WORKING CAPITAL MANAGEMENT AND FINANCIAL STATEMENTS ANALYSIS

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.
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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.

2 x conversion cost x annual demand for cash

ECQ = √
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).
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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 order (or
EOQ = 2aD ordering cost)
k D – annual demand in units
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)
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where: a – set-up cost

2aD D – annual production
ELS = k requirement
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:
Average Inventory = EOQ
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
Interest
rate. Effective interest rate =
Principal amount−Discounted Interest

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

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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.

ANALYSIS OF FINANCIAL STATEMENTS

A. Importance of Statement Analysis. The purpose of financial statement analysis is to assist

statement users in predicting the future.

Three techniques are commonly used to make comparisons and to detect trends.
• Peso and percentage changes in financial statement items.
• Common-size statements.
• Ratios.

B. Statements in Comparative and Common-Size Form. Two basic approaches are often used to
compare financial statements between companies or between different years for the same company:
horizontal (trend) analysis and vertical (common-size) analysis.

1. Horizontal Analysis; pesos and percentage changes on statements - the financial statements are
placed side-by-side. Two types of comparisons can then be made.
a. Trend percentages restate a time-series of financial data in terms of a base year.
Particularly when plotted against time, this approach allows the analyst to quickly gauge the
rate and direction of changes.
b. The difference (increase or decrease) between two statements can be shown in separate
columns in both peso and percentage forms. Showing changes in peso form helps to zero in
on key factors that have materially affected profitability or financial position. Showing
changes in percentage form helps to gain a feel of how unusual the changes might be.

2. Vertical Analysis; Common-size Statements. A common-size statement is one that shows each item
as a percentage of a total rather than in peso form. These kinds of statements make it much
easier to compare firms of different sizes and to track balance sheet and income statement
relationships within a company over time as its size changes.

a. When preparing common-size statements for the balance sheet, the various items on the
balance sheet are typically stated as percentages of total assets.
b. When applying common-size techniques to the income statement, all items on the income
statement are usually stated as a percentage of total sales pesos.