TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY

MAS 3: FINANCIAL MANAGEMENT

WORKING CAPITAL AND CURRENT Simply stated, the goal is to minimize the
ASSETS MANAGEMENT length of the cash conversion cycle, which
minimizes current liabilities.
Current assets, commonly called working
capital, represent the portion of investment FUNDING REQUIREMENTS OF THE
that circulates from one form to another in CASH CONVERSION CYCLE
the ordinary conduct of business. This idea
Permanent VS Seasonal Funding Needs
embraces the recurring transition from
cash to inventories to accounts receivable If the firm's sales are constant, then its
and back to cash. investment in operating assets should also
be constant, and the firm will have only a
Net working capital is the difference
permanent funding requirement. If the
between current assets and current
firm's sales are cyclic, then its investment
liabilities. When current assets exceed
in operating assets will vary over time with
current liabilities, the firm has positive net
its sales cycles, and the firm will have
working capital. When current assets are
seasonal funding requirements in addition
less than current liabilities, the firm has
to the permanent funding required for its
negative net working capital.
minimum investment in operating assets.
Working capital management relates to the
Aggressive VS Conservative Funding
management of cash, marketable
Strategies
securities, receivables, inventory and
current liabilities. Working capital Under an aggressive funding strategy, the
management has dual objectives; ensure firm funds its seasonal requirements with
liquidity and optimize profitability. short-term debt and its permanent
requirements with long-term debt. Under a
Trade-off Between Profitability and Risk
conservative funding strategy, the firm
Ratio Change Effect on Effect on funds both its seasonal and its permanent
in ratio profit risk
requirements with long-term debt.
Current
Increase Decrease Decrease STRATEGIES FOR MANAGING THE
Assets
Total Assets Decrease Increase Increase CASH CONVERSION CYCLE

Current 1. Turn over inventory as quickly as

Increase Increase Increase
Liabilities possible without stockouts that
Total Assets Decrease Decrease Decrease
result in lost sales.
2. Collect accounts receivable as
CASH CONVERSION CYCLE (CCC)
quickly as possible without losing
Measures the length of time required for a sales from high-pressure collection
company to convert cash invested in its techniques.
operations to cash received as a result of 3. Manage mail, processing, and
operations. clearing time to reduce them when
collecting from customers and to
CCC=( AAI + ACP ) −APP increase them when paying
suppliers.
4. Pay accounts payable as slowly as
possible without damaging the
firm's credit rating.
INVENTORY MANAGEMENT
Common Techniques for Managing
Inventory
ABC System
A firm using the ABC inventory system
divides its inventory into three groups: A,
A positive cash conversion cycle means the
B, and C. The A group includes those
firm must use negotiated liabilities to
items with the largest peso investment. The
support its operating assets.

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 TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY
MAS 3: FINANCIAL MANAGEMENT

B group consists of items that account for inventory carrying costs with an average
the next largest investment in inventory. inventory of 200,000 units. What would be
The C group consists of a large number of the total carrying costs in 2020 if the order
items that require a relatively small size is 500,000 units or 900,000 units,
investment. assuming the company does not maintain
safety stock quantity.
Economic Order Quantity (EOQ) Model
Sample Problem 3
EOQ assumes that the relevant costs of
inventory can be divided into order costs EOQ. Assume an annual requirement of
and carrying costs. 24,000 units, a cost per unit of P20, a cost
per order of P750, and a carrying cost
Order costs include the fixed clerical costs
percentage of 20%.
of placing and receiving orders: the cost of
writing a purchase order, of processing the Sample Problem 4
resulting paperwork, and of receiving an
EOQ WITH VARIABLE QUANTITY
order and checking it against the invoice.
DISCOUNT. Let’s assume the same data in
Order costs are stated in dollars per order.
sample problem 3. Additionally, quantity
Carrying costs include storage costs, discounts are given by a supplier as
insurance costs, the costs of deterioration follows:
and obsolescence, and the opportunity or
Order size Quantity discount
financial cost of having funds invested in 24,000 10%
inventory. These costs are stated in dollars 12,000 6%
per unit per period. 8,000 4%
6,000 3%
Order costs decrease as the size of the 2,400 2%
order increases. Carrying costs, however, 1,000 1%
increase with increases in the order size.
The EOQ model analyzes the tradeoff Sample Problem 5
between order costs and carrying costs to
determine the order quantity that EOQ AND TRADE DISCOUNT. Assume an
minimizes the total inventory cost. annual need of 50,000 units; unit cost of
P80; carrying cost percentage, 20%; cost
The resulting equation is: per order, P90. A company’s supplier has
offered a 3% trade discount if purchases
EOQ=
√ 2 x AD x CPO
CCPU
are made on a quarterly basis.
Reorder Point (ROP)
Where,
Refers to the inventory level where the
AD = annual demand purchase order should be placed.
CPO = cost per order
CCPU = carrying cost per unit ROP = Lead time quantity + Safety stock
quantity
Sample Problem 1
Where,
ORDERING COSTS. Big City Corporation
expects to use 10,000 units of material Lead time quantity = normal usage x
XPO per month in 2020. Last year, the normal lead time
total ordering costs amounted to P200,000 Safety stock = Safety stock (usage) + Safety
for a total of 40 orders. It is expected that stock (time)
prices in 2020 would be 10% higher than
that of last year. Determine the expected Safety stock (usage) = (Max. usage –
ordering costs in 2020 if the company Normal usage) x Normal lead time
orders in a batch of 12,000 units or 24,000
Safety stock (time) = (Max. lead time –
units.
Normal lead time) x Normal usage
Sample Problem 2
And,
CARRYING COSTS. In 2019, Fit It
Company incurred a total of P800,000 for

