Working Capital

Management
 Working Capital Management
 Involves managing the firm’s current assets
and liabilities to achieve a balance between
profitability and risk that contributes
positively to the firm’s value.
 WORKING CAPITAL = Current Assets –
Current Liabilities (Accounting Perspective)
 WORKING CAPITAL = Current Assets
(Financial Analyst’s Perspective)
Trade-Off Between Risk and
Returns
 The management of net working capital
requires consideration for the trade-off
between risk and returns.
 Holding more current than long term
assets means greater flexibility and
reduced liquidity risk. However, the rate of
return will be less than with current assets
than with long term assets.
 Long term assets typically earn a greater
return than current assets. Long-term
financing has less liquidity risk associated
with it than short-term debt, but it also
carries a higher cost.
 Working Capital Policy
Conservative Aggressive
Level of Working Capital (Current Assets) HIGH LOW
Reliance on Long Term Financing HIGH LOW
Liquidity Risk LOW HIGH
Profitability and Returns LOW HIGH
 CONSERVATIVE
CURRENT LIABILITIES
CURRENT ASSETS
 AGGRESSIVE
CURRENT ASSETS
CURRENT LIABILITIES
Factors to Consider in Managing
Working Capital
 Appropriate Level – adequacy of working
capital.
 Structural Health – composition of working
capital.
 Liquidity – relative transformation or
current assets into more liquid assets.
 In general, sound working capital policy
requires:
 Managing cash and its temporary investment
efficiently. (Cash/Marketable Securities
Management)
 Ensuring efficient manufacturing operations
and sound material procurement. (Inventory
Management)
 Drafting and implementing effective credit and
collection policies. (Receivable Management)
 Seeking favorable terms from suppliers and
other temporary creditors. (Short-term Credit
Financing)
 Example
 Given the following information of Isko
Company.

Cash 12,000.00 Accounts Payable 10,000.00

Accounts Receivable 18,000.00 Current Tax Liability 3,000.00
Inventory 20,000.00 Accrued Payroll 7,000.00
Fixed Assets 50,000.00 Bonds Payable 80,000.00

The bonds wil mature in 10 years. All amounts are correctly stated.
Required
 Net working Capital
 Current Ratio = (Current Assets/Current
Liabilities)
 Acid Test (Quick Assets Ratio) = Quick
Assets/Current Liabilities
 Quick Assets = Cash + Receivables +
Marketable Securities
CASH AND MARKETABLE
SECURITIES MANAGEMENT
 Cash – involves the maintenance of the
appropriate level of cash to meet the firm’s
cash requirements and to maximize
income on idle funds.
 Marketable Securities – involves the
process of planning and controlling
investment in marketable securities to
meet the firm’s cash requirements and to
maximize income on idle funds
 Objective: To minimize the amount of
cash on hand while retaining
sufficient liquidity to satisfy business
requirements (e.g. take advantage of
cash discounts, maintain credit rating,
meet unexpected needs.)
Reasons for Holding Cash
 Transaction motive (Liquidity Motive)
 Cash is held to facilitate normal transactions
of the business
 Precautionary motive (Contingent Motive)
 Cash is held beyond the normal operating
requirement level to provide for buffer against
contingencies, such as slow-down in accounts
receivable collection, possibilities of strikes
etc.
 Speculative motive
 Cash is held to avail business incentives
(e.g. discounts) and investment
opportunities
 Contractual Motive – Compensating
Balance Requirements
 A company is required by a bank to
maintain a certain compensating balance
in its demand deposit account as a
condition of loan extended to it
OPTIMAL CASH BALANCE(OCB):
BAUMOL MODEL
 OPTIMAL CASH BALANCE =

