WORKING CAPITAL

MANAGEMENT
Learning Objectives

Explore the importance of working

capital and cash management in the
business.

Integrate the acquired learning to craft

good implication and recommendation
in analyzing company’s performance
through financial ratios.
 Working Capital

This is the difference between the firm’s

current assets and current liabilities.

It is used as a measure to check the

liquidity of the firm.
If the firm’s current assets are greater than
the current liabilities, it is capable of paying its
current obligations.
If the current assets are less than the current liabilities,
then the firm cannot pay its current obligations and has
to resort to borrowings.
Working Capital

Having a well-planned working capital, the company can

take advantage of business opportunities to achieve its
goal promptly and meet its financial obligations.

Optimizing the use of excessive working capital prevents

excessive investment.

Having an excessive working capital has a negative impact

on the profitability and liquidity of the company due to
various factors associated with it.
Working Capital Management

Is concerned with the efficient

and effective utilization of
working capital to attain the
It is also pertinent of the
predetermined objectives of the
administration and control of
company relative to profitability
working capital to ensure that it is
of operations, liquidity of
adequate and effectively utilized.
financial resources, and
administration of risks and
company costs.
 Current •
•
Cash
Accounts receivable
Assets •
•
Marketable securities
Inventory
comprise: • Prepaid assets

Current
• short-term obligations
Liabilities • (expected to mature within one year)

comprise:
Working Capital Management

It requires decision on how the current

assets will be financed and utilized.

Managing current liabilities, implies

maximizing the company’s holding period
before the firm finally pays off its obligation.

Top management determines how much

investment should be made in current
assets.
Working Capital Management
Current assets are not properly managed if funds are tied
up in one or several assets that do not provide any return
when in fact, it could be more productive and beneficial to
the firm if placed somewhere else.

Goal of management is to maintain a cash level at a

minimum without putting the company at risk, thus
maintaining a level of cash that is enough to support the
firm’s operations.

Maintaining too much cash is hazardous to the company.

As the most liquid among the assets, cash is susceptible to
theft. (mutual funds, time deposit, bonds, and capital
investment)
Working Capital Management

In managing accounts receivable, the company does not want to be

too lax nor strict in granting credits. Being lenient would result in
accounts receivable increases and bad debts.

In managing inventories, investing in excessive stocking levels may

result in obsolescence and losses. Maintaining inventories at a level
enough to support the market demand means a lot of cost savings in
terms of warehousing, insurance, and ,manpower, among others.

In handling current liabilities, the firm has to be prudent in making

use of time before it finally pays off its obligations. Its prime
responsibility is to hold on to current obligations that can be easily
handled by its current assets.
 Components of Working Capital
Current Assets & Current Liabilities
are collectively known as
WORKING CAPITAL

Cash & Marketable Securities:

Cash: Dollar Bills & Bank Deposits.
DEMAND DEPOSITS: Money in checking accounts that the firm can pay out immediately.
TIME DEPOSITS: Money in saving accounts that the firm can pay out only with a delay.

Marketable Securities: Commercial Paper & Tresury Bills

Accounts Receivable:
arise because of companies do not usually expect
customers to pay for their purchases immediately.
These unpaid bills are a valuable asset that companies
expect to be able to turn into cash in the near future.
TRADE CREDIT : Unpaid bills from sales to other companies.
CONSUMER CREDIT : Sales of goods to the final customers.
Components of Working Capital
Accounts Payable: Unpaid Bills
Outstanding payments due to other companies
One firm’s credit is another firm’s debit

NET WORKING CAPITAL

CURRENT ASSETS – CURRENT LIABILITIES
Generally called as

WORKING CAPITAL
 CASH

RECEIVABLES CASH CONVERSION CYCLE INVENTORY

FINISHED
GOODS

CASH CONVERSION CYCLE =

(Inventory Period + Receivables Period) – Accounts Payable Period
 CASH CONVERSION CYCLE = 10800232
(Inventory Period + Receivables Period) – Accounts Payable Period

CASH CONVERSION CYCLE :

Period between firm’s payment for materials and collection on its sales

Inventory Period = Average Inventory / [Cost of Goods Sold / 360]

