautionary motives are the important determinants of
the cash requirement, factors influencing their combined level in the firm must be analysed.
There are techniques that are available for reducing the needs for precautionary balances.
These include:

1. More accurate cash budgeting. Most critical is the accuracy of the cash budget or
forecast. The closer the fit between cash inflows and outflows, the more certain the
forecasts the less need for precautionary balances.

2. Lines of credit. This is the pre-arranged loan where the company can withdraw
anytime within the period agreed upon.

3. Temporary investments. Investments in highly liquid securities may be maintained

instead of holding idle precautionary cash balances.
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MARKETABLE SECURITIES MANAGEMENT

OBJECTIVE OF MARKETABLE SECURITIES MANAGEMENT

The firm may hold excess funds in anticipation of a cash outlay. When funds are
being held for other than immediate transaction purposes, they should be converted from
cash into interest-earning marketable securities. Marketable securities which should be of
highest investment grade usually consist of treasury bills, commercial paper, certification of
time deposits from commercial banks, and money market notes.

REASONS FOR HOLDING MARKETABLE SECURITIES

1. They serve as a substitute for cash balances. Many firms prefer to hold marketable
securities as a substitute for transaction balances, precautionary balances, for
speculative balances or for all three. In most cases, however, the securities are held
primarily for precautionary purposes or as a guard against a possible shortage of
bank credit.

2. They are held as a temporary investment where a return is earned while funds are
temporary idle.

3. They are built up to meet known financial requirements such as tax payments,
maturing bond issue and so on.

FACTORS INFLUENCING THE CHOICE OF MARKETABLE SECURITIES

1. Risks such as

a. Default risk. The risk that the issuer of the security cannot pay the principal or
interest at due dates.

b. Interest rate risk. The risk of declines in market values of the security due to
rising interest rates.

c. Inflation risk. The risk that inflation will reduce the “real” value of the
investment. In periods of rising prices, inflation risk is lower on investments
(common stock, real estate) whose returns tend to rise with inflation than on
investment whose returns are fixed.

d. Marketability (liquidity) risk. This refers to the risk that securities cannot be sold
at close to the quoted market price and is closely associated with liquidity risk.

e. Event risk. The probability that some event (such as merger, recapitalization
or a leverage buyout) will occur and suddenly will increase a firm’s default
risk. Bonds issued by regulated companies as banks or electric utilities
generally have lesser event risk than bonds issued by industrial and service
companies.
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2. Maturity. Marketable securities held should mature or can be sold at the same time
cash is required. Firms generally invest in marketable securities that have relatively
short maturities. The maturity period of different investments should match with the
payment obligations like dividend payments, tax payments, and capital
expenditure and interest payments on debt instruments. Many firms restrict their
temporary investments to those maturing in less than 90 days.

3. Yield or returns on securities. Generally, the higher a security’s risk, the higher its
required return. Corporate investors must make a trade-off between risk and return
when choosing marketable securities.

TYPES OF MARKETABLE SECURITIES

1. Money Market Instruments

 These are the most suitable investment for idle funds. The money market is the
market for short-term debt instruments. Money market instruments are high-grade
securities characterized by a high-degree of safety of principal and maturity of
one year or less.

a. Discount Paper. A money market instrument which sells for less than its par
or face value. The difference between the security’s purchase price and
par value represents the investor’s income. At maturity, the investor
receives the face value or par value of the instrument.

b. Interest-bearing securities. These are instruments which pay interest based

on the par value or face value of the security and the period
(days/months) of investment.

2. Treasury Bills

 These are short-term government securities with a maturity of one year or less,
issued at a discount from face value often called risk-free security.
 These securities are tax exempt with high degree of marketability.

3. Other Short-term Commercial Papers Issued by Finance Companies, Banks and

Other Corporations

 These are typically unsecured and maturities ranged from a few days to 270 days.
 Commercial paper is usually discounted but it can be interest bearing.

4. Negotiable Certificates of Deposit

 Certificate of deposits are short-term loans to commercial banks with maturities

ranging from a few weeks to several years. Certificate of deposits contain some
default and interest rate risks can easily be sold prior to maturity.

5. Repurchase Agreements (REPOS)

 These are sale of government securities (treasury bills) or other securities by a

bank or securities dealer with an agreement to repurchase. REPOS usually involve
a very short-term overnight to a few days. These are attractive to corporations
because of the flexibility or maturities.
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6. Banker’s Acceptance

 A time draft drawn on, and accepted by a bank usually used as a source of
financing in international trade. Banker’s acceptances are sold as discount
paper with maturities ranging from a few weeks to 9 months.

7. Money Market Mutual Fund

 This is an open-ended mutual fund that invests in money-market instruments.

MMMF sell shares to investors and then accumulate the funds to acquire money
market instruments.
 These funds allow small investors to participate directly in high-yielding securities
that are often denominated in large amounts.
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ASSIGNMENT:

R E V I E W Q U E S T I O N S

Direction: Answer comprehensively the following questions.

1. In the management of cash and marketable securities, why should the primary
concern be for safety and liquidity rather than maximization of profit?

2. Why does float exist and what effect would electronic funds transfer systems have
on float?

3. Why would a financial manager want to slow down disbursements?

4. “Efficient cash management will aim at maximizing the availability of cash inflows by
decentralizing collections and decelerating cash outflows by centralizing
disbursements”. Discuss.

5. Would it be possible for a decision to deny credit to your customers to be value

maximizing? How?