Using Working Capital

Management Effectively
CHAPTER 5
EVALUATING WORKING CAPITAL

 Working Capital = Current Assets – Current

Liabilities
 Making decisions on how assets should be
financed.
 Evaluating the trade-off between return and
risk.
 Hedging approach
CASH MANAGEMENT
 The goal is to invest excess cash for a return and
at the same time have adequate liquidity
A proper cash balance should neither be
excessive nor deficient
 The minimum cash to hold is the greater of:
(1) compensating balances or (2) precautionary
balances plus transaction balances.
ACCELERATION OF CASH INFLOW
The types of delays in processing checks are (1) Mail
float, (2) Processing float & (3) Deposit collection float.

Ways to accelerate cash receipts:

 Lockbox
 Return envelopes
 Pre-authorized debits (PADs)
 Wire transfer
 Depository transfer checks.
DELAY OF CASH OUTLAY
 CentralizePayables.
 Zero Balance Account (ZBA).
 Drafts.
 Delay in Mail.
 Check Clearing.
 Delay Payment to Employees.
 CASH MODELS
 Determining Optimal Cash Balance Under Conditions of
Certainty [William Baumol’s Cash Model]
The objective is to minimize the sum of the fixed costs of transactions and the
opportunity cost of holding cash balances.
 These costs are expressed as: F × [T/C] + i[C/2]
Where:
F = the fixed cost of a transaction
T = the total cash needed for the time period involved
i = the interest rate on marketable securities
C = cash balance
 The optimal level of cash is determined using the following formula:
CASH MODELS (cont..)
 Determining Optimal Cash Balance Under Conditions of
Uncertainty [Miller-Orr’s Cash Model]
The purpose is to satisfy cash requirements at the least cost. A major
assumption is the randomness of cash flows.
The Miller-Orr model places an upper and lower limit for cash
balances.
 The optimal cash balance “z” is computed as:

 The optimal value for d is computed as 3z. The average cash

balance will approximate (z + d)/3
CASH MODEL (cont..)
Example:

You wish to use the Miller-Orr model. The following information is supplied:

Fixed cost of a securities transaction = $10

Variance of daily net cash flows = $50
Daily interest rate on securities (10%/360) = 0.0003

The optimal cash balance, the upper limit of cash needed, and the average cash
balance are:
Miller-Orr Cash Model Example

The optimal cash balance is = $102.

INVESTING IN MARKETABLE SECURITIES
Cash management also requires knowing the
amount of funds available for investment and the
length of time for which they can be invested. A firm
may invest its funds in the following:
Time deposits.
Money market funds.
Interest.
Treasury securities.
MANAGEMENT OF ACCOUNTS
RECEIVABLE

 Directly impacts the profitability of

the firm.
 Determines discount policy and
credit policy.
 Involves invoicing and mail float.
MANAGEMENT OF ACCOUNTS
RECEIVABLE (cont..)
 Monitoring Receivables
1. Biling
2. Customer Evaluation Process
3. Insurance Protection
4. Factoring
DETERMINING THE INVESTMENT IN
ACCOUNTS RECEIVABLE
 Takes into account the annual credit sale and the
length of time receivables are outstanding.

Example:
A business enterprise sells on terms of net/30.
Accounts are on ave. 20 days past due. Annual credit
sales are P600,000. The investment in accounts
receivable is:

