Big Picture B

Week 4-5: Unit Learning Outcomes (ULO): At the end of the unit, you are
expected to:
a. Explain the importance of working capital management.
b. Compute for the optimal cash balance and discuss the different cash
management techniques.
c. Discuss the importance of trading off liquidity and profitability in establishing
credit and collection policies.
d. Determine the optimal inventory level and reorder point.

Big Picture in Focus: ULOa. Explain the importance of working

capital management.

Metalanguage
For you to demonstrate ULOa, you will need to have an operational understanding of
the following terms below.
1. Working Capital Management. It is associated with short – term financial
decision making. It also involves finding the optimal levels of cash, marketable
securities, accounts receivable, and inventory and then financing that working
capital at the least cost.

2. Short – term financial decisions. It involves cash inflows and outflows that
occur within a year or less.

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

4. Cash Conversion Cycle. The length of time that 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.

5. Inventory Conversion Period. The average time required to purchase

merchandise or to produce raw materials and convert them into finished goods
and then sell them.

6. 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.

7. Payment Period. The average length of time between the purchase of

materials and labor or merchandise and the payment of cash for them.
Essential Knowledge
To perform the aforesaid big picture (unit learning outcomes) for the weeks 4-5 of the
course, you need to fully understand the following essential knowledge laid down in
the succeeding pages. Please note that you are not limited to exclusively refer to
these resources. Thus, you are expected to utilize other books, research articles and
other resources that are available in the university’s library e.g. ebrary,
search.proquest.com etc., and even online tutorial websites.
1. Importance of Working Capital
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 often, 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 levels 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.

2. Factors Affecting Working Capital Policy

1. The nature of operation.
2. The volume of sales.
3. The variation of cash flows.
4. The operating cycle periods.

3. Operating Cycle (OC)

OC = Inventory Period (IP) + Ave. Collection Period (CP)
= (365/Inventory Turnover)+ (365/Receivable Turnover)
Or = [Ave. inventory/(COGS/365)] + [Ave. Accounts Receivable / (Net Credit
Sales/365)]
IT* =Cost of Goods Sold / Ave. Inventory
RT** = Net Credit Sales / Ave. Accounts Receivable
*IT = Inventory Turnover

**RT = Receivable Turnover

It is important to note that the formulas above were derived from any of each formula given.
So, using any of them will arrived at the same answer.
Illustration:
Suppose that Mermaid Industries has annual sales of P1,000,000, costs of goods sold
of P650,000, average inventories of P116,000, and average accounts receivable of
P15,000. Assuming that all Mermaid Industries sales are on credit, what will be the
firm’s operating cycle?
Solution:
OC = [116,000 / (650,000/365)] + [150,000/(1,000,000/365)]
= 119.89 or 120 days

4. Cash Conversion Cycle/ Net Operating Cycle (CCC or NOC)

CCC or NOC = IP + CP – PP
CCC or NOC = OC = PP
*PP = Payment Period

PP = 365 / Payable Turnover

Or = Ave. Accounts Payable / (Net Purchases/365)
Payable Turnover (PT) = Net Purchases / Ave. Accounts Payable
Illustration:
Using the information from previous illustration and assuming that the average
accounts payable balance is P120,000, what will be the firm’s cash conversion cycle?
Solution:
CCC or NOC = 120 days – [120,000(650,000/365)]
= 120-68
= 52 days

5. Working Capital Investing Policies

Policies
Conservative Moderate Aggressive
Current Assets
Current Liabilities
Net working capital
Default Risk
Liquidity
Profitability
Investment on currents assets represents liquidity. While investment on Non-Current
assets represents growth.

7. Working Capital Financing Policies

Financing

1 2 3 4 5
Current Assets: TA – LTF Partly STF STF STF
PA - LTF LTF LTF Partly STF
Non-Current Assets LTF LTF LTF LTF STF

TA – Temporary Assets
PA – Permanent Assets
STF- Short- term Financing
LTF – Long – term Financing
Partly – Combination of Short-term and Long – term Financing

Self-Help: You can also refer to the sources below to help you
further
*Cabrera, E. B. (2016). Financial management: Principles and application (Vol. 1).
Manila: GIC Enterprises & Co., Inc.
*Brigham, E., & Houston, J.(2013). Fundamentals of financial management (13th
ed.). Singapore: Cengage Learning Asia Pte Ltd.
*Agamata, F. T. (2012). Reviewer in management advisory services (2013 Ed.).
Manila: GIC Enterprises & Co., Inc.

