WORKING CAPITAL MANAGEMENT

Working Capital refers to the difference between

current assets and current liabilities. Or simply;

The central issues in working capital are reduction in

operating cycle days and to ensure that such cycles
be shorter than the payable days to prevent
insolvency.
The operating cycle days is the total cash days,
receivable days and inventory days.
The cash cycle is the difference between the
operating cycle days and payable days. By
formula;

Working Capital= Current Assets- Current

Liabilities
By its name, the working capital management
refers to the management of current assets which
composes of cash and marketable securities,
receivables and inventories and current liabilities.
Also, it has dual objectives: ensure liquidity and
optimize profitability.
There is a trade-off between liquidity and
profitability, as the firm chooses short term
financing over the long term financing it might
compromise its profitability and vice versa.
Working capital policy may be classified as either
conservative or aggressive. A summary table is
shown below;
Working
Capital Policy
Conservative
Aggressive

Working Capital
Management
Increase
Decrease

Profitability

Liquidity

Lower
Higher

Higher
Lower

Working capital assets have 2 components, the

permanent working capital and the temporary
working capital.
The permanent balance of assets is necessary
to sustain the acquisition, holding, and
exchange activities relative to normal business
operations.
Permanent working capital shall be financed by
long term financing.
There are 3 options in financing the temporary
working capital assets; very conservative,
moderately conservative, and aggressive
policies. A description table of each option is
summarized under;
Policies
Very Conservative
Moderately
Conservative
Aggressive

Method of Financing
Long-term financing
Partly Long-term, partly shortterm
Short-term financing

Net cash cycle= Receivable days + Inventory

days - Payable days
CASH AND MARKETABLE SECURITIES MANAGEMENT
A minimum cash balance is maintained for several
motives: transactional, speculative and
precautionary.
Considering those reasons, the optimum cash
maintained by a business is composed of the
following:
Permanent cash balance
Transactional cash balance
Cash balance should be at its optimum and cash
flows should be synchronized.
The optimum cash balance is computed as follows:
Optimum Cash Balance=

2 x annual cash need x cost per transaction

carrying cost rate
When short term debt is tapped as a mode of
financing, the effective cost of borrowing is
determined as follows:

Effective Borrowing Rate= Net borrowing

costs/ Net Proceeds
Float refers to funds that have been sent by the
payer but are not yet usable funds to the payee. Float
has 3 components;
Mail Float
Processing Float
Clearing Float
The attitude of the management towards an efficient
operating cash flows is to speed up collections and
maximize timing of cash
Speeding up collections includes these ff. techniques:
High Standards on credit approval
Shorter trade discount and credit period
Efficient and effective billing system
Cost-effective collection system such as:
Frequency of collection follow-up
Visibility of collection personnel
Use of specialized postal system(i.e., lockbox
system)
Electronic fund transfer
Concentration banking
Automatic debit/credit
Depository check
Some effective cash outflow management
Use of checks and drafts
Voucher system
The 300 o clock habit
Thank God Its Friday Syndrome
Payroll Management
RECEIVABLES MANAGEMENT
Trade Receivables. The success in managing of
accounts receivable starts from the credit policy.
Next, would be good customer relations and effective
collection policy.

Credit Policies are integral part of the entire credit

cycle which includes among others credit standards,
credit evaluation and credit approval, and credit
system assessment.
The enterprise should always maintain the attitude of
conservatism in processing and approving the credit
lines. The indispensable 5Cs of credit should always
be followed:
1

Character
2. Capacity 3. Capital
4. Collateral 5. Conditions

Credit Standards- the firms minimum requirements

for extending credit to a customer
Credit and collection has direct relationship. If credit
standards are high, the rate of collection is expected
to be high, and vice-versa. The company may choose
to adopt a conservative or aggressive policy in
managing its trade receivables.
Credit Policy

Credit
sales

Collectio
n rate

AR
Balan
ce

Bad
debts

Collecti
on Exp.

