Working Capital

Management
Working Capital Management
Working capital management involves
making sure a company has enough cash
to pay for its expenditures as they come
due.
Working Capital
Current assets
– Current liabilities
= Working capital
Types of Working Capital
The minimum amount of working capital
that is maintained at all times is called
permanent working capital.

Increases that occur from time to time are

called temporary working capital.
How Much Working Capital
The amount of working capital a company
should maintain is a question for
management.
Components of Working Capital
1. Inventory
2. Accounts receivable
3. Marketable securities
4. Cash and cash equivalents
Current Liabilities
The main classifications of current liabilities are:
• Trade credit, or accounts payable
• Warehouse financing and inventory financing
• Short-term bank financing
• More permanent sources of financing such as a
revolving line of credit secured by receivables
• Commercial paper
• Repurchase agreements
• Bankers’ acceptances
Inventory Management
Inventory Management
Balance cost and benefit of inventory.

A company should minimize its total inventory

costs.

A small per unit decrease in the cost of holding

inventory can become a very large amount
when multiplied by the number of units held
in inventory.
Costs of Inventory
There are five main categories of costs of
inventory:
1. Purchasing costs
2. Ordering
3. Carrying
4. Stockout costs
5. Inventory shrinkage
Inventory Terms
Lead time
Safety stock
• The variability of the lead time
• The variability of the demand for the
product
• The cost of a stockout
Reorder point
Average inventory
Example: The average lead time is 10 days and the average daily
usage of widgets is 20. The company has determined that safety
stock should be 100 units. The reorder point will be when inventory
on hand gets down to 300 units, as follows:
Reorder point =
(Average daily usage × Average lead time) + Safety Stock
(20 × 10) + 100 = 300 units
The average inventory level will be:
[(# of units ordered each time an order is placed) ÷ 2] + Safety
Stock
If the company orders a 15-day supply each time it places an order,
it will order 300 units each time (15 days × 20 units per day).
Therefore, its average inventory level will be (300 ÷ 2) + 100, or 250
units.
400

300 ! Re o rd e r P o in t ! Re o rd e r P o in t

200

100

S a fe t y S t o c k

0
0 5 10 15 20 25 30

Da y s
Economic Order Quantity Calculation

EOQ = 2aD
K
where
a = variable cost of placing an order
D = periodic demand
K = carrying cost per unit per period
Example: Medina Co. makes footballs and is trying to determine the quantity
of leather it should order every time an order is placed. The relevant
information is as follows:
• Over the year 12,000 square meters of leather will be needed.
• The cost of storing one square meter of leather is 3.
• The cost of placing an order is 450.
The EOQ for inventory is calculated as follows:
EOQ = √ (2×450×12,000) / 3 = 1,897.4
Every time Medina orders leather, it should order 1,898 square meters in
order to minimize its costs of ordering and carrying the leather inventory.
Furthermore, the EOQ can be used to determine the number of times that
Medina will need to order inventory per year. Given a demand for leather of
12,000 square meters per year and an EOQ of 1,898 square meters per
order, Medina will need to order inventory 7 times per year in order to have
enough leather for production during the year
(12,000 ÷ 1,898 = 6.3).
Just-in-Time Inventory Systems
The goal of a JIT system is to minimize the
level of inventories that are held in the
plant at all stages of production, while
meeting customer demand in a timely
manner with high-quality products at the
lowest possible cost.
Inventory Valuation
Inventory is defined by IAS 2, Inventories, as
an item that is “held for sale in the ordinary
course of business; in the process of
production for such sale; or in the form of
materials or supplies to be consumed in
the production process or in the rendering
of services.”
Inventory Cost Flow
Assumptions
When inventory items are not ordinarily
interchangeable, the cost assigned to
each sale is determined by means of
specific identification.
When the inventory constitutes large
numbers of interchangeable items, the
first-in, first-out (FIFO) or the weighted
average cost method should be used.
Valuing the Inventory
Inventory is recorded on the balance sheet
at the lower of:
1. Cost, or
2. Net realizable value.
Net Realizable Value
Selling price
- Costs to complete
- Costs to sell
= Net realizable value

