AE 19 – FINANCIAL MANAGEMENT

WORKING CAPITAL MANAGEMENT

WORKING CAPITAL MANAGEMENT – refers to the administration and control of current assets and
current liabilities to maximize the firm’s value by achieving a balance between
profitability and risk

WORKING CAPITAL FINANCING POLICIES

1. Matching Policy (also called self-liquidating policy or hedging policy) – matching the maturity of
a financing source with an asset’s useful life
• short-term assets are financed with short-term liabilities.
• long-term assets are funded by long-term financing sources

2. Conservative (Relaxed) Policy – operations are conducted with too much working capital; involves
financing almost all asset investments with long-term capital

3. Aggressive (Restricted) Policy – operations are conducted on a minimum amount of working

capital; uses short-term liabilities to finance, not only temporary, but also part or all of the
permanent current asset requirement

4. Balanced Policy – balances the trade-off between risk and profitability in a manner consistent with
its attitude toward bearing risk.

WAYS OF MINIMIZING WORKING CAPITAL REQUIREMENT

1. Managing cash and raw materials efficiently.
2. Having efficiency in making collections and in the manufacturing operations.
3. Implementing effective credit and collection policies.
4. Reducing the time lag between completion and delivery of finished goods.
5. Seeking favorable terms from suppliers and other creditors.

FORECASTING FINANCIAL STATEMENT VARIABLES

ASSUMPTIONS:
1. All variables are tied directly with sales
2. The current levels of most balance sheet items are optimal for the current sales level.

STEPS:
1. Identify assets and liabilities that vary spontaneously with sales
2. Estimate the amount of net income that will be retained.
3. Compute the amount of External Financing Needed (EFN) by subtracting increase in spontaneous
liabilities and income retained from increase in total financing required (increase in assets due to
increase in sales).

EFN = ΔS x (SA/S0) – ΔS x (SL/S0) – (<ROS x S1> x <1 - Payout%>)

Where: SA/S0 = percentage relationship of spontaneous assets (variable assets) to sales at period 0.

SL/S0 = percentage relationship of spontaneous liabilities (variable liabilities) to sales at period 0.

CASH MANAGEMENT

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
income on idle funds.

REASONS FOR HOLDING CASH

1. Transaction Purposes – firms maintain cash balances that they can use to conduct the ordinary
business transactions; cash balances are needed to meet cash outflow requirements for operational
or financial obligations.
 2. Compensating Balance Requirements – a certain amount of cash that a firm must leave in its
checking account at all times 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 reserved are allowed to build up in anticipation
of a future investment opportunity such as a 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 on its own books.

TYPES OF FLOAT:

1. Mail Float – peso amount of customers’ payments that have been mailed by a customer but
not yet received by the seller.
2. Processing Float – peso amount of customers’ payments that have been received by the
seller but not yet deposited.
3. Clearing Float - peso amount of customers’ checks that have been deposited but not yet
cleared.

CASH MANAGEMENT STRATEGIES

1. accelerate cash collections – reduce negative (mail and processing) float
2. control (slow down) disbursements
3. reduce the need for precautionary cash balance

Operating Cycle – The amount of time that elapses from the point when the firm inputs materials and labor
into the production process to the point when cash is collected from the sale of the
finished goods. Its two components are: average age of inventories and average
collection period of receivables. When the average age of accounts payable is subtracted
fro the operating cycle, the result is called cash conversion cycle.

Economic Conversion Quantity (Optimal Transaction Size) – the amount of marketable securities that must
be converted to cash (or vice versa), considering the conversion costs and opportunity
costs involved.

ECQ =
√ 2 x conversion x annual demand for cash
Opportunity Cost

Conversion Cost – the cost of converting marketable securities to cash

Opportunity Cost – the cost of holding cash rather than marketable securities (rate of interest that can
be earned on marketable securities).
 MARKETABLE SECURITIES

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

REASONS FOR HOLDING MARKETABLE SECURITIES (MS):

1. MS serve as substitute for cash (transactions, precautionary, and speculative) balances.
2. MS serve as a 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.