50/360 x P600,000 = P83,333.28

DISCOUNT POLICY
 Determine if customers should be offered a discount for
the early payment of account balances.
Example:
Providing the following data:
Current annual credit sales = $14,000,000
Collection period = 3 months
Terms = net/30
Rate of return = 15%
The business enterprise is considering offering a 3/10, net/30
discount and expects 25 % of its customers will take advantage of
the discount. As a result of the discount policy, the collection period
will decline to two months.
 DISCOUNT POLICY (cont..)
Calculations:
Advantage of discount: Increased profitability
Ave. A/R -balance – bef. policy change (P14,000,000/4) = P3,500,000
Ave. A/R -balance —aft. policy change ($14,000,000/6) = P2,333,333
Reduction in average accounts receivable P 1,166,667
Rate of return x .15
Return P 175,000
Disadvantage of discount
Cost of discount:
(0.25 x $14,000,000 x0.03) = P 105,000
Net advantage of discount:
(P175000– P105,000) = P 70,000
DISCOUNT POLICY (cont..)
 Changing Credit Policy
The profitability on additional sales generated
must be compared with the amount of additional
bad debts expected, higher investing and
collection costs, and the opportunity cost of
tying up funds in receivables for a longer period
of time.
Example:
Present Credit Policy and scenario:
Sale Price per unit= $60;
Variable cost per unit = $40;
Fixed cost per unit = $15;
Annual credit sales = $600,000;
Collection period = 1 month;
Minimum return = 16%
If the existing credit policy is liberalized, the
projections are:
=> Sales will increase by 40%
=> Collection period will increase to 2
Calculation of Additional profits:
(Advantage of change in policy)
Incremental sales in units x
Contribution margin per unit
=> 4,000 units x ($60 - $40) =>
$80,000
Disadvantages of change in policy
(Incremental bad debts +
opportunity cost of funds tied up in
incremental A/R)


 Steps for calculating opportunity cost of investment tied up in A/R:

 Turnover of accounts receivables:


 Proposed plan = Number of days in the year/Average collection period = 360/60 = 6 times or(number of months in
a year/average collection period in months 12/2) Present Plan = 360/30 = 12 times
 Total cost of sales:


 Present plan = Number of units x cost per unit => 10,000 x $55 = $550,000
 Proposed plan => $550,000 + (4,000 units x $40) => $710,000.
 (please note that at idle capacity fixed cost remains constant and therefore incremental cost is the only variable
cost of $40 per unit)
 Average investment in accounts receivables = Total cost of sales/A/R turnover


 Present plan = $550,000/12 times =>$45,833

 Proposed plan = $710,000/6 times => $118,333
 Marginal investment in A/R => $118,333 - $45,833 = $72,500
 Minimum return = 16%. So opportunity cost of funds tied up = $72,500 x 16% => $11,600

EXPORT RECEIVABLES
The multinational business enterprise should take into
account the ff:
 Variance in foreign payment schedule.
 Stability of economic, financial, and political
conditions.
 Fluctuation in foreign exchange rates.
 Knowledge of financial management by the
country’s trade representatives and other
government officials.
INVENTORY MANAGEMENT
 The purpose of inventory management is to develop policies
that will achieve an optimal inventory investment.

 Syptoms of problems in inventory management:

 Significant write-offs of inventory
 Downtime of manufacturing facilities
 Lack of storage space
 Uneven production
 Extension of time for back orders
 Shortages in raw materials
 Cancellation of orders
 Significant differences between book inventory and physical
inventory
INVENTORY MANAGEMENT (cont..)
 Quantity Discount – reduces the cost of material.
 Investment in Inventory – average inventory x the
per unit cost.
 Carrying cost = Q/2 × C
 Ordering cost = S/Q x P
 Total inventory cost = QC/2 + SP/C
INVENTORY MANAGEMENT (cont..)
 EOQ(Economic Order
Quantity)
-amount of goods to order
each time to minimize total
inventory costs.

EOQ = 2SP
C
INVENTORY MANAGEMENT (cont..)
 The Reorder Point (ROP)
- a signal that tells you when to place an order.

ROP = lead time x average usage per unit of

time

If Safety Stock is needed:

ROP = (lead time x average usage per unit of

time) + safety stock
MANAGING DEPENDENT-DEMAND
INVENTORIES
 Material Requirements Planning (MRP)
- system that works backwards from
scheduled quantities & need dates for end
items in a Master Production Schedule(MPS).

 Just-in-Time (JIT)