When inventory is written down to NRV, it

is recognized as a loss on the statement of
profit or loss.
Gross Margin and Inventory
A company’s historical gross margin can be
used to estimate its ending inventory
under limited circumstances such as for
interim financial statements.
Example: Estimation of ending inventory using the gross margin
percentage for SYZ Company, a company that needs to estimate
its ending inventory in order to prepare its first quarter interim
financial statements.
Gross margin is the amount of sales revenue remaining after cost
of goods sold has been deducted from it. The averages of SYZ’s
quarterly sales revenue, cost of goods sold, and gross margin for
the last four quarters is:
Sales revenue 1,000,000
Less: Cost of goods sold 750,000
Gross margin 250,000
 
The gross margin percentage is the percentage of sales revenue
represented by gross margin. It is the gross margin divided by
sales revenue. SYZ’s average gross margin percentage is 25%:
Percentage
of Sales
Sales revenue 1,000,000100%
Less: Cost of goods sold 750,00075%
Gross margin 250,000 25%
 
When cost of goods sold for the period is not known, it can be
estimated by multiplying the current sales revenue by (1 – the
historical gross margin percentage). Current period sales
revenue for SYZ Company is 1,200,000. Using the historical
average gross margin percentage of 25%, cost of goods sold can
be estimated as 900,000:

Sales revenue 1,200,000

× (1 – 0.25) × 0.75
= Estimated cost of goods sold 900,000
 
After cost of goods sold has been estimated, SYZ company can
calculate the estimated cost of the ending inventory using an
adaptation of the formula used for calculating cost of goods sold.

Cost of beginning inventory

+ Cost of inventory added during period
= Cost of goods available for sale
- Cost of ending inventory
= Cost of goods sold
 
The adapted formula solves for a different variable—estimated
cost of ending inventory. The estimated cost of goods sold is
deducted from the cost of goods available for sale, as follows:

Cost of beginning inventory

+ Cost of inventory added during period
= Cost of goods available for sale
- Estimated cost of goods sold
= Estimated cost of ending inventory
 
SYZ’s cost of beginning inventory is 75,000, cost of inventory
added during the period is 910,000, and its estimated cost of
goods sold, as calculated previously, is 900,000. Therefore, the
estimated cost of SYZ’s ending inventory is 85,000, as follows:
 
Cost of beginning inventory 75,000
+ Cost of inventory added during period 910,000
= Cost of goods available for sale 985,000
− Estimated cost of goods sold 900,000
= Estimated cost of ending inventory 85,000
 
Supply Chain Management
All of the organizations, resources, activities,
and technologies involved in moving a
product or service from suppliers to the end-
user, the customer, are referred to collectively
as the supply chain.
A supply chain begins with the delivery of
materials by a supplier to a manufacturer and
ends with the delivery to the end consumer of
the completed product or service.
Supply Chain Management
The physical flows are the most visible part
of the supply chain, but the information
flows are just as important.
Information flows allow the various supply
chain partners to forecast demand,
coordinate their long-term plans and to
control the day-to-day flow of goods and
material up and down the supply chain.
Managed Inventory
In some supply chain systems the retailer
allows the distributor, and/or the
distributor allows the manufacturer, to
manage its inventories, shipping product
to it automatically whenever its
inventory of an item gets low.
Such a practice is called supplier-managed
or vendor-managed inventory.
Accounts Receivable
Management
Accounts Receivable
Management
Must balance increased sales from
extending credit and the cost to extend
credit.
Credit Policy
One of the main factors in receivables
management is the credit policy (i.e. who
will receive credit).
• Credit standards
• Credit terms
• Collection efforts
• Credit scoring
Accounts Receivable Valuation
Like all assets, need to be certain that
receivables are not overstated on the
balance sheet.
Allowance for
Uncollectible Receivables
The expected loss is represented by an
allowance for uncollectible receivables, a
contra-asset account.

Dr Bad debt expense X

Cr Allowance for uncollectible receivables X
Writing Off a Receivable
When an account finally goes bad and the
company becomes aware of the specific
entity that is not going to pay, that
individual receivable is written off the
books.