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 TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY
MAS 3: FINANCIAL MANAGEMENT

Max. inventory level = Safety stock Cost of stockout occurrences = (No. of

quantity + Order size orders x Probability of occurrence) x
Stockout cost per occurrence
Sample Problem
If stockout occurs and production cannot
Linda Corporation has the following
be shifted to another product, production
production data:
stops. In this case, set-up costs increase
Annual requirement 40,000 units and the cost of stockout increases by the
Number of working days 320 days length of time the facility is shutdown.
Normal lead time 10 days
Maximum lead time 16 days Sample Problem
Maximum usage 150 units
EOQ 5,000 units
To illustrate, assume a company uses an
inventory where it places 12 orders per
Determine the lead time quantity, safety year, the cost of the stockout is P200 per
stock quantities, reorder point, and occurrence, the carrying cost per unit is P2
maximum and minimum inventory levels. per year, and the probabilities of stockouts
have been estimated for various levels of
Stockout Costs safety stock as follows:
Inadequate inventory levels carried by a Safety stock (in units)
Probability of
business have the following costs: Stockout
0 60%
 Extra purchasing, handling and 100 50%
200 40%
transportation costs.
400 20%
 Lost sales and lost of customer 600 10%
goodwill.
 Additional clerical costs due to Determine the optimal safety stock.
keeping customer-back order
records. Just-in-Time (JIT) System
 Inflation-oriented increases in prices Used to minimize inventory investment.
when inventory purchases are The philosophy is that materials should
deferred. arrive at exactly the time they are needed
 Frequent stock-outs leading to for production. Ideally, the firm would have
disruptions of production schedules, only work-in-process inventory. Because
overtime and extra setup time. its objective is to minimize inventory
 Higher price due to small quantities investment, a JIT system uses no (or very
(e.g., extra purchasing on little) safety stock.
transportation costs).
 Foregone suppliers' discounts. The goal of the JIT system is
manufacturing efficiency. It uses inventory
Reducing stockout occurrences have direct as a tool for attaining efficiency by
relations with the level of safety stock. The emphasizing quality of the materials used
higher the safety stock quantity, the lower and their timely delivery. When JIT is
the possibility of stockout, and vice-versa. working properly, it forces process
Stockout has two costs, the carrying costs inefficiencies to surface.
of safety stock and the costs of stockout
occurrences. These are expressed Materials Requirement Planning (MRP)
mathematically as: System

Total stockout cost = Cost of carrying
safety stock quantity + Cost of stockout
occurrences
Where,
Cost of carrying safety stock quantity =
Safety stock quantity x Carrying cost per
unit
Used to determine what materials to order
and when to order them. ARP applies EOQ
concepts to determine how much to order.
Using a computer, MRP simulates each
product's bill of materials, inventory
status, and manufacturing process.
ACCOUNTS RECEIVABLE MANAGEMENT

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 TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY
MAS 3: FINANCIAL MANAGEMENT

