Financial Planning, Tools and Concepts Part 2

( Working Capital Management)

Objectives:
At the end of the lesson, the learner are able to:
1. define working capital
2. assess the risk profitability tradeoff involved in working capital

management
3. identify common compositions of a working capital
4. identify techniques and methods to manage inventories, to
manage receivables and to manage cash receipts and
disbursements
Opening Case
Carl, the proprietor of Mango Merchandising reported a profitable result of
operation over the past three years. It was with no doubt that the entity was able
to generate sufficient earnings to keep a stable financial health for the firm.
However, Carl noted some problems confronting the firm despite its profitable
operation result. First, Carl observed that although he was able to sell a lot his
merchandise, he often experienced times wherein he was overstocked with goods
or worst, there was an under stock of goods that led to lost sales. Aside from
that, since a majority of its customers purchased on credit, Carl observed that it
had been taking the firm too long to collect its customer receivable. Some of its
customer were even to the point of defaulting when payment were schedule to be
made. Given this collection problem encountered by Carl, in turn he found himself
in a disadvantageous situation when it came to paying his obligations to his
suppliers when they became due. Carl is now in trouble. The business is
earnings, but how come it is experiencing financial difficulties.
Working Capital Management
Working Capital Management specifically refers to the efficient management of the
firm’s current assets (cash, receivables, and inventory) and current liabilities
(short-term payables) Through working capital management, managers are given
the challenge to balance risk and profitability that comes along each current asset
and liability in order to positively contribute to the firm’s value.

Working Capital refers to the firm’s current assets, which represents a portion of
investment that circulates in one form to another in conducting the ordinary course
of business.
An example of this is cash being converted to inventories for sale, that is eventually
converted to receivable once they are sold on account and converted back to cash,
once this receivables have been collected.
Current liabilities are also part of the firm’s working capital management since these
are short-term obligations, maturing within one year or less. Most sources of
current liabilities are obligations to supplier for goods purchased, salaries to
employees, and other obligations incurred as part of the ordinary course of
business.

Working capital refers to that part of the capital of the company which is
continually circulating. It is circulating in the sense that the initial cash
funds of the firm are converted into inventories, which in turn are
converted into cash or accounts receivable and ultimately into cash
again.
Working capital maybe described in two ways:
1. Gross working capital, which is the total amount of the firm’s current assets and
2. Net working capital, which is the total amount of current assets minus current
liabilities.
Net working capital refers to the difference between the firm’s current assets
and current liabilities.

If the firm’s current assets exceeds its liabilities the firm has a positive working
capital. On the other hand, if current liabilities exceed current assets, the firm has a
negative working capital.

The gross working capital of the firm is usually composed of the following:
1. cash in the firm’s safe;
2. checks to be cashed;
3. Balances in its bank accounts;
4. Marketable securities (not including stocks in subsidiaries);
5. Notes and accounts receivable;
6. Supplies;
7. Inventories;
8. Prepared expense and
9. Deferred items.

The Need for Working Capital

Working capital is needed for the following purpose:
1. Replenishment of Inventory. A sufficient stock of inventory is required to
support the sales target of 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 payment.
3. Support for Credit Sales. At times, conditions require that credit sales be
extended to the firm’s client.
4. Provision of 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.
Tradeoff Between Risk and Profitability
The level at which the firm maintains its current assets and current liabilities
implies a choice between profitability and risk. For one, firms would want to have a
higher level of current assets in order to avoid liquidity problems. If a firm has a
high level of current assets, it faces a low risk of insolvency then, since it has
sufficient current assets to pay an obligation once it becomes due. However, a
higher level of current assets decreases profitability.
Current assets do not add more value compared to the value added by fixed
assets.
Furthermore, by choosing to hold more current assets, the firm forgoes possible
opportunities to earn that could maximize profitability. Holding excess cash
prevents insolvency. However, this excess cash could have been invested to earn
interest that could increase the firm’s profitability.
 Relationship between risk and Profit: low risk with high profit

-----------------------------------------------------------------------------------
Risk

Profit
 for current liabilities--- a tradeoff between profitability and risk is to faced. If a firm
would have a higher level of current liabilities, it contributes to profitability since
current liabilities are less costly in terms of interest cost incurred. If a firm chooses
to incur more current liabilities, ii faces a higher risk of insolvency since it has more
obligations that are maturing in the near future, which it might not be able to pay
when due.