Receivables Period = Average Accounts Receivables / [Sales / 360]
Payable Period = Average Payable / [Sales / 360]
 Working Capital Trade-off
Carrying Costs:
Costs of maintaining Current Assets; including opportinity cost of capital.
Investment in CASH & RECEIVABLES may cause an interest loss and

Investment in INVENTORY has opportinity cost of capital; storage & insurance costs

Carrying Costs encourage firm to hold current assets to a MINIMUM

Shortage Costs:
Costs incurred from shortages in Current Assets
Shortage in CASH may incur unnecassary transaction costs of selling marketable securities and

Shortage in RECEIVABLES may cause to lose customers because of credit sales’ restrictions

Shortage in INVENTORY may have shut down production & unable to to fill orders promptly

Shortage Costs encourage firm to hold current assets to a MAXIMUM

It’s an art to find the LEVEL of CURRENT ASSETS

that minimizes the sum of
Carrying Costs & Shortage Costs
- END -
Working Capital
Policies
Learning Outcomes

1. Discuss the guidelines set for working

capital policies of the firm.

2. Discuss how is working capital

managed.
Working Capital Policies

- this refers to the policies and

guidelines on the amount of a capital
the company should maintain.
 Working Capital Policies

1. Matching Policy
• The policy works in an
arrangement where the
current assets of the business
are used to perfectly match
the current liabilities.
• This type of policy provides
moderate risk and moderate
return to the company.
2. Aggressive Policy
• This type of policy has a
high risk and, often, high
return to the company. The
company keeps a low
amount of current assets to
support the operations.
• Moreover, for this type of
policy, the company is
financing its temporary
current assets and some of
its permanent current
assets with short-term
liabilities.
3. Conservative Policy
• Lowest risk and lowest
return.
• In this policy, the
company matches a
portion of the
temporary current
assets, and the entire
permanent current
assets and fixed assets
with long-term
liabilities or equity
issuance.
Ways to help improve the firm’s
management of working capital:
1. LOOKING AT THE FINANCIAL RATIOS
- financial ratios play a crucial role in managing working capital. It draws
important information that the firm may use in order to improve its
working capital.
- high current ratio but low quick ratio gives high investment in
inventories.
- high investment inventories does not necessarily have a bad impact on
the firm’s profitability if such investment has a high turnover.
- thus, high and slow moving inventory will result in spoilage and high
cost of maintenance.
- with the aide of financial ratio, the firm becomes aware of how to
handle its inventories at a level that would minimize costs.
1. LOOKING AT THE FINANCIAL RATIOS
- a high current ratio coupled with a high quick ratio gives
the firm a high level of either cash, accounts receivable,
marketable securities, or any combination of the three.
- having a high investment in cash is risky because of its
susceptibility to theft.
- too many receivable may lead non-collection and cash
shortage.
- if high current ratio and quick ratio are the result of a high
investment in short-term marketable securities, it can be
concluded that the firm is knowledgeable in properly
handling excess cash.
2. Putting up proper internal
control
INTERNAL CONTROL
- has an important part in securing the working capital of the firm.
- Proper internal control of cash averts theft, mishandling, or
misappropriation; proper internal control of inventories prevents
unauthorized releasing of goods from warehouse; and proper internal
control of receivables disallows the non-recording of cash collections.
3. Changing company policies
POLICIES
- serve as a guideline in executing the
transactions and activities of the company.
- if the existing policy does not contribute to
the general welfare of the company,
changing it would be better option.
Cash Management
Cash
– is a current asset used to purchase raw materials, pay for
labor, buy capital assets, and pay for dividend, taxes, and
obligations.
- it does not earn interest for itself if not properly managed.
 • Maintain the
Cash use of cash and
Management maintain
Objective optimum cash
at the right time
Reasons for Maintaining Cash
1. Transaction Motive
• This refers to the intention to meet the minimum
business operations requirement.
• Cash balance should be enough to pay for the routine
payments such as obligations to creditors, periodic
payrolls, supplies, and overhead and other
predictable expenses.
• Shortage in cash collections results in borrowings and
any excess funds may be invested in maketable
securities.
Reasons for Maintaining Cash
2. Speculative Motive
• This leads to the use of cash balances to
take advantage of bargain purchases on
materials or unusual cash discounts.
• Firms believe that they will be better off
if they grab any opportunity in the
market by immediately paying cash.
Reasons for Maintaining Cash
3. Precautionary Motive
• This results in holding cash for unforeseen
fluctuations in cash inflow and outflow.
• Maintaining credit line with banks is
usually done by firms to meet their
precautionary needs. This way, the need
for maintaining cash is reduced.
CASH
EQUIVALENTS
Learning Outcomes
◦Discuss what is cash equivalents and
its advantages.
◦Explain the factors affecting cash
requirements.
◦Explain the possible placement for
excess cash.
 CASH EQUIVALENTS
• These are short-term, highly liquid investments that
are readily convertible to cash.
• These are investment which are so near their
maturity dates, making risks inherent to the
investment insignificant.
• Based on the Philippine Accounting Standard No. 7,
investment with the original maturity of three
months or less is qualified as a cash equivalent.
• Thus, the purchase date must be three months or
less before the maturity date.
• Firms usually take advantage of placing their excess
funds in cash equivalents rather than maintaining a
credit line.
CREDIT LINE
◦It is a loan granted by banks for a
certain amount for a particular
period.
Examples:
◦ A 90 –day treasury bill
◦ A 180- day treasury bill purchased within 90 days
before its maturity
◦ A 90 – day time deposit
◦ A 90 – day commercial paper
◦ Long- term commercial paper purchased within
90 days before its maturity
◦ Other money market instruments whose
maturity is within three months
Advantages of Holding Cash or
Cash Equivalents
1. Taking
• Suppliers give discounts to encourage early payments, it
advantage of the result in less outflow of cash.
trade discounts.