Conservativ
e (Strict)
Aggressive
(Lax)

Trade discounts or credit discounts are given to

encourage credit customers to pay their accounts
earlier.
The Effective Discount Rate the discount rate
adjusted on an annual basis. Computed as follows:
Effective discount rate = (Days in a year/Remaining
credit time) x (Discount rate/ 100% - discount rate)
Effective discount rate = Discount time turnover x
adjusted discount rate per discount time
Discount time is set in relation with the discount
rate. If the discount is short, the discount rate goes

higher; and if the discount time is long, the discount

is lowered.
Credit Period the number of days after the
beginning of the credit period until full payment of
the account is due
Some popular credit policies are:
1
2

3
4

Credit class : group of customers to whom

merchandise shall be delivered
Credit cap: the limitation of credit line in terms of
amount set or imposed by the seller to a given
customer depending on his capability to meet trade
payments.
Credit block: policy of non-delivery of merchandise to
customers once their accounts become past due.
Cash discount: a percentage deduction from the
purchase price for paying within a specified time.

The variables in credit management and their effects to

collections are:
Credit
management
variables
Discount rate
Discount time
Credit period
Credit cap
Credit class

Credit
policy

Collecti
on

Effects to
AR balance
Receivable
Turnover

Collectio
n period

High
Low
Short
Long
Short
Long
Low
High
Low
High

Faster
Slower
Faster
Slower
Faster
Slower
Faster
Slower

Decrease
Increase
Decrease
Increase
Decrease
Increase
Decrease
Increase
Decrease
Increase

Shorter
Longer
Shorter
longer
Shorter
Longer
Shorter
Longer
Shorter
longer

Increase
Decrease
Increase
Decrease
Increase
Decrease
Increase
Decrease
Increase
Decrease

Reminder:
AR Turnover = Net credit sales/Ave. AR balance
Collection period = 365 days/AR Turnover
Ave. AR = [(AR be. + AR ending)/2]
Ave. AR = Ave. Daily sales X collection period

Collection policy covers the effective and efficient

billing system and other collection policies. Like the
credit policy, a change in the collection policy of an

enterprise has an impact on the sales, collection rate,

bad debts, collection expenses, and investment in AR
balance.
Collection costs include the amount spent on man
hours lost, machine hours used, telecommunications,
gas and oil, supplies, opportunity lost on hours used,
and the opportunity costs of the money tied up in the
receivables which could have been used to generate
earnings in other activities (e.g., ROI on accounts
receivables).
Effective collection system employs the following
techniques:
1 Maintain an efficient billing system
a Bill completeness
b Error-free statement of bills
c Timely dispatch of billing statements
2 Collect just collect it!
a Frequency of collection follow-up
b Visibility of collection personnel
c Concentration banking
d Electronic fund transfer
Optimizing the AR balance
Using the Baumol Model for cash and the EOQ model for
inventory also applies in determining the optimal balance,
as follows:

(2 x Total AR Need x Cost per transaction)

Optimal AR=
Carrying cost rate
Another way of analyzing AR balance is through aging of
accounts receivable
Aging of accounts receivable a credit monitoring
technique that breaks down accounts receivable into
groups on the basis of their time of origin
EDR = [Discount rate / (100% - Discount rate)] x
[Days in a year/ Non-free Credit Days]
EDR = Periodic effective discount rate x No. of nonfree credit days

 non-free credit days are the days left from the

entire credit period which do not arise to a discount.

carrying cost, and the total inventory cost is at its

minimum.

PEDR
Discount rate / (1-discount rate)
n
360/Non-free credit days
SAEDR
PEDR x n
CAEDR
[(1+PEDR)n 1]
Where:
PEDR = periodic effective discount rate
SAEDR = simple annual effective discount rate
CAEDR = compounded annual effective discount rate

Total relevant inventory costs= Ordering costs

+ Carrying costs

The EDR serves as the benchmark in making treasury

decisions as follows:
Party
SELLER
SELLER
BUYER
BUYER
BUYER
BUYER

If the
EDR >
EDR <
EDR >
EDR <
EDR >
EDR <

ROI of the money collected in advance

ROI of the money collected in advance
cost of money (e.g., interest rate)
cost of money
ROI from the alternative use of money
ROI from the alternative use of money

Ordering costs- costs spent on placing an

order, waiting for an order, inspection and
receiving costs, setup costs, and quantity
discounts cost.
Carrying costs- costs spent on holding,
maintaining, or warehousing inventories.

EOQ with back orders- if possible, can be maintained

at lower levels; EOQ will be modified for the cost of
back orders and in effect will increase the EOQ.