The objective for managing accounts score is used to make the accept/reject
receivable is to collect accounts receivable decision for granting the applicant credit.
as quickly as possible without losing sales
The purpose of credit scoring is to make a
from high-pressure collection techniques.
relatively informed credit decision quickly
Accomplishing this goal encompasses three and inexpensively, recognizing that the
topics: (1) credit selection and standards, cost of a single bad scoring decision is
(2) credit terms, and (3) credit monitoring. small. However, if bad debts from scoring
decisions increase, then the scoring system
CREDIT SELECTION AND STANDARDS
must be reevaluated.
Credit selection involves application of
Changing Credit Standards
techniques for determining which
customers should receive credit. This Effects of Relaxation of Credit Standards
process involves evaluating the customer's Direction Effect on
Variable
creditworthiness and comparing it to the of change profits
firm's credit standards, its minimum Sales volume Increase Positive
requirements for extending credit to a Investment in A/R Increase Negative
customer. Bad-debt expense Increase Negative

Five C's of Credit

CREDIT TERMS
One popular credit selection technique,
Cash Discount
however, because of the time and expense
involved, this credit selection method is Including a cash discount in the credit
used for large-peso credit requests. terms is a popular way to speed up
collections without putting pressure on
1. Character: The applicant's record of
customers. The cash discount provides an
meeting past obligations.
incentive for customers to pay sooner. By
2. Capacity: The applicant's ability to
speeding collections, the discount
repay the requested credit, as
decreases the firm's investment in
judged in terms of financial
accounts receivable, but it also decreases
statement analysis focused on cash
the per-unit profit. Additionally, initiating a
flows available to repay debt
cash discount should reduce bad debts
obligations.
because customers will pay sooner, and it
3. Capital: The applicant's debt relative
should increase sales volume because
to equity.
customers who take the discount pay a
4. Collateral: The amount of assets the
lower price for the product. Accordingly,
applicant has available for use in
firms that consider offering a cash
securing the credit. The larger the
discount must perform a benefit-cost
amount of available assets, the
analysis to determine whether extending a
greater the chance that a firm will
cash discount is profitable.
recover funds if the applicant
defaults. greater the chance. The Effective Discount Rate
5. Conditions: Current general and
industry-specific economic The discount rate adjusted on an annual
conditions, and any unique basis. It is computed as follows:
conditions surrounding a specific Discount rate Days∈a year
transaction. x
100 %−discount rate Remaining credit time
Credit Scoring Or, Discount time turnover x adjusted
Credit scoring is a method of credit discount rate per discount time
selection that firms commonly use with Party If the, Then,
high volume/small-peso credit requests.
Applying statistically derived weights to a Seller EDR < ROI of money Offer CD
credit applicant's scores on key financial collected in advance
Seller EDR > ROI of money Do not offer
and credit characteristics, the procedure collected in advance CD
results in a score that measures the
applicant's overall credit strength, and the Buyer EDR > cost of money Avail of the CD