2. Maintenance of • Having a good current and quick asset ratio on a par with
the industry, the firm will be able to maintain good credit
goods credit standing with suppliers offering favorable credit terms and
rating. with banks giving low interest rate.

3. Favorable
• Firms may take advantage of special offers from suppliers
business and a possible takeover of another firm.
opportunities
Advantages of Holding Cash or
Cash Equivalents
• Firms may immediately recover
4. Meeting losses brought about by fire,
emergencies typhoons, strikes, and other
unexpected events.

• Having enough cash enables the

5. Capacity firm to face its competitors by
to compete expanding or developing new
products or advertisements.
Factors Affecting Cash Requirements

1. Firm’s policy on cash management

2. Availability loans
3. Forecasted cash inflow and outflow
4. Unpredictable events
 Possible Placement for
Excess Cash
Having idle funds for a certain period of time is
a good source of an incremental income
(Harrington, 2004).
Some of the possible places of investments are
as follows:
 Possible Placement for
Excess Cash
1. Savings/ Current accounts
➢These are bank placements with no holding period.
However, the interests earned in these kinds of
placements are lower than those earned in time deposits.
➢In the past, the current account does not bear interest,
but because of the growing need of firms, other financial
institutions now offer current accounts that bear interest.
➢However, the interest offered by a current account is
lower than the interest offered by a savings account.
 Possible Placement for
Excess Cash
2. Time deposits
➢These are placements with holding period.
➢Time deposits are normally taxed at 20% of
the interest income.
➢These are placements offered by banks that
earn a higher interest than the savings
account.
 Possible Placement for
Excess Cash
3. Time deposits
➢ These are placements with holding period.
➢Time deposits are normally taxed at 20% of
the interest income.
➢ These are placements offered by banks
that earn a higher interest than the savings
account.
 Possible Placement for
Excess Cash
4. Treasury bills
➢These are short-term obligations issued by the
government.
➢Treasury bills are usually offered with a maturity of 91
days.
➢However, there are treasury bills that mature in more than
91 days but less than a year.
➢Treasury bills are unique because these are traded on a
discount basis; that is, it earns interest until the maturity
date. The maturity value less the discounted value is the
profit earned for investing in treasury bills.
Possible Placement for
Excess Cash
5. Commercial papers
➢These are unsecured promissory notes
issued by firms with high credit
standings.
➢ The interest earned from commercial
papers is normally higher than that
from the firm's good track record of
cash inflows.
CONTROLLING CASH FLOW

◦Controlling the cash flow is the main

objective of cash management.

