Lesson Plan on Working Capital Management

I. Working Capital (or net working capital) - excess of current assets over current liabilities.
Investment in working capital consists of cash, marketable securities, accounts receivable and
inventories as well as current liabilities.

Net Working Capital = Current Assets Current Liabilities

Current Assets - defined as assets turning over within one year or the production cycle whichever is
longer. These are classified into two types:

1. Permanent Current Assets represent the minimum required level of current assets needed to
support the firms operations. Due to seasonality, this is measured at the lowest point of its
operating cycle.

2. Temporary Current Assets by its nature, the amounts of these assets fluctuate as the asset
amounts needed to support these levels vary as well.

Current Liabilities defined as liabilities to be paid within one year or the production cycle whichever
is longer.

Principle behind Working Capital Management

It involves the determination of the level, quality and maturity of each major
current asset and current liability as well as the administration and control of current
assets and current liabilities to ensure that they are adequate and used effectively for
business purposes.

Sources of Working Capital

1. Profitable operations (net of working capital used in operations)

2. Sale of non-current assets
3. Long-term borrowing
4. Investments for owners

Clue: Working Capital (dr)

Non-Working Capital (cr)

Uses of Working Capital

1. Operations (deducted from sources of working capital)

2. Purchase of non-current assets
3. Retirement or payment of long-term debt
4. Return of capital to owners through dividend payments (excluding stock dividends), retirement of
capital stock or withdrawals

Clue: Non-working Capital (dr)

Working Capital (cr)

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Risk - Return Trade Off

The management of net working capital requires consideration for the trade-off between return and risk.
Holding more current than fixed assets means a reduced liquidity risk. It also means greater flexibility
since current assets may be modified easily as sales volume changes. However, the rate of return will be
less with current assets than with fixed assets. Fixed 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.

Appropriate Level of Working Capital

To determine the appropriate level of working capital for the firm the Hedging Principle (Rule of Self-
liquidating Debt) is used. This principle is a good basis to follow when making working-capital decisions
by stating that we need to finance assets with liabilities of similar maturity. Thus, permanent asset
investments should be financed with permanent sources while temporary investments should be financed
with temporary sources of financing.

a. Conservative Approach Under this approach, there is a proportionately higher level of long
term financing sources which fund not only permanent current assets and fixed assets but some if
not all temporary current assets as well. The tradeoff is that potential profitability is reduced due
to maintaining a relatively higher level of idle liquid current assets.

Marketable
P securities Zero or Limited
Short term
Debt

Long Term
Perm C.A. Financing.

Fixed Assets

Years

b. Aggressive Approach Under this approach, there has a relatively lower level of liquid assets
and a much- reduced margin of safety. Financing current assets with short term debt raises the
risk of technical insolvency; however, there is also greater potential profitability because of a
reduced level of idle liquid current assets.
P Temp. C.A.

Short term
Loans

Perm C.A.

Long Term Financing

Fixed Assets

Years
Lower dashed line would be more aggressive.

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 Cash Conversion Cycle

Formula:

Inventory Conversion period + Receivables Collection period Payable Deferral Period

Inventory Conversion period = Inventory / Sales per day

Receivable Collection Period = Receivables/ ARTO

Payables Deferral Period = Payables / Cost of Sales per day

Reasons for Holding Cash:

1. Transaction motive - cash is needed to facilitate normal transactions and business operations.
(operating cash)

2. Precautionary motive - cash is held beyond its normal operating requirement level in order to
provide for a buffer against contingencies and unexpected losses. (excess cash)

3. Speculative motive - cash is held ready for profit-making or investment opportunities. (excess
cash)

4. Contractual motive - cash is held as required by a financial institution or a contracting party. eg.
cash held as compensating balance and cash held in escrow. (accommodation cash)

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Illustrative Problem:

1. A firm is considering several plans that affect its current accounts. Given the five plans and their
probable results shown in the following table, which one would you favor?

Plan Ave. Age of Ave. Collection Average Payment Period Cash Conversion Cycle
Inventory Period
A +30 days +20 days +5 days
B +20 days -10days +15 days
C -10 days 0 -5 days
D -15 days +15 days +10 days
E +5 days -10 days +15 days

A. CASH Management

Objective: Involves the maintenance of a cash and marketable securities investment level which will
enable the company to meet its cash requirements and at the same time optimize the income on idle funds.

