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Working capital Introduction

Working capital typically means the firms holding
of current or short-term assets such as cash,
receivables, inventory and marketable securities.
These items are also referred to as circulating
Corporate executives devote a considerable
amount of attention to the management of
working capital.

Definition of Working
Working Capital refers to that part of the firms capital which is required
for financing short-term or current assets such a cash marketable
securities, debtors and inventories. Find thus invested , in current assets
keep revolving fast and are constantly converted into cash and this cash
flow out again and exchange for other current assets. Working Capital
also known as revolving or circulating capital or short term capital.

Components of Working
The Working Capital cycle is made up of four core components:
Cash & cash equivalent
Creditors / accounts payable
Inventory / stock in hand
Debtors / accounts receivables

Types of working capital

The working capital need can be bifurcated into permanent
working capital and temporary working capital.
Permanent working capital- There is always a minimum level
of working capital which is continuously required by a firm
in order to maintain its activities like cash, stock and other
current assets in order to meet its business requirements
irrespective of the level of operation.
Temporary working capital- Over and above the permanent
working capital, the firm may also require addition working
capital in order to meet the requirements arising out if
fluctuations in sales volume. This extra working capital
needed to support the increased volume of sales is known as
temporary or fluctuating working capital.

Determination of Working
Capital Requirements

General nature of business

Production cycle
Business cycle fluctuation
Credit policy
Growth and expansion
Profit level
Level of taxes
Dividend policy
Depreciation policy
Price level changes
Operating efficiency


Working capital is required for the following purposes:
1. Replenishment of Inventory
- A sufficient stock of inventory is required to support the sales target of the firm.
This requirement, however, will depend on the availability of resources.
An unserved portion of demand may mean lost revenues for the firm.
2. Provision for Operating Expenses
- To maintain the operations of the firm on a day- to- day basis, a working capital
is required. This will be needed to take care of salaries and wages, advertising,
taxes and licenses, insurance premium, and interest payments.

3. Support for Credits Sales

- At times, conditions require that credit sales be extended to the
firms clients. This will need sufficient working capital to enable the
firm to maintain its operations until receivables are converted
4. Provision of a Safety Margin
- The firm should have sufficient amount of capital to provide for
unexpected expenditures, delays in the expected inflow of cash, and
possible decline in revenue.


Cash Requirements
- The firm needs cash to pay for expenditures that arise from time to time. Even if the
cash receipts is equal to the anticipated cash expenditures, it is still necessary to
maintain a
sufficient cash fund for the firm to meet its cash commitments. It is, therefore, required
that a positive cash balance be maintained so that the firms obligations are settled they
become due.
The amount of cash needed depends upon the following:
1. The amount of the firms purchases and cash sales;
2. The time period for which the firm receives and grants credit;
3. The time period from the dates of purchase of raw materials and
payment of wages to the dates of cash receipts from sales;
4. The amount of cash to be used for investment in inventories; and
5. The amount of cash needed for other purposes such as cash

Accounts Receivable Requirements

- Since liquidity is a primary concern of sound business finance, firms prefer cash
sales over credit sales. Many companies, however, cannot avoid the extension
credit to customer for various reasons. Credit is used to sustain and to
production, distribution, and consumption of goods and services.
Inventory Requirements
- The production of large stocks of inventory generate savings as a result of lower
production cost. It will also provide the firm with large quantity of stocks to
increasing or unusually large orders from customers. The maintenance
of large
stocks of inventory, however, may unnecessarily tie up funds which
could have
been made available for other uses. Outside financing may even
be required. In
addition, storage and warehousing costs may also increase.


Working capital must always be able to cover fund requirements of the company as they
are needed.
The are times when unusual pressures on working capital makes the job of the finance
very. To overcome this, a system should be adopted considering the following
1. Working capital must be adequate to cover all current financial
requirements. The quantity of inventory stocks to be carried and the
allowable amount of receivables must be decided in advance.
2. The working capital structure must be liquid enough to meet current
obligations as they fall due. Salaries and wages must be paid on time. Raw
materials and supplies must be acquired on days they are needed.
3. Working capital must be conserved through proper allocation and
economical use.
4. Working capital must be used in attainment of the profit objectives of
the firm.

Liquidity refers to the ability of the firm to pay its bills on time or otherwise meet its current
obligations. Activities geared towards achieving the liquidity management.
The objective of management is to acquire sufficient amounts of funds to cover the cash
of the firm. The cash inflows of the firm come from various sources which are briefly described
as follows.
1. Cash Sales
- The percentages of cash derived from sales vary from company to company and
from industry to industry.
2. Collection of Accounts Receivables
- The credit policies and the pattern of company sales determine the frequency
volume of collections form receivables.
3. Loans
- Loans from banks and other creditors may be availed of by management mostly
its own initiative.


The timing and amount of cash receipts derived
borrowing firm.

from loans depend largely on the

4. Sale of Assets
-Assets are sometimes sold by the company for various reasons.
Obsolescence is one of those.
5. Ownership Contribution
- Additional contribution from the owners are sometimes tapped to
the liquidity posture of the firm.
6. Advances from Customers
- Manufacturers, at times, require cash advances from customers soon as
order is made and before production is started.



Cash Management
- Idle cash earns nothing and even if it is kept in a bank, the interest it earns in
minimal. If sufficient amounts of profit must be attained, cash should be invested.
Sufficient cash must be maintained, however, to cover the firms cash
expenditures. The activity involved in achieving these two opposite goals is called
cash management.
Money Mobilization
- Some companies maintain branches and agencies in distant places. Those that
serve customers directly may find that they are also serving customers from farflung areas.
Improved Cash Flow Forecasting
- A cash flow forecast with a high degree of precision and reliability provides the
firm with realistic approaches to planning and budgeting. The disadvantages of
cash excess and cash shortages are eliminated if not minimized.