Cash Conversion Cycle

A firm operating cycle begins from the time goods for sale are purchased to the
eventual collection of cash from the sale of this goods. The opeating cycle of a firm
is mainly composed of ywo current asset categories: inventories and account
receivable. It is specifically measured as the sum of the Average Age of inventory
and average collection period.
 operating cycle = Average Age Inventory + Average collection Period

Firms would generally want to speed up their operating cycle. The faster their
operating cycle is, the faster they are able to convert other forms of current assets
to cash, which can be used to pay current obligations.
However in the process of purchasing and selling goods, firms would incur
obligation for purchases of merchandise inventory on account which results
resource is tied up to its operating cycle. Thus including account payable in our
early equation, gives us the firm’s cash conversion cycle.

Cash conversion cycle = Operating cycle – average payment Period

 The operating cycle less the average payment period provides us the firm’s
cash conversion cycle. Carefully analyzing the equations provided above, a
firm’s cash conversion cycle can be re-expressed as follows:

Cash Conversion Cycle = Average Age of Inventory +

Average Collection Period – Average Payment Period
 Bloom Manufacturing had an average age of inventory of 18.5 days, an
average collection period of 48.5 days and an average payment period of 53.5
days. Bloom’s operating and cash conversion cycle can be obtained as follows:

Operating Cycle = Average Age of Inventory + Average Collection Period

= 18.5 days + 48.5 days
= 67 days

Cash Conversion Cycle = Operating Cycle – Average Payment Period

= 67 days - 53.5 days
= 13.5 days
Inventory Management
The objective in managing inventory is to convert it as quickly as possible to
cash without losing sales due to stockouts. Therefore, the financial manager plays
a crucial role in overseeing that the firm maintains an appropriate quantity of
inventory --- not too much and not too little. Maintaining too much inventory applies
that the firm incurs more costs associated with carrying these inventories.
However, carrying too little inventory quantities might lead to possible stock outs
that could further lead to lost sales, and worse, lost customer.

The appropriate question to ask then is, what is the appropriate inventory quantity
to be maintained by the firm? There are differing views as to the appropriate
inventory level, depending upon whom you’ll be asking.
Common Techniques in Managing Inventory
1. ABC Inventory System
Under ABC Inventory System, the firm’s inventory is divided into three
groups, specifically A, B, C. The groupings are determined in terms of the
level of investment in inventory.
Inventories falling under group A includes
those items, which has the highest investment in pesos. Due to highest
investment in these items, there is an intense monitoring on Group A items.
For instance, they are tracked on a daily basis, under perpetual inventory
system.

Group B items on the other hand consist of items that account for the
second largest investments in inventory. Since the investment in inventory is
lesser for these items, a relaxed monitoring is applied.
Group B items are frequently controlled using a periodic inventory system.

Group C is composed of a large number of items with a relatively lower investment.

Since these items are lower in terms of value, unsophisticated techniques
are applied to manage them, such as the two-bin method. Under the two-bin
method, inventory is stored in two bins. If an inventory is needed, it is then
removed from the first bin. If the first bin becomes empty, an order is made
to refill the first bin, while inventories from the second bin are now being
used to meet demands while the first bin is being refilled.
2. Economic Order Quantity
Another way to manage inventories is through the use of an Economic Order
Quantity ( EOQ) model, an optimal inventory size is being determined. This
optimal size is the quantity that minimizes total costs associated with inventories. I

In this model there are two relevant costs identified with inventories:
ordering costs and carrying costs.
Ordering costs includes costs associated in placing and receiving order.
Order costs include cost of writing a purchase order and processing paper works
related to the order. Ordering costs are stated per order.