2TD
i
T = transaction cost which is a fixed
amount per transaction. It includes the
cost of securities transactions or cost
of obtaining a loan.
 i= interest rate on marketable
securities or the cost of borrowing cash
 D = total demand for cash over a
period of time.
 TotalCosts of Cash balance =
Holding Costs + Transaction Costs
 Holding Costs = Average Cash
Balance* x Opportunity Cost
 Transaction Costs = Number of
Transactions** X cost per transaction
*Ave. Cash Balance = OCB/2
**No. of Transactions = Annual
Cash Requirement/OCB
Example
 KAS Corp. is expecting to have a
total payment of P1,800,000 for
one year, cost per transaction
amounted to P25, and the interest
rate of marketable securities is
10%.
Required
 What is the company’s optimal initial cash
balance that minimizes total cost?
 What is the total number of transactions
(cash conversions) that will be required per
year?
 What will be the average cash balances for
the period?
 What is the total cost of maintaining cash
balances?
Cash Conversion Cycle
 Is the average length of time a peso is tied
up in current assets. It runs from the date
the company makes payment of raw
materials to the date company receives
cash inflows thru collection of accounts
receivable. This is also known as the cash
flow cycle.
 Inventory Conversion Period Inventory/CGS per day
+ Receivable Collection Period Receivables/Sales per day
- Payable deferral Period Payables/Purchases per day
CASH CONVERSION CYCLE
Marketable Securities
 Short term money market instruments that
can easily be converted to cash.
Certificates of Deposit (CD) – savings
deposits at financial institution (e.g. time
deposit)
Money market funds – shares in a fund
that purchases higher yielding bank
CDs, commercial paper, and other
large-denomination, higher-yielding
securities
Government Securities
 Treasury Bills – debt instruments
representing obligations of National
Government issued by the Central
Bank and usually sold at a discount
through a competitive bidding.
 CB Bills or Certificate of Indebtedness
(CBCIs) – represent indebtedness by
the Central Bank.
Commercial Papers – unsecured short
term promissory notes issued by
corporations with very high credit
standing.
Accounts Receivable (AR)
Management
 Involves the determination of the amount
and terms of credit to extend customers
and monitoring receivables from credit
customers.
 Objective:To collect AR as quickly as
possible without losing sales from high-
pressure collection techniques.
Factors to Consider for AR Policy
 CREDIT STANDARD

 Character – customers’ willingness to pay

 Capacity – customers’ ability to generate cash flows
 Capital – customers’ financial resources (i.e., net
worth)
 Conditions – current economic or business conditions
 Collateral – customers’ assets pledged to secure debt
 CREDIT TERMS

 Thisdefines the credit period and discount

offered for customer’s prompt payment.

 COLLECTION PROGRAM
RECEIVABLES TURNOVER
 It is the time required to complete one
collection cycle from the time receivables
are recorded, then collected, to the time
new receivables are recorded again.
 = NET (CREDIT) SALES / Average
Receivables
 Average Receivables = (Beginning
Balance + Ending Balance) / 2
Average Age of Receivables
 It indicates the average number of days
during which the company must wait
before receivables are collected.
 = 360 Days / Receivable Turnover
SAMPLE PROBLEM
 Troso Company’s financial records for
2007 shows the following:
Sales
Net Credit Sales P500,000
Net Cash Sales 250,000
750,000
 Accounts Receivable
January 1, 2007 75,000
December 31, 2007 50,000

- What is the average receivables?

- What is the receivables turnover?
- What is the average age of
accounts receivable?
SAMPLE PROBLEM
 B1B2 Corp. sells on terms of 2/10, n/30.
70% of customers normally avail of the
discounts. Annual sales are P900,000.00,
80% of which is made on credit. Cost of
approximately 75% of sales.
REQUIRED:

 Average Balance of
Receivables
 Average investment in
Accounts Receivable
 Jackson Distributors sells to retail stores
on credit terms of 2/10, net 30. Daily sales
average 150 units at a price of P300 each.
Assuming that all sales are on credit and
60% of customers take the discount and
pay on day 10 while the rest of the
customers pay on day 30, what is the
amount of Jackson’s accounts receivable?
INVENTORY MANAGEMENT
 Refers to the process of formulation and
administration of plans and policies to
efficiently and satisfactorily meet production
and merchandising requirements and
minimize costs relative to inventories.
Objective: To maintain inventory at a
level that best balances the estimates of
actual savings, the cost of carrying
additional inventory, and the efficiency of
inventory control.
INVENTORY MANAGEMENT
TECHNIQUES
 Inventory Planning – involves
determination of the quality and quantity
and location of inventory, as well as the
time of ordering, in order to minimize costs
and meet future business requirements.
 Inventory Controlling – involves regulation
within predetermined level; adequate
stocks should be able to meet business
requirements, but the investment in
inventory should be at the minimum.
Components of Inventory Costs
 Carrying Costs: This cost increases with
the order size or quantity of inventory on
hand. (e.g. storage costs, insurance on
inventory , normal spoilage, record
keeping costs)
 Ordering Costs: This cost decreases with
order size or quantity of inventory on hand.
(e.g. delivery costs, handling costs)
Economic Order Quantity (EOQ)

 This is the number of units to place per

order that minimizes the sum of ordering
costs and carrying costs.
 At EOQ, a firm incurs the minimum total
inventory costs.
Economic Order Quantity
 Economic Order Quantity

2 (Annual Demand in units)(Cost of placing order)