Improved Cash Flow Forecasting contd

The advantages brought by an improved cash flow forecast are the following:
1. Surplus funds are more fully invested;
2. Alternative methods of meeting the outflows can be explored; and
3. The creation of special reserves for major future outlays will be
Defining and Quantifying the Liquidity Reserve Needs of the Firm.
- Firms are faced with a number of uncertainties and contingencies which may require cash
reserves. To be protected against the worst possibilities, a very large reserve of cash will be
needed. The idea is to avoid unnecessary losses or expenditures brought about by liquidity
problems. Several steps are:
1. Identification of contingencies requiring protection;
2. Assessment of the probabilities of the contingencies occurring;
3. Assessment of the probabilities of the contingencies occurring at the same
time; and

Assessment of the probable amount of cash required if each of the contingencies happens.
To illustrate, assume that a labor strike happening in the premises of the company will
paralyze operations. Borrowing funds to cover the necessary expenditures of the firm will
the firm with interest charges amounting to one million pesos. It has also been ascertained
if a reserve fund has to be carried for the contingency, the firm will be penalized with eight
pesos in the form of lost income which could have been otherwise earned by the idle cash

If the probability of the strike happening is placed at 50%, the expected value of the
options may be computed as follows:




Carrying a cash reserve in this case is more economical to the firm because it carries a
No reserve
lower penalty
expected value.
of Alternative
Sources of
With cash
- Once
the liquidity reserve needs of the firm have been defined and quantified,
alternative sources of meeting these needs should be identified and evaluated.
One possible alternative is the exploitation of the unused borrowing capacity of the firm.

Search for More Productive Uses of Cash Surplus

- Cash surplus may be utilized by the firm to earn higher returns. A gap may exist , however,
between the time when cash starts coming in and the time it is actually made more productive.
As various planning activities must also be geared towards eliminating the unproductive or
less productive gap.
- In as much as new investment opportunities may be made available from time to time, a
continuous search and evaluation activity must be done.
Accounts Receivable Management
- As sales on account be avoided most of the time, management must face the difficulty
squarely and make it work to the advantage of the firm. This is
important because when
accounts receivables are not properly managed, the financial
viability of the firm may be impaired.
Objectives. One of the goals of business finance is to maximize profitability. In this regard,
all activities of the firm, more credit is extended. Increased sales, however, is not an end in itself.
The objective of accounts receivable management is to determine the cost and profitability of
credit sales. The second objective accounts receivable management is the projection of cash
flows from receivable.

Elements of the cost of Credit

- The cost of credit is composed of three elements: (1) bad debts costs; (2) cost of
invested funds; and (3) administrative costs.
Bad debts cost refers to accounts receivable uncollected and subsequently written off. The
cost of
invested funds refers to the rate at which the firm could borrow funds to finance credit
sales. These
include form letters, individually written letters, telephone charges, clerical and
administrative time
spent on an account, and credit and investigation expenses.
Functions of the Credit Department
- The credit department performs the following functions:
1. gathering and organizing of information necessary for decisions
the granting of credit to particular customers;
2. assuring that efforts are made to collect receivables when they
become due; and
3. determining and carrying out appropriate efforts to collect accounts
of customers who cannot or do not intend to pay.

Sources of Credit Information

- A variety of sources may be used to obtain credit information concerning
customers. The sources most commonly used are the following:
1. personal interviews;
2. references;
3. credit bureaus;
4. credit-reporting agencies; and
5. banks
-Personal interviews provide basic information concerning an applicant for credit. The
is usually required to fill up a credit application blank. The credit application the following
1. the name of the applicant;
2. residence and former address;
3. occupation or business
4. business address
5. bank where applicant maintains an account; and
6. Property owned

Credit bureaus are institutions organized for the exchange of ledger information
among associated creditors.
1. reports
2. bulletins;
3. credit guides; and
4. special services.

Evaluation of Credit Risk

- Before credit is granted, the risk involved is evaluated. This is done after
information regarding the credit risk has been gathered. In the evaluation of a credit
risk, the basic criteria used to refer the following:
1. Capital;
2. Capacity;
3. Character; and
5. Collateral

Capital refers to the financial resources of the credit applicant. The balance sheet is a
very useful tool in determining the resources of the applicant.
Capacity refers to the ability of the applicant to operate successfully.
Character refers to the reputation for honesty and fair dealing of the applicant or the
owners of the firm applying for credit.
Conditions refer to the environment required for the extension of credit.
Inventory Management refers to the activity that keeps track of how many of the
procured items needed to create a product or service are on hand, where items is , and
who has responsibility for each item.
A successful inventory management programs main objective is to strike a balance
among three key elements as follows:
1. Customer service
2.Inventory investment
3. Profit

Customer Service
- the period between when the order is made and the date of delivery is very
important to the customer. Shorter periods are preferred.
Inventory Investment
- funds tied up in inventory should ideally be kept to a minimum without
sacrificing customer service. These usually take the form of interests, insurance,
taxes, obsolescence, and storage.
-the level of inventory carried by the company most often affects the profitability
of the company. The task of the management is to determine the level of which
would bring the highest return of equity.
Functions of Inventory
- Inventories perform certain functions. These are the following:
1. they serve to offset errors contained in the forecast of the demand for
the companys products.
2. they often permit more economical utilization of equipment, buildings,
and manpower when the nature of the business is such that fluctuations in
demand exists; and

3. it permits the company to purchase or manufacture in
economic lot

Forms of Inventory
1.Raw materials
2. Work-in-process; and
3. Finished goods.



Cash Flow
Use of Surplus


Cost and
of Credit
Projection of
Cash Flows

Direction and
Control of