Let’s Check

Questions:

1. What is the importance of working capital management in business entities?

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2. Which is favorable to the entities? A longer operating cycle or a shorter operating
cycle? Explain why.
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3. Which working capital financing policy is more favorable for the company? Explain
why.
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Let’s Analyze
Questions:
1. Determining the appropriate level of working capital for a firm requires
A. Changing the capital structure and dividend policy for the firm.
B. Maintaining a high proportion of liquid assets to total assets to
maximize the return on total investments.
C. Offsetting the profitability of current assets and current liabilities against
the probability of technical insolvency.
D. Maintaining short-term debt at the lowest possible level because it is
ordinarily more expensive than long term debt.
E. Evaluating the risks associated with various levels of fixed assets and
the types of debt used to finance these assets.
2. Compared to other firms in the industry, a company that maintains a
conservative working capital policy will tend to have a
A. Higher total asset turnover.
B. Greater percentage of short-term financing.
C. Higher ratio of current assets to fixed assets.
D. Greater risk of needing to sell current assets to repay debt.
3. A firm following an aggressive working capital strategy would
A. Hold substantial amount of fixed assets.
B. Minimize the amount of short-term borrowing.
C. Finance fluctuating assets with long-term financing.
D. Minimize the amount of funds held in very liquid assets.
4. The working capital financing policy that subjects the firm to the greatest risk of
being unable to meet the firm’s maturing obligations is the policy that finances
A. Fluctuating current assets with long-term debt.
B. Fluctuating current assets with short-term debt.
C. Permanent current assets with long-term debt.
D. Permanent current assets with short-term debt.
5. Jarrett Enterprises is considering whether to pursue a restricted or relaxed current
asset investment policy. The firm’s annual sales are $400,000; its fixed assets are
$100,000; debt and equity are each 50 percent of total assets. EBIT is $36,000,
the interest rate on the firm’s debt is 10 percent, and the firm’s tax rate is 40
percent. With a restricted policy, current assets will be 15 percent of sales. Under
a relaxed policy, current assets will be 25 percent of sales. What is the difference
in the projected ROEs between the restricted and relaxed policies?
A. 1.6% C. 5.4%
B. 3.8% D. 6.2%

6. Wildthing Amusement Company’s total assets fluctuate between $320,000 and

$410,000, while its fixed assets remain constant at $260,000. If the firm follows a
maturity matching or moderate working capital financing policy, what is the likely
level of its long-term financing?
A. $ 90,000 C. $320,000
B. $260,000 D. $410,000

7. Bully Corporation purchases raw materials on July 1. It converts the raw materials
into inventory by September 30. However, Bully pays for the materials on July 20.
On October 31, it sells the finished goods inventory. Then, the firm collects cash
from the sale 1 month later, on November 30. If this sequence accurately represents
the average working capital cycle, what is the firm's cash conversion cycle in days?
A. 92 days. C. 133 days.
B. 123 days. D. 153 days.

8. Ten Q’s Inc. has an inventory conversion period of 60 days, a receivable conversion
period of 35 days, and a payment cycle of 26 days. If its sales for the period just ended
amounted to P972,000, what is the investment in accounts receivable? (Assume 360
days a year.)
A. P72,450 C. P85,200
B. P79,600 D. P94,500

In a Nutshell

Based on the concepts on financial forecasting presented, write the three remarkable
lessons you learned.
1. _______________________________________________________

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2. _______________________________________________________

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3. _______________________________________________________

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Q&A List
Do you have any question for clarification? Write them here.

Questions/Issues Answers

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Keyword Index

Working capital
Operating cycle
Cash Conversion cycle
Inventory Conversion Period
Payment period