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 TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY
MAS 3: FINANCIAL MANAGEMENT
Buyer EDR < cost of money Ignore the CD
Buyer EDR < ROI if money is Ignore the CD
used
Buyer EDR > ROI if money is Avail of the CD
used
Cash Discount Period
The net effect of changes in this period is
difficult to analyze because of the nature of
the forces involved. For example, if a firm
were to increase its cash discount period
by 10 days (for example, changing its
credit terms from 2/10 net 30 to 2/20 net
30), the following changes would be
expected to occur: (1) Sales would
increase, positively affecting profit. (2) Bad-
debt expenses would decrease, positively
affecting profit. (3) The profit per unit
would decrease as a result of more people
taking the discount, negatively affecting
profit.
The difficulty for the financial manager lies
in assessing what impact an increase in
the cash discount period would have on
the firm's investment in accounts
receivable. This investment will decrease
because of non-discount takers now paying
earlier. However, the investment in
accounts receivable will increase for two
reasons: (1) Discount takers will still get
the discount but will pay later, and (2) new
customers attracted by the new policy will
result in new accounts receivable. If the
firm were to decrease the cash discount
period, the effects would be the opposite of
those just described.
Credit Period
For example, increasing a firm's credit
period from net 30 days to net 45 days
should increase sales, positively affecting
profit. But both the investment in accounts
receivable and bad-debt expenses would
also increase, negatively affecting profit.
The increased investment in accounts
receivable would result from both more
sales and generally slower pay, on average,
as a result of the longer credit period. The
increase in bad-debt expenses results from
the fact that the longer the credit period,
the more time available for a firm to fail,
making it unable to pay its accounts
payable. A decrease in the length of the
credit period is likely to have the opposite
effects.
Sample Problem
Robert Company is considering to change
its credit terms from 2/10, n/30 to 2/10,
n/45. This change would push the 2020
sales to reach P48 million, or an increase
of 20% from last years’. 90% of total sales
would be on credit. 80% of credit
customers are expected to avail of the
discount offered by Robert Company.
Accounts receivable at the end of year is
estimated at 15% of sales. Variable costs
ratio shall be maintained at 75%.
In relation to changing the credit period,
collection costs would increase by 10% of
the incremental gross sales. Doubtful
accounts are expected to increase from 1%
to 1.75% of credit sales. The effective rate
of return on a given investment is
determined at 12%.
Should Robert Company change its credit
period in 2020?
CREDIT MONITORING
Credit monitoring is an ongoing review of
the firm's accounts receivable to determine
whether customers are paying according to
the stated credit terms. Two frequently
used techniques for credit monitoring are
average collection period and aging of
accounts receivable. In addition, a number
of popular collection techniques are used
by firms.
Average Collection Period
The average collection period has two
components: (1) the time from sale until
the customer places the payment in the
mail and (2) the time to receive, process,
and collect the payment once it has been
mailed by the customer. The formula for
finding the average collection period is
360
Ave .Coll . Period= ¿
Receivables ¿
Where,
Net credit sales
Receivables ¿=
Ave . Receivables
Assuming receipt, processing, and
collection time is constant, the average
collection period tells the firm, on average,
when its customers pay their accounts.
Aging of Accounts Receivable
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 TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY
MAS 3: FINANCIAL MANAGEMENT
An aging schedule breaks down accounts
receivable into groups on the basis of their
time of origin. The breakdown is typically
made on a month-by-month basis, going
back 3 or 4 months. The resulting
schedule indicates the percentages of the
total accounts receivable balance that have
been outstanding for specified periods of
time.
The purpose of the aging schedule is to
enable the firm to pinpoint problems. A
simple example will illustrate the form and
evaluation of an aging schedule.
Age of AR Outstanding Percentage of
Balance total balance
0-30 days P 80,000 40%
31-60 days 36,000 18%
61-90 days 52,000 26%
91-120 days 26,000 13%
Over 120 days 6,000 3%
Total P 200,000 100%
Popular Collection Techniques
In the order typically followed in the
collection process.
 Letters
 Phone calls
 Personal visits
 Collection agencies
 Legal action
CASH FLOAT MANAGEMENT
Float refers to funds that have been sent
by the payer but are not yet usable funds
to the payee. Float is important in the cash
conversion cycle because its presence
lengthens both the firm's average collection
period and its average payment period.
However, the goal of the firm should be to
shorten its average collection period and
lengthen its average payment period. Both
can be accomplished by managing float.
Float has three component parts:
1. Mail float is the time delay between
when payment is placed in the mail
and when it is received.
2. Processing float is the time between
receipt of the payment and its
deposit into the firm's account.
3. Clearing float is the time between
deposit of the payment and when
spend able funds become available
to the firm. This component of float
is attributable to the time required
for a check to clear the banking
system.
CASH RECEIPTS
Speeding up collections reduces customer
collection float time and thus reduces the
firm's average collection period, which
reduces the investment the firm must
make in its cash conversion cycle. Some
effective methods of cash inflow
management are:
 Use of specialized postal system
(lockbox system)
 Electronic fund transfer (EFT)
 Concentration banking and zero-
balance accounts
CASH DISBURSEMENTS
Float is also a component of the firm's
average payment period. In this case, the
float is in the favor of the firm. The firm
may benefit by increasing all three of the
components of its payment float. Some
effective methods of cash outflow
management are:
 Use of checks and drafts
 Voucher system
 The 3 o’clock habit
 Thank God Its Friday (TGIF)
Syndrome
 Payroll management
In summary, a reasonable overall policy for
float management is (1) to collect payments
as quickly as possible because, once the
payment is in the mail, the funds belong to
the firm; and (2) to delay making payment
to suppliers because, once the payment is
mailed, the funds belong to the supplier.
MARKETABLE SECURITIES
Marketable securities are short-term,
interest-earning, money market
instruments that can easily be converted
into cash. Marketable securities are
classified as part of the firm's liquid assets.
The firm uses them to earn a return on
temporarily idle funds. To be truly
marketable, a security must have (1) a
ready market so as to minimize the
amount of time required to convert it into
cash, and (2) safety of principal, which
means that it experiences little or no loss
in value over time.
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 TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY
MAS 3: FINANCIAL MANAGEMENT

The securities that are most commonly

held as part of the firm's marketable
securities portfolio are divided into two
groups: (1) government issues, which have
relatively low yields as a consequence of
their low risk; and (2) nongovernment
issues, which have slightly higher yields
than government issues with similar
maturities because of the slightly higher
risk associated with them.

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