◦Maximizing the use of cash means

minimizing cash outflows and maximizing
cash inflows.
Tools for controlling
cash flows :
1. Synchronizing Cash Flow
2. Floats on Disbursements
3. Accelerating Collection of Funds
by Reducing Collection Float
The following tools may be used
for controlling cash flows:
1. SYNCHRONIZING CASH FLOW
➢This is a process in which the cash inflows coincide with
the outflows.
➢A synchronized cash flow is highly dependent on an
accurate forecast of inflows and outflows. A more accurate
forecast helps the firm minimize its cash balance since it can
immediately determine the time when cash will actually be
needed.
➢As a result, there will be less borrowings, lower interest
expense, and maximized profits.
2. Floats on Disbursements
➢These are the differences between the company's book
balance and bank account balance in any period of time.
➢Floats exist when the firm issues its own check and sends it
to the payee company.
➢The payee, in return, has to deposit the check in their bank
account. The number of days from the issuance of the check
to its clearance is known as float days.
➢ The issuer of the check prefers that the recipient deposits
the check in its own bank at a much later date.
2. Floats on Disbursements
➢However, for various reasons, the check may not be
deposited in the bank.
➢Factors like misplacement of the check, getting lost in
transit, or technical errors or problems in the check
presented are only some of the reasons for the delay of
clearing.
➢Geographical location is also another factor in which the
clearing of checks may be delayed. Checks are cleared
depending on the type of check issued.
➢An on-us check takes a day for clearing, local checks take
three days' clearing, the regional checks take five to seven
days, and out-of-town checks take about seven to ten days.
A float can be classified into
three categories:
1. Mail float - It is from the time the check is issued
up to the time the check is received by the payee.
2. Processing float - It is from the time the check is
received by the payee until the time it is deposited
in the payee's bank account.
3. Clearing float - It is from the date the check is
deposited up to the date the check is cleared and
made available for use.
3. Accelerating Collection of Funds
by Reducing Collection Float
1. Collecting center or agent
➢ Float can be reduced by strategically locating a collection center
near the customer.
➢ The collection center can be a firm providing a collection service,
or a bank where payments are made directly to the firm's
account.
➢ Having a collecting center near the customer may even lead to a
zero float, making the check collection as good as cash.
➢ A firm may also consider the possibility of having its own
collecting agents or collecting centers, if it is economically
possible to reduce the collection period in a certain area.
➢ The finance manager should be able to determine the additional
cost associated with this separate set-up and the benefits
attached to it to arrive at the possible solutions.
Example:
Cunanan Corporation has an agreement with Rizal
Commercial Banking Corporation (RCBC) to collect P3,000,000
a day in exchange for a compensating balance of P1,000,000.
The firm, with a significant increase in its customer in the
area, is thinking of canceling the agreement and dividing the
service provided by RCBC with ABC Bank. With this plan, RCBC
will handle the collection of P2,000,000 with a compensating
balance of P800,000.
On the other hand, ABC bank will handle the other
P1,000,000 collection in exchange for a compensating balance
of P700,000. With the planned arrangement with the two
banks to perform the collection, the firm is expecting to reduce
the collection period by one day.
The firm's rate of return is 9%. Should Cunanan
Corporation pursue the division of service between RCBC and
ABC bank?
Analysis on the problem:
Amount of cash collection per day P 3,000,000.00
Number of days freed on the collection X 1
Amount of cash freed P 3,000,000.00
Less: Increase in compensating balance (500,000.00)
Increase in cash flow P 2,500,000.00
Rate of return X 0.09
Incremental income 225,000.00

Based on the analysis above, Cunanan Corporation should pursue the plan
of dividing the service between RCBC and ABC Bank. Despite the increase in
compensating balance from P1,000,000 to P1,500,000 (P800,000 from RCBC
+ P700,000 from ABC), the firm will be able to increase its cash inflow by
P2,500,000 resulting to an incremental income of P225,000 per year.
2. Lockbox system
➢It is a system where the company has a "P.O. box number"
address.
➢This P.O. box is rented in a postal office where all
collections made by the customer will be directed to.
➢Lockboxes are normally managed by banks. A bank
employee goes to the post office to empty the postal box
and immediately deposits the check payment made by the
customers.
➢Several factors, like average size of the receipts from
customers, quantity of receipts collected per day, and
average number of mail received, have to be considered
before selecting the location of the lockbox.
➢ A lockbox is not offered free by whoever is willing
to render the service.
➢ Firms who like to avail of such a service have to
consider the costs involved. A cost-benefit analysis
has to be made before deciding whether or not to
make use of the lockbox system. The variables in
the analysis are: cost of the service, number of
days in which float is reduced, the amount of check
to be converted immediately into cash, and
expected rate of return on the cash freed.
Example:
Cunanan Corporation has average cash receipts of P 150,000 per day.
Normally, it takes 7 days from the time the check is received for it to be
made available as cash. How much cash is tied up?