Cashflow management techniques

1. Accelerate collections
a. prompt billings
b. offering trade and cash discounts
c. maintenance of regional collections office
d. regular follow-ups
e. legal action for delinquent accounts
f. Lockbox Plan incoming checks are sent to post office boxes instead of corporate
headquarters particularly regional or out of town accounts
g. Concentration Banking funds are channeled to one or few larger banks from the local
depository banks which operate its lockboxes.
h. Pre-authorized debits allows funds to be automatically transferred from a customers
account to the firms account on specified dates.
i. Electronic Transfers / Telegraphic Transfers

2. Slowing Disbursements
a. Delaying payment - pay on the last day of the credit period if no trade or cash discount is being
offered.
b. Play the Float - taking advantage of the time it takes for the company's check to clear the
banking system
1. Disbursement Float
2. Collections Float
c. Centralized processing of payables.
d. Zero-balance Accounts special disbursement accounts having a zero-peso balance on which
checks are written.

3. Reducing the need for precautionary balance

a. Lines of credit - pre-arranged loan where the company can withdraw anytime within the
period agreed upon.
b. Temporary investment - investments in highly liquid securities

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 4. Cash flow Synchronization matching the timing of cash outflows with cash inflows

Illustrative Problems:
1. Goodseal Sales Company opened two new dealership in Sta. Barbara and Tanauan. All payments
by these dealers are by check, sent by mail, averaging about P420,000 per week. At present, these
payments become available to Goodseal on the 6th day, on average after the check is written.
a. How much money is tied up during the float period?

b. The company is considering weekly pick ups from the dealers to reduce the delay. In all, two
cars will be needed and two additional people hired for a total cost of P60,000 per year. This
would reduce the delay by four days. The present opportunity cost of funds to the company is
the average money market rate of 24% per year. Should the company undertake this plan?

c. A commercial bank with a large branch network offered to do the collection for the company
through its Sta. Barbara and Tanauan branches. This procedure will reduce the delay by two
days and will cost the company about P27,000 annually in collection charges. Should the
company accept the offer?

Managing Cashflows

1. Cash Budget Preparation

A listing of all potential cash collections as well as future payments are prepared in a schedule to
determine cash balances and requirements for a particular period.

2. Cash Break-even Chart

Just like the traditional break-even chart, this chart shows the relationship between the companys
cash needs and cash sources. It indicates the minimum amount of cash that should be maintained to
enable the company to meet its obligations.

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 Cash Breakeven
point
Total cash generation

Cash variable Costs

Cash fixed Costs

Cash Breakeven Point = Fixed Costs (cash basis only)

Contribution Margin per unit

B. MARKETABLE SECURITIES Management

Objectives for Holding Marketable Securities:

1. As a substitute for Cash

2. Held as Temporary Investment

a. To finance seasonal or cyclical operations
b. To meet known financial requirements

Factors Influencing the Choice of Marketable Securities

1. Default Risk risk that a borrower will be unable to make interest payments or to repay the
principal amount on schedule.

2. Event Risk probability that some event will occur and suddenly increase a firms default risk.

3. Interest Rate Price Risk risk of declines in bond prices to which investors are exposed due to
rising interest rates.

4. Inflation Risk risk that inflation will reduce the purchasing power of a given sum of money.

5. Marketability Risk risk that securities cannot be sold easily at close to the quoted market price.

Marketable Securities Alternatives

1. Treasury Bills direct short term obligation of the Philippine government sold on a regular basis
by the Bureau of Treasury.
They are sold at discount from their face value
No coupon payments
Interest due is received at maturity
Tenors are 91-day, 182-day and 364-day

2. Bankers Acceptances are used to facilitate import and export transactions. Bank guarantees

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 the transaction and the BA can be sold in the open market. Manufacturers can be paid for their
goods while they are in transit to the purchasers.

Drafts drawn on a specific bank by an exporter in order to obtain payment for goods
shipped to a customer who maintains an account with that bank
Sold on a discount basis
Income is fully taxable
Provide higher yields than do treasury bills

3. Negotiable Certificates of Deposit (CD) is a large time deposit by banks that cannot be
withdrawn before maturity but can be sold in the secondary market.

Fixed time period and fixed interest rate

Higher yields than T-bills and bankers acceptances
Taxable

4. Commercial Paper unsecured promissory notes sold by large businesses in order to raise cash.

Sold at a discount
Only marketable securities that are not traded in the secondary market

5. Money Market Mutual Funds usually invest in a diversified portfolio of short-term, high
grade debt instruments.

6. Money Market Deposit Accounts this is like a prime savings account that earns higher interest
rate than a regular savings account. It only allows a number of transactions per month. Hence, it
is inappropriate for most businesses.