Dr Allowance for uncollectible receivables X

Cr Accounts receivable X
Example: Anita’s Supply Co. determines its expected credit
losses on trade receivables by using an aging schedule of its
accounts receivable and historical loss rates for each aging
category, adjusted by forward-looking information. At December
31, 20X9, Anita’s prepared the following aging schedule in order
to calculate the balance it needed to have in its allowance for
uncollectible receivables account:
Outstanding % Estimated
Age of Accounts Balances Uncollectible
Under 60 days 925,000 2%
61-90 days 115,000 5%
91-120 days 56,000 10%
Over 120 days 44,000 30%
As of December 31, 20X9, before recording the year-end
adjustment for the allowance account, Anita’s had a debit
balance of 5,000 in its allowance account because more
accounts had been written off during the year than had been
expected.
The accounts receivable manager calculated that the balance in
the allowance account needed to be a credit balance of 43,050
by multiplying each aging category’s receivable balance by its
expected loss rate and summing the results, as follows:
(925,000 × 0.02) + (115,000 × 0.05) + (56,000 × 0.10) + (44,000
× 0.30) = 43,050
The balance before adjustment in the allowance account was a
debit balance of 5,000. To adjust the debit balance of 5,000 to a
credit balance of 43,050, a credit transaction in the amount of
48,050 (43,050 + 5,000) was recorded in the allowance account
as of December 31, 20X9. The other side of the transaction was
a debit of 48,050 to a loss account on the statement of profit or
loss.
Note: If the balance before adjustment in the allowance account
had been a credit balance of 5,000 instead of a debit balance of
5,000, the necessary credit to the allowance account to adjust its
balance to a credit balance of 43,050 would have been 38,050
(43,050 − 5,000), and the debit to the loss account would have
also been 38,050.
Marketable Securities and
Cash Management
Marketable Securities Management
Balance risk and return.
Cash Management
Factors that influence how much cash is held
include: 
• How much cash is needed in the near future
• The amount of risk a company is willing to take
• The level of other short-term assets that a
company holds
• Interest rates on other short-term investments
• At what point in its operating cycle it is in.
Goals of Cash Management
1. Accelerate cash inflows
2. Slow down cash outflows
Accelerating Cash Inflows
A company can accelerate cash inflows
through the following:
• Mailing invoices as soon as possible
• Credit terms that encourage prompt
payment
• Using electronic data interchange (EDI)
• Accepting credit cards / wire transfers
• Using a lockbox syste
Lock Box System
Company maintains special post office boxes,
called lockboxes, in different locations around
the country.
Invoices sent to customers contain the address of
the lockbox nearest to each customer so
customers send their payments to the closest
lockbox.
The company authorizes local banks to check these
post office boxes as often as is reasonable, given
the number of receipts expected.
Slowing Cash Outflows
A company can slow cash outflows by:
• Paying as close to the deadline as possible,
except when using cash discounts is
beneficial
• Making payments using checks
• Having zero balance checking accounts
• Using overdrafts
• Calculate compensating balances on average
basis
Short-term Financing
Short-term Financing
Short-term financing relates to the
company’s current liabilities that need to
be paid or settled within 12 months.
Three main sources of short-term
financing:
• Trade credit
• Bank loans
• Factoring of receivables
Trade Credit
Trade credit is a source of credit that arises
from the process of purchasing an item on
credit, and it is a major source of financing
for many small and medium-sized
businesses.
Paying Within Discount Period
Cost of NOT Taking discount:

360 Discount %
Total period for payment 100% - Discount %
x
– period for discounted
payment
If this is higher than cost of capital,
company should pay WITHIN discount
period.
Example: A vendor offers terms of 2/10, net 30. If the company
pays within 10 days, it will receive a 2% discount. If payment is
not made within 10 days, then the full (undiscounted) amount is
due in 30 days.
The calculation of the cost of not taking the discount is :

30 × 0.02 = 0.3673 or 36.73%

30 − 10 1.00 − 0.02
 
If the company pays in 30 days and thus does not receive the
discount, the annualized cost to the company of not taking this
vendor’s discount, expressed as an annual interest rate, is
36.73%.
Short-Term Bank Loans
Need to calculate different effective
interest rates.
1. Compensating balances
2. Discounted interest
1. Compensating Balances
Some amount of money needs to be kept
at the bank during the loan.

Interest is paid on the full amount, even if

come of the loan amount is kept as the
compensating balance.
Compensating Balance Formula
Annualized interest paid on full amount
borrowed – Annualized interest received on
cash deposited to meet compensating
balance requirement, if any
Amount of the loan – The amount of the
loan that was required to be kept in bank
to meet the compensating balance
requirement
Example #1: Assume a one-year loan of $100,000 at 6% simple
interest that requires a $20,000 compensating balance.
Annual simple interest is $6,000 and the usable loan balance is
$80,000 ($100,000 − $20,000), so the effective annual interest
rate is

$6,000 ÷ $80,000 = 0.075 or 7.5%.