Cost of carrying one unit for one year

- Average inventory = EOQ / 2

Sample Problem
 Shirley Co. requires 40,000 shells for its
$100 signature product, “Pearly Shirl.” The
shells, which are purchased from outside
suppliers, will be used evenly throughout
the year. The cost to place one order is
P20, while the cost to carry the shells in
inventory for one year is P 0.40
Required
 The optimal order quantity (EOQ).
 The number of times the company should
place orders within a year.
 The average inventory.
 BCF manufactures a line of office computer
chairs. The annual demand for the chairs is
estimated to be 5,000 units. The annual cost to
hold one unit in inventory is P10 per year, and
the cost to initiate a production run is P1,000.
There are no computer chairs on hand, and BCF
has scheduled four equal production runs of
computer chairs for the coming year, the first of
which is to be run immediately. BCF has 250
business days per year, sales occur uniformly
throughout the year, and production start-up is
within one day. BCF is using the EOQ formula.
Required
 The optimal order quantity (EOQ).
 The number of times the company should
place orders within a year.
 The average inventory.
Inventory Turnover
 It measures the number of times that the
inventory is replaced during the period.
 = COST OF GOODS SOLD / AVERAGE
MERCHANDISE INVENTORY
 AVERAGE MERCHANDISE INVENTORY
= (BEG. + END. MERCHANDISE
INVENTORY) / 2
Average Age of Inventory
 It indicates the average number of days
during which the company must wait
before the inventories are sold.
 = 360 days / Inventory Turnover
Sample Problem
 Rand Co. merchandise for January 1,
2007 is P200,000 and P180,000 for
December 31, 2007. The cost of goods
sold for 2007 was P900,000.
 What is the inventory turnover for the year?
 What is the average age of inventory?
PROBLEM SOLVING
 The following selected data taken from the
financial statements of Citizens, Inc. for
the year indicated. (360 days / year)
 2005 2006 2007

Accounts Receivable, net 40,000.00 42,500.00 45,000.00

Inventory 40,000.00 50,000.00 45,000.00
Current Assets 120,000.00 140,000.00 130,000.00
Total Assets, net 700,000.00 750,000.00 725,000.00
Current Liabilities 70,000.00 80,000.00 50,000.00
Cash Sales 400,000.00 420,000.00 450,000.00
Credit Sales 120,000.00 125,000.00 131,250.00
Cost of Sales 310,000.00 324,000.00 345,000.00
Determine the following
 Working Capital for 2005, 2006, 2007.
 Current Ratio for 2005, 2006, 2007
 Receivables Turnover for 2006 & 2007
 Average Age of Receivables for 2006 &
2007
 Inventory Turnover for 2006 & 2007
 Average Age of Inventory for 2006 & 2007
SHORT-TERM CREDIT
FINANCING
 Sources of short-term financing may be
unsecured or secured. They appear as
current liabilities in the balance sheet as
accounts payable, accrued expenses and
notes payable.
Sources of Short-Term Funds
 Unsecured Credits – (without collateral)
 Accruals – expenses already incurred but not
yet paid.
 Trade Credit – refers to acquisition of
merchandise (or raw materials) on “open”
account (that is, without any formal note
signed to evidence the liability) which gives
rise to the current liability Accounts Payable.
 Commercial Papers – a promissory note
issued by big firms of unquestionable credit
standing and reputation.
Sources of Short-Term Funds
 Secured Loans – (with collateral or
security)
 Receivable financing – receivables may be
used in raising short-term funds. (e.g.
pledging, factoring, assignment and
discounting)
 Inventory Financing – the general requirement
for inventory to be acceptable as collateral is
that it should be marketable and
nonperishable.( floating lien, trust receipts,
warehouse receipts)
Sources of Short-Term Funds
 Banking Credits – source of short term
funds from banks (e.g. loan, line of credit,
revolving credit agreement)
Factors of Consideration in
Selecting Sources of Short Term
Funds
 COST – The effective costs of various credit
sources.
 AVAILABILITY – The readiness of credit as to
when needed and how much is needed.
 INFLUENCE – The influence of use of one credit
source and availability of other sources of
financing.
 REQUIREMENT – The additional covenants
unique to various sources of financing (e.g.
loans)
Cost of Short-Term Credit
 Cost of TRADE CREDIT with supplier

Discount Rate 360 days

COST = x
10 %-Discount Rate Credit Period-Discount Period
Sample Problem
 ABC Trading Co. purchases merchandise
for P200,000, 2/10, n/30
 Required:
 The annual cost of credit
 The annual cost of credit if term is changed to
1/15, n/20.
 If a firm purchases raw materials from
its supplier on a 2/10, net 40, cash
discount basis. What is the equivalent
annual interest rate (360-day year) of
foregoing the cash discount and
making payment on the 40th day?
Cost of Bank Loans (Effective
Annual Rate)
 Without compensating balance