Optimal Cash Balance

Optimal Cash Balance means enough cash to meet maturing obligations and not too large to incur
opportunity costs of holding on to excess cash rather than other productive alternatives.

Baumol Model: balances the opportunity cost of holding cash against the transaction costs associated
with replenishing the cash account by selling off marketable securities or by borrowing.

Total Costs = Holding Costs + Transaction Costs

Holding Costs = Average Cash Balance X Opportunity Cost

(C / 2) X k

Transaction Costs = Number of transactions X Cost per Transaction

T/C X F

T = Total amount of net new cash required

C = amount of cash raised for each transaction
F = fixed cost per transaction

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 Economic Conversion Quantity (Optimal Cash Transfer)

ECQ : Holding Costs = Transaction Costs

______________________________________________
/
ECQ = / Cost of each Withdrawal x Use of Cash during the period x Two
\/ Opportunity cost

(ECQ = CUTO)

Illustrative Problem:
The Hairdressers Corporation incurs a fee of P55 each time it withdraws cash from short term
investments. It anticipates paying out P500,000 over the next year and can earn an average of 6.5%
on short term marketable securities. What is the optimal cash balance that it should maintain for
transactions?

C. INVENTORY Management

Objective: To maintain a sufficient amount of inventory to ensure the smooth operation of the firm's
production and marketing functions and at the same time avoid tying up funds in excessive and slow
moving inventory

Major Categories of Inventory Costs

1. Ordering Costs/ Setup costs - all paperwork needed to place the order and shipping costs

2. Carrying costs - including holding costs, storage costs, risk costs and capital costs

3. Stockout costs - costs which result either from not having a product available for sale when
required or in a manufacturing operation from being out of raw materials or component parts
required in the manufacturing process.

Effects of stockout:
a. disruption of production including added labor and overhead costs
b. extra costs of uneconomic production runs
c. extra costs of purchasing and transportation
d. foregone quantity discounts
e. loss of customer goodwill

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In determining the optimum level of inventory to minimize stockout costs, the least total cost (stockout
cost + carrying cost) should be computed.

Illustration:

*** Casino Company wishes to determine the amount of safety stock that it should maintain for Product
X that will result in the lowest cost. The following information is made available:
Stockout cost P750 per occurrence
Carrying cost P10 per unit
Number of purchase orders 5 per year

The available options open to Casino are as follows:

Units of Safety stock Probability of Running out of Safety stock
10 40%
20 20%
40 10%
80 5%

Required. The number of units of safety stock that will result in the lowest cost.

Inventory Control Systems

1. Min-max system Inventory levels are kept at pre-determined minimum and maximum levels.

2. Two-bin system Inventory are maintained in two bins whereby when the first bin is fully
consumed, this signals the need to reorder another batch of inventory.

3. Red-line method similar to the first two systems, inventory reorder point is set once the red-line
is breached.

4. Order-cycling system - physical count is done at predetermined periodic intervals to determine

reorder point.

5. Statistical inventory control system - statistical and mathematic models are used.

6. Turnover rates inventories that are kept in stock are based on the speed of its movement. Slow
moving inventories are phased out while fast moving inventory are ordered in its place.

7. ABC system goods are classified as types A, B, or C depending on its value and inventory
turnover rate.

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 8. Just-in Time Systems system where zero or minimum level of inventory is kept to reduce cost of
money tied up with inventory. However, this system should ensure that stock out costs are not
encountered.

Mathematical and Statistical Models

1. Economic Order Quantity (EOQ) model - Total ordering costs = Total carrying costs

a. Tabular method
b. Graphic method
_________________________
c. Formula method = \ / 2 x S x OC
\/ CC
where S - annual sales demand or usage
OC - cost per order
CC - carrying cost ( % carrying cost x Unit inventory Cost)

*** Ordering Costs = Carrying Costs

Optimum Number of orders placed annually = S

---------
EOQ
Annual ordering costs = S X OC
EOQ

Average Inventory = EOQ

2

Annual Carrying costs = CC x EOQ

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lllustrative Problems

1. The Production Control Department of the 5-C Manufacturing Company wishes to establish economic
lot sizes in units for different items of materials. The cost department has determined the unit cost,
ordering cost and carrying cost and has made the data available in this form:

Item Annual Req'ts Unit Cost Ordering cost Carrying Cost %

(in units) (per order) of total cost
1 10,000 P10.00 P 4.00 10%
2 4,000 .80 3.00 25
3 1,000 1.00 16.00 20
4 10,000 5.00 18.00 20
5 20,000 8.00 20.00 5

Required: Compute the economic order size for the five items.