Example #2: However, if the company already has an average
balance of $10,000 on deposit in the bank, then it would need to
add only $10,000 to its existing deposit to meet the $20,000
requirement.
Now, the effective annual interest rate would be calculated as

$6,000 ÷ $90,000 = 0.0667 or 6.67%.

Example #3: Now assume that the bank will pay 2% interest per
annum on the money deposited in the bank as a compensating
balance and that the company already maintains a $10,000
balance at the bank.
The effective interest expense will be the interest expense
reduced by the amount of interest earned on the additional
money that needed to be deposited in order to meet the
compensating balance requirement, which is $10,000.
The 2% interest on $10,000 is $200, which reduces the effective
interest expense (the numerator) to $5,800 ($6,000 minus $200).
Earning interest on the compensating balance reduces the
effective interest rate to 6.44% ($5,800 ÷ $90,000).
2. Loans with Discounted
Interest
Interest on the principal amount of the
loan
Principal amount – interest “withheld”
Example: Assume a $100,000 one-year bank loan with 4%
discounted interest, principal and interest due in one year.
Because the interest of $4,000 is discounted, this amount will not
be disbursed to the borrower with the rest of the loan proceeds.
So, the borrower is paying $4,000 in interest but receiving only
$96,000 in available proceeds.
When the loan matures, the borrower repays $100,000, which
includes the $96,000 principal disbursed plus the $4,000 in
interest.

Thus, the effective interest rate is 4.17% ($4,000 ÷ $96,000).

Example: Assume the same one year, $100,000, 4% discounted
loan as in the previous example, but the bank also requires a
10% compensating balance.
The borrower will have the use of only $86,000, because the
$4,000 of discounted interest will be deducted from the loan
proceeds and the borrower will not have the use of the $10,000
of the loan proceeds required for the compensating balance.
However, the borrower must pay interest as if it had received the
full $100,000.

The effective rate of interest to be paid on the loan will be 4.65%

($4,000 ÷ $86,000).
Factoring Receivables
Factoring receivables occurs when the
owner sells the receivables to another
party.
Ways of Factoring
WITH Recourse – Seller DOES need to pay if
the customer does not pay

WITHOUT Recourse – seller does NOT need

to pay if the customer does not pay.
Cash Received from Factoring
The amount of money that is actually received
from the factor of the receivables is reduced by:
• Factoring fee: the more risk related to
receivables, the higher the amount.
• Interest charge: almost always higher than
market rate.
• Reserve amount: if all receivables are
collected, the reserve will then be paid to the
seller.
Advantages of Factoring
May reduce the costs of collection by
outsourcing this function.

Bad debts may be eliminated because the

risk of noncollection is passed to the
factor.
Cash Received Calculation
Cash to be received from factoring is:
Face amount of receivables
– Reserve amount
– Factors fee
= Amount needed to pay interest on
– Interest on amount of cash to be received
= Cash received from factoring
Example: The factor charges a 4% factor’s fee plus 12% interest
on all monies that are advanced to the seller. The factor also holds
back 7% for potential sales returns. The receivables are being sold
without recourse. The receivables being sold total $150,000 and
the weighted-average estimated collection time is 120 days. The
amount of proceeds to the seller is calculated as follows:
Amount of receivables submitted $ 150,000
Less: 7% holdback on gross receivable (10,500)
Less: 4% factor’s fee on gross receivable (6,000)
Funds available before estimated interest charge $ 133,500
Less: 12% interest for 120 days
($133,500 × 0.12 ÷ 360 × 120) (5,340)
Cash available to the seller $128,160
In addition to the $128,160 the seller receives at the time of
factoring, any receivables collected in excess of $139,500
($150,000 − $10,500) will be paid to the seller because the factor
withheld that $10,500 as a protection against some of the sales
being returned and the receivables not being collected as a result.
Furthermore, the seller might receive a refund of some of the
interest if the receivables are collected more quickly than expected
or the seller might receive a bill for additional interest if the
receivables are collected more slowly than expected.
If all of the receivables are ultimately collected when expected, the
total cost to the seller of factoring the receivables will be $11,340
($6,000 factor’s fee + $5,340 interest). The total factoring cost
must be compared to the costs that the selling company would
have incurred if it had operated its own collections department and
the cost of other financing options available.