Computation shall be as follows:

Average cash receipts per day P 150,000

Number of days tied up x 7
Amount of cash tied-up P 1,050,000
Example:
Cunanan Corporation has an average of seven days to
receive and deposit the checks from customers. The owner
believes that it takes too long for the firm to use the funds
to support its operations. In answer to this problem, a bank
offers its service through the use of a lockbox system.
The banker explains that with the system in place,
the expected float time will be reduced to 4 days. The bank
charges P 10,000 per month for its overhead cost on the
service. Should Cunanan Corporation avail of the service
offered by the bank? How much is the advantage or
disadvantage of the lockbox system, considering the firm's
average daily collection of P 450,000 and the annual rate of
return of 12% in the market ?
The cost-benefit analysis is as
follows:
Average cash receipts per day P 450,000.00
Number of days cash is freed (7 days – 4 days) X 3
Amount of cash freed –up P 1,350,000.00
Rate of return X 12%
Expected return (benefit) P 162,000.00
Less: Cost of the lockbox system (P10,000 x 12) ____120,000.00
Net average of availing the lockbox system P 42,000.00

Since the net worth is P 42,000.00, then Cunanan

Corporation should avail of the service offered by the
bank.
Activity 1
The Toy Company has average cash receipts of P 300,000 per day.
Normally, it takes 9 days from the time the check is received for it to be
made available as cash. How much cash is tied up?
Activity 2
A & A company has an agreement with Metrobank, Inc and
BDO bank to collect P500,000 a day in exchange for a
compensating balance of P100,000.
The bank, with a significant increase in its client in the
area, is thinking of canceling the agreement and dividing the
service provided by MTBC with BDO Bank. With this plan,
MTBC will handle the collection of P400,000 with a
compensating balance of P100,000.
On the other hand, BDO bank will handle the other
P100,000 collection in exchange for a compensating balance of
P70,000. With the planned arrangement with the two banks to
perform the collection, the firm is expecting to reduce the
collection period by two (2) days.
The firm's rate of return is 11%. A & A company pursue
the division of service between MTBC BDO Bank?
3. Accelerating Collection of Funds by Reducing
Collection Float (Cont.)
3. Concentration banking
◦ A firm doing business over a wide geographical
area normally maintain several accounts in
different banks.
◦ The accounts are used for several reasons,
including payroll of employees in the different
parts of the country or region, payments to
suppliers, receipts of collections from customers,
and other transactions that may be accounted as
normal operations of the firm.
◦Concentration banking has many forms :
◦Direct send where checks are sent directly
to the drawee bank;
◦Direct deposit to the company’s bank
account, provided that the bank is already
on-line;
◦And an auto-debit arrangement wherein
the payee’s account is credited while that
of the payor is debited.
EXTENDING CASH
DISBURSEMENTS
Two sides of cash management:
◦Cash inflow
◦Cash outflow - is concerned with how
cash disbursements can be extended
from the time the billing statement is
received.
Stretching payables
➢ is an obvious way of extending
cash disbursement or postponing
the payments to their due dates
or maximizing the paying period of
the firm.
7 Ways to conduct Cash
Disbursements
1. Playing the float
2. Payment by draft
3. Auto-debit transfer
4. Debit transfer
5. Stretching of payables
6. Centralization of disbursements
7. Use of statistics to predict the amount of
check issued.
7 Ways to conduct Cash
Disbursements
1. Playing the float
- this is the process of taking advantage
of the clearing system in order to make
use of the funds in the firm’s bank
account.
7 Ways to conduct Cash
Disbursements
2. Payment by draft
- a draft is an unconditional order made
in writing addressed by one person to
another, signed by the person giving it,
requiring the receiver to pay on
demand or at a fixed or determinable
future time a certain sum of money to
order or to the bearer.
7 Ways to conduct Cash
Disbursements
3. Auto-debit transfer
- is one of the services offered by the bank. To avail
of this kind of services, the firm has to maintain a
certain amount in their account, normally called
average daily balance.
- this bank service provides the firm two or more
accounts to facilitate payment and collection.
1. Savings account -
2. Current account – maintained with zero balance.
7 Ways to conduct Cash
Disbursements
4. Debit transfer
- the feature of this service are practically the same
as those of auto-debit transfer. The only difference
is that the debit transfer is done manually, usually
at the end of the banking day or early on the next
banking day.
- the amount of funds to be transferred to the
current account is determined by the total of all
charges made to the firm.
7 Ways to conduct Cash
Disbursements
5. Stretching of payables
- this is the process of extending payments
to supplier or creditors.
- this is not advisable but this is normally
done in the industry.
- it is important to know that payment
should only be delayed for a time that is
tolerable to the creditor.
7 Ways to conduct Cash
Disbursements
6. Centralization of disbursements
-Firms are able to monitor their payments
and satisfy their obligations to the optimum
time.
-Firms can select creditor who must be paid
first and extend payments to those who can
tolerate delays.
7 Ways to conduct Cash
Disbursements
7. Use of statistics to predict the amount of
check issued.
- by looking at the historical disbursements
of the firm, one can establish how much
funds must be deposited to cover the checks
issued.
 COST OF FOREGOING A CASH
DISCOUNT
Cash Discount
- is offered by the suppliers of goods to the purchasers
to encourage them to make an early payment.
- not paying within the discount period is an
opportunity cost to the firm.
- a firm without fully knowing cost of discount will
typically take advantage of a discount offered by the
creditor because of the attached opportunity cost.
However, going beyond the normal understanding of
the term, cash discount, will make a difference.
CREDIT TERM
-Is a payment term where credit is granted to a
customer.
-Its benefits include the credit period, the cash
discount offered, and the discount period.
-For instance, if the term of sale is 2/10, net/ 30, the
customer will get a 2% cash discount if the
purchase is paid within ten days. Otherwise, the
total amount of obligation is due on the 30th day.
CASH DISCOUNT FORMULA :