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2. Reorder Point - inventory level at which a new order should be placed to ensure that sufficient stock
will be continuously available to meet future requirements.

ROP = Lead Time Usage + Safety Stock

or
Average daily sales or usage x Maximum lead time in days
where:
LTU = Normal lead time in days x average daily sales or usage in units
Safety Stock = (Max daily usage - Normal daily usage) x Lead Time in days

Illustration:

The following information is available for Wisp and Warp Company's material L

Annual usage in units 100,000

Working days per year 250
Normal lead time in working days 30
Maximum lead time in working days 70

Required: Compute for Reorder Point

1. Inventory Turnover - measures how efficiently the inventory portion of the working capital is
being used in terms of the number of times inventory is replaced every year.

Formula: Cost of Sales

-----------------
Average Inventory

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Example:
A major supplier has offered Alpha Corporation a year end special purchase whereby Alpha could
purchase 180,000 cases of sport drink at P10 per case. Alpha normally orders 30,000 cases per month at
P12 per case. Alphas cost of capital is 9%. In calculating the overall opportunity cost of this offer, the
cost of carrying the increased inventory would be:

D. RECEIVABLES Management

Objective: Encourage sales and gain additional customers by extending credit, to evaluate the pertinent
costs and benefits related to credit extension; to finance the firm's investment in account receivable,
implement the firm's chosen policy and to enforce collection.

Costs associated with Accounts Receivable (C2D2)

1. Credit analysis, accounting and collection costs

2. Capital costs - investment in accounts receivable

3.Discount costs discount extended for prompt payment

4. Default costs/Delinquency costs costs due to non-collection of accounts

Setting the Credit Period and Standards

Credit Standards refer to the strength and credit worthiness a customer must exhibit in order to qualify
for credit.

Credit Quality defined in terms of the probability of a customers default.

Credit Scoring Systems evaluation of various credit criteria particularly the following areas popularly
known as the 5Cs of credit

a. Character
b. Capacity
c. Capital
d. Collateral
e. Conditions

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Summary of Trade-offs in Credit and Collection Policies

Action Benefits Cost

1. Relaxation of credit standards Increase in sales and Increase in A/R
contribution margin

2. Lengthening of credit period Increase in sales and Higher capital costs

contribution margin

3. Granting cash discounts Increase in sales and Lesser profits

contribution margin
Opportunity income on
lower A/R investment

4. Intensified collection efforts Lower default costs Higher collection expenses

Lower opportunity costs

Format of Receivables Management Analysis

Below is a format that may be used in the analysis of receivables management with certain proposals to
improve level of receivables through:

a. Relaxation/ Tightening of credit policy to increase sales

b. Change in Credit Terms
c. Extension of Cash Discounts to induce prompt payments

With the objective of reducing investment in receivables, the lower investment will be the acceptable
alternative.

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In cases where increase in Sales is the result of new AR policies, the corresponding increase in
Contribution Margin will have to be factored into the computation.

Illustrative Problems:

1. The ABC corporation is planning to increase its level of collection expenditures from the current
P250,000 to P400,000, on sales of P24 million. The move is expected to accelerate payments and
increase turnover of receivables from 10 to 12 times and cut bad debt losses from 2% to 1%. The
opportunity cost of funds is 12%.
Required: Should the corporation adopt the new collection policy?

2. The Winks Trading has 12% opportunity cost of funds and currently sells on terms of net/20. The
firm has sales of P10 million a year, which are 80% on credit and spread evenly over the year.
Currently, the average collection period is 60 days. If Winks offered terms of 2/10, n/30, 60% of its
customers would take the discount, and the collection period would be reduced to 40 days.
Required: Should Winks change its terms from n/20 to 2/10, n/30?

3. An aggressive credit manager has taken over the Standard Corporation. Currently, sales are about
P1.5 million a year with an average collection period of three months. The credit manager believes
that by establishing terms of 2/10, n/30, he can reduce collection period to 20 days on average.
Given that the cost of goods sold represents 80% of the selling price, assume that 50% of the
current sales will take advantage of the discount and that all of the funds recovered from the
receivables can be invested at 6%.
Required: Should the new credit policy be adopted?

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 4. Simon Corporation is evaluating a relaxation of its credit policy. At present, 70% of sales are on
credit and there is a gross margin of 20%. Additional data are:

Current Anticipated
Sales P500,000 P600,000
Collection expenses 3% of credit sales 4% of credit sales
Collection period 72 days 90 days.

Current cost of capital is averaging 10%.

Required: Should the corporation relax its current credit policy?

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