Carrying costs, are the variables costs associated with holding one unit of
inventory. These includes storage costs, insurance costs and even the opportunity
costs associated with those inventories.
There is a tradeoff incurred in managing these costs. As the order sizes increases,
the ordering costs decreases. An increase in the order size would mean that
carrying costs would increase.

The economic order quantity (EOQ) method is used to determine what quantity to
order so as to minimize total inventory costs.

To balance these two factors, and economic order quantity should be determined.
The EOQ formula is as follows:
 EOQ=

EOQ=

S = usage in units per period

C = carrying cost per unit per period
O = order cost per order
Q = order quantity in units

if annual usage is 400; Order cost is 5; cost per unit is 20; =

Using the same function, we can also identify the costs associated with the
optimal order quantity. Ordering cost can be expressed as the product of the
cost per order and the number of orders. the number of orders is assumed to be
same as the number of usage. Usage of units per period is divided by the order
quantity in units to determine how many times would the firm place an order within
a given period. Thus, the following formula is derived:

Ordering Cost = O (S/Q)

Order cost per order 500,

usage in units per period 60
Order quantity per unit 10
Carrying costs on the other hand is computed as the product of the cost of
carrying a unit of inventory and the average inventory quantity. An average
inventory was used since it is assumed that inventory is being consumed at a
constant rate. The following formula is then obtained:

Carrying Cost = C (Q/2)

carrying cost per unit per period - 200

order quantity in units - 20
Under the EOQ Model total inventory costs is then determined as the sum of both
the order cost and the carrying cost, expressed as follows:

Total Cost = Ordering Cost + Carrying Cost

ordering cost 2000

Carrying Cost 1000
The EOQ still provides quantification that aims to help decision makers arrive at
more rational decisions.

For example, QRS Company is engaged in the production of high quality steel
cabinets. A critical input to the production process would be steel handles used in
each cabinet. Each piece of steel handle costs P 1,800 and QRS uses 2,400 units
of this item per year. It has been determined that the cost of placing an order is P
150.00 and carrying costs per unit is 200. QRS wants to determine the optimal
order quantity for the steel handles. Using the equation, EOQ can be computed as
follows:
EOQ=

EOQ =
Problem Solving

1. Timothy cycle parts who is engaged in selling motorcycle spare parts and
components is encountering difficulties in collecting its receivables. It takes him
an average of 45 days to collect costumer receivables. On an average it also
takes Timothy 60 days to sell an inventory from the date it was originally
purchased.

Compute for Timothy’s operating cycle.

Problem Solving

2. Beatriz Bakery Supplies is one of Laguna’s largest bakery needs supplier.

Beatriz usually sells on credit and on usual terms, it takes 60 days for a costumer
receivable to be collected. Due to the indemand nature of Beatriz products, it only
takes Beatriz 25 days to sell its supplies after being purchased from the supplier.
On the other hand, Beatriz makes use of a 30-day period before it pays its
obligations to its suppliers.

Compute for Beatriz operating cycle and cash conversion cycle.

Problem Solving
3. Faith Trading, engaged in reselling of school bags is having problem when it
comes to managing its inventory quantities. Most of the time, Faith would run out of
bags because she would order too few quantities. Faith has an annual requirement
of 24,000 bags as forecasted by its proprietress. Costs associated with carrying
every unit of school bag would be P 7.00. Faith estimated that each order from the
supplier will cost her P 300.00. Faith wonders if there would be a way to calculate
her optimal inventory quantity.

a. Compute for Faith’s economic order quantity

b. Compute for Faith’s average inventory balance
c. Compute for total order costs under economic order quantity
d. Compute for total carrying costs under economic order quantity
e. Compute for total inventory costs under economic order quantity
Problem Solving