Cost of Discount = Discount % x 360

100% - Discount % Final due date – Discount period
Trade credit

- a business-to-business (B2B)
agreement in which a customer can
purchase goods without paying cash up
front, and paying the supplier at a later
schedule date.
Example:
If the term of the sale is 2/10, n/30.
(the first 10 days represents the free trade credit
and the remaining 20 days represents the costly
trade credit. If the buyer does not pay during the
discount period, the buyer is obliged to pay in the
30th day.)
If the term of the sale is 2/10, n/30.
Cost of Discount = 2.0 % x 360
100% - 2.0 % 30 – 10

= 36.73%

If the term of the sale is 2/10, n/45.

Cost of Discount = 2.0 % x 360
100% - 2.0 % 45 – 10

= 21.0%
When to avail of discount?
◦Before availing of the cash discount, the
firm should conduct cost-benefit
analysis first. Thus, if the borrowing rate
in the market is greater than the cost of
the discount.
◦If the borrowing rate is less than the cost
of discount, it will be better for the firm
to take advantage of the discount.
Example:

ABC company is considering the

discount on the credit term offered by
the supplier. The terms are 4/10, n/60.
At the time the term is offered, the
borrowing rate in the market id 12%
per annum. Should ABC company avail
of the cash discount?
Example:
ABC company is considering the discount on the credit term offered by
the supplier. The terms are 4/10, n/60. At the time the term is offered, the
borrowing rate in the market id 12% per annum. Should ABC company
avail of the cash discount?

Cost of Discount = 4.0 % x 360

100% - 4.0 % 60 – 10

= 30.0%

Since the cost of borrowing is 12% which is lower

than the cost of discount forgone, ABC company
should avail of the discount. Thus, the firm may
borrow from the bank at the rate of 12% and pay the
supplier at a discount rate. The net advantage of the
firm from the discount is 18% (30%-12%).