RECEIVABLES MANAGEMENT

ACCOUNTS RECEIVABLE MANAGEMENT – formulation and administration of plans and policies related
to sales on account and ensuring the maintenance of receivables at a predetermined level and their
collectibility as planned.

WAYS OF ACCELERATING COLLECTION OF RECEIVABLES

1. Shorten credit terms.
2. Offer special discounts to customers who pay their accounts within a specified period.
3. Speed up the mailing time of payments from customers to the firm.
4. Minimize float, that is, reduce the time during which payments received by the firm remain
uncollected funds.

AIDS IN ANALYZING RECEIVABLES

1. Ratio of receivables to net credit sales 3. Average collection period
2. Receivable turnover 4. Aging of accounts

INVENTORY MANAGEMENT

INVENTORY MANAGEMENT – formulation and administration of plans and policies to efficiently and
satisfactorily meet production and merchandising requirements and minimize costs
relative to inventories.

INVENTORY MODELS
A basic INVENTORY MODEL exists to assist in two inventory questions:
1. How many units should be ordered?
2. When should the units be ordered?

Economic Order Quantity – the quantity to be ordered, which minimizes the sum of the ordering and
carrying costs.

• Economic Order Quantity may be computed as follows:

where: a – cost of placing one orde (or ordering cost)

EOQ = 2aD D – annual demand in units
k
k – annual costs of carrying one unit in inventory for one
year
Assumptions of the EOQ Model
1. Demand occurs at a constant rate throughout the year.
2. Lead time on the receipt of the orders is constant.
3. The entire quantity ordered is received at one time.
4. The unit costs of the items ordered are constant; thus, there can be no quantity
discounts.
5. There are no limitations on the size of the inventory.

 When applied to manufacturing operations, the EOQ formula may be used to compute the
Economic Lot Size (ELS)
 where: a – set-up cost
ELS = 2aD D – annual production requirement
k k – annual costs of carrying one
unit in inventory for one year
 When the EOQ figure is available, the average inventory is computed as follows:

EOQ
Average Inventory =
2
 When to Reorder:
When to reorder is a stock-out problem. i.e., the objective is to order at a point in
time so as not to run out of stock before receiving the inventory ordered but not so early
that an excessive quantity of safety stock is maintained

Lead time – period between the time the order is placed and received
Normal time usage = Normal lead time x Average usage
Safety stock = (Maximum lead time – Normal lead time) x Average usage
Reorder point if there is NO safety stock required = Normal lead time usage
Safety stock + Normal lead time usage
Reorder point if there is safety stock required or
Maximum lead time x Average usage

SHORT TERM FINANCING

1. ACCOUNTS PAYABLE – the major source of unsecured short-term financing.

a. Credit terms: credit period, cash discount, cash discount period

b. Analysis of credit terms:
• Taking the cash discount – If cash discount is to be taken, a firm should pay on the last day of
the discount period.
• Giving up cash discount – If the firm has to give up the cash discount, it should pay on the last
day of the credit period.

• Cost of giving up cash discount = [CD/(100% - CD)] x (360/N)

Where: CD = cash discount percentage

N = number of days payment can be delayed by giving up the cash discount

The above formula assumes that a firm gives up only one discount during the year. If a firm continually
gives up the discount during the year, the annualized cost is calculated as follows:

Annualized cost of giving up cash discount = [1 + (CD/(100% - CD)]360/N – 1]

c. Stretching Accounts Payable: A firm should pay the bills as late as possible without damaging its credit
rating. When a firm can stretch the payment of accounts payable, the cost of foregoing the discount is
reduced.
 2. Bank Loans

a. Single-payment notes – If the interest is payable upon maturity, the effective interest rate is equal to the
nominal rate.

b. Discounted Note – The effective interest rate is higher than the nominal rate.
Interest
Effective interest rate =
Principal amount−Discounted Interest

If the term is less than a year, the interest rate is annualized.

c. Compensating Balance - an arrangement whereby a borrower is required to maintain a certain percentage

of amount borrowed as compensating balance in the current account of the borrower.