Then
Do not offer the trade discount
Economic Production Run (EPR) or Economic
Offer the trade discount
Avail of the trade discount Production Quantity- refers to the size of production
Ignore the trade discount where the total costs of materials will be at minimum.
Avail of the trade discount
a Reorder Point- Establishes the level of inventory on
Ignore the trade discount

hand when order is made. It is the sum of lead time

quantity and safety stock quantity.

INVENTORY MANAGEMENT

Proper inventory management links to the

operating goal of a company of giving the best
service to the customers. Currently, under the
present managerial framework, serving customers on
time could be done by applying technology and
redesigning the processes of production.

Order Cycling Method- establishes schedules of

periodic or regular review of quantities of inventories
on hand to determine the number of units to be
ordered and bring the stock balance at a desired level

Min-max Method- sets definable limits in inventory

balances; the safety stock quantity to minimize the
occurrence of stockout is included. (i.e., the
maximum inventory level is the sum of stockout
quantity and the order size.)

Traditional inventory management techniques

Economic Order Quantity (EOQ Model)- refers to

the units of materials that should be purchased to
minimize total relevant inventory costs. It is also the
point where the total ordering cost equals the total

Lead Time- waiting time from the date the

order is placed until the date the delivery is
received
Safety Stock- set to serve as the margin in
case of variations in normal usage and normal
lead time

ABC Model- also known as selective control

model; it classifies inventories into three (3) classes,
A, B, and C. Class A includes high value, critical
items; Class B includes middle-value items; and,
Class C represents low-value items.

1
2

Modern Inventory Management Model

a

JIT Inventory System- a system based on the

principle that materials should be received just-intime they are needed for production, and finished
goods are completed just-in-time they are needed by
the customers.

SHORT-TERM FINANCING MANAGEMENT

Financing refers to the process of raising money
either from owners or creditors for investing and
operating activities. Financing may also be
spontaneous or nonspontaneous. An example of a
spontaneous financing is accounts payable and
accrued expenses to utility companies, revolving
bank credit and credit cards. Trade credit arises from
the willingness of the supplier to provide ready and
unsecured credit line with the end-view of selling
goods to their customers. This pushes more than the
use of short term trade credit. It normally accounts to
the majority of short-term financing because of its
ease in use.
Commercial papers are unsecured notes payables,
usually in large denominations, issued by large
corporation, which have established good credit
rating. Commercial papers are normally issued at a
lower cost of funds because it does not maintain a
compensating balance and avoids the regular cost of
issuing securities through the normal market
brokerages.
Reasons for Short-term financing

3
4

Short-term financing (or Current liabilities) is intended

to primarily sustain short-term investments (current
assets) operations.
Inasmuch as the current assets are expected to be
recovered within a short period of time, normally not
exceeding one (1) year, the current liabilities are
likewise to be paid within a year.
Short-term financing is tapped to lessen the equity
exposure and risk of the firm to finance its operating
activities.
Since operating suppliers benefit significantly from
the enterprises operations, they are inherently
willing to equitably share in the financing and
sustaining the operating activities of the firm.
Spont
aneou
s

Accounts payable
Accrued expenses
Bank loan, single
line
Bank loan, multiple
line
Bank loan, revolving
credit agreement
Factoring of
accounts receivable
Pledging of accounts
receivable
Discounting of notes
receivable
Floating inventory
liens
Trust receipt
inventory loans
Warehouse receipt
loan

NonSpont
aneou
s

Secu
red

Unsec
ured

Money market
placements

Working capital
policy
Annual sales

Effective cost of short-term financing

Effective borrowing rate= Net borrowing costs /
Net proceeds
Annualized effective financing rate
Annual effective financing rate = Periodic
effective financing rate x (360/ period of debt)

PROBLEMS

Restricted

PHP 400
Million
25%

PHP 400
Million
10%

50 Million
40 Million
50%
10%

50 Million
40 Million
50%
10%

The company is under the 30% tax rate.

General Working Capital Management

1. Working capital balances: Dolce Amore Corporation found
out the following working capital balances in its last 12
months of operations:
Cash and cash
equivalents
Trade receivables
Inventories
Trade Payables

Currents assets as
a % of sales
Fixed assets
EBIT
Debt-equity rate
Interest rate on
debt

Relaxed

Minimum
PHP
100,000
300,000
250,000
400,000

Maximum
PHP
180,000
500,000
400,000
600,000

Compute for the following:

a. Permanent current assets balance
b. Temporary current assets balance
c. Average current assets
d. Permanent working capital balance
e. Average working capital balance
2. Conservative or aggressive working capital policy: Mimi
Enterprises is considering whether to pursue a restricted or
relaxed current asset investment policy. The following data
were assembled for analysis:

Required: What is the difference in the projected return on

equity between the relaxed and restricted policies?
3. Brother Corporation prepared its Fund flow statement.
The following data are presented to you for analysis:
Depreciation expense
Amortization of patents
Cash dividends declared
Cash dividends paid
Bonds payable issued
Sale of common stock
Amortization of bond discount
Gain on sale of equipment
Working capital provided by operations
Purchase of land
Decrease in deferred income taxes

PHP
48,50
12,000
27,000
34,000
90,000
175,000
1,500
9,500
121,000
310,000
18,000

Calculate the profit or loss for the period from the above
data.

Cash and Marketable Securities Management

1. LOCKBOX SYSTEM. A firm that has an opportunity cost

of 9% is contemplating installation of a lockbox system at
an annual cost of PHP 90,000. The system is expected to
reduce mailing time by 2.5 days and reduce clearing time
by 1.5 days. If the firm collects PHP 400,000 per day,
determine the net benefit (cost) of installing the lockbox
system.
2. Optimum cash balance. Liquid industries forecasts
cash outlays of PHP 48 Million for its next fiscal year. A
financial analyst of the company has estimated the
conversion cost of converting marketable securities from/to
cash at PHP 900 per conversion transaction and the annual
operating cost of holding cash instead of marketable
securities to be 8%. Presently, the company converts cash
to marketable securities and vice-versa on a monthly basis.

The commercial papers dealers fee to place the issue would

be a one-time charge of 1/8%. The commercial paper dealer
will require Carmelo to establish a PHP 400,000
compensating balance.
Management prefers the flexibility of bank financing.
However, if the cost of bank financing should exceed the
cost of the commercial paper by more than 1 percent,
Carmelo plans to issue the commercial paper.
Required: Calculate the effective cost of selling the
commercial paper and based solely upon your cost
calculation; recommend the method of financing Carmelo
should select.

Required: Using the Baumol model, calculate the following:

a. The optimal cash transfer
b. The average cash transfer
c. The number of transfers to be made during the year.
d. The total cash costs at the optimal transaction level.
e. The net advantage if the company follows the optimal
cash conversion model.
3. Cost of issuing commercial papers: Carmelo Inc. will
be needing PHP 4 Million over the next year to finance its
short-term requirements. The company is considering the
following financing strategies: bank financing and sale of
commercial papers.
Tarlac Union Bank is willing to loan Carmelo the necessary
funds provided that the company maintains a 20%
compensating balance requirement. The effective cost of
the bank loan, considering the compensating balance
requirement is 10.4% on a pretax basis.
On the other hand, Carmelo may sell PHP 4 Million of 90-day
maturity commercial papers every 3 months. The
commercial paper will carry a rate of 7.75%, The interest
rate is expected to remain at this level throughout the year.

Receivables Management
1. Relaxing credit standards. Pepito Corporation is
considering relaxing its credit standards to increase its
currently sagging sales. As a result of the proposed
relaxation, sales are expected to increase by 10% from
10,000 units to 12,000 units during the coming year; the
average collection period is 3% of sales. The sales price per
unit is PHP 40, and the variable cost per unit is PHP 31. If
the firms return on equal-risk investments is 25% and uses
a 360-day year, determine the net advantage/disadvantage
of relaxing the credit standard.
2. Initiating a cash discount. Felicidad Company
currently makes all sales on credit and offers no cash
discount. The firm is considering a 2% cash discount for
payment within 15 days. The firms current average
collection period is 60 days, sales are 40,000 units, selling
price is PHP 45 per unit, and variable cost per unit is PHP
36. The firm expects that the change in credit terms will
result in an increase in sales to 42,000 units, that 20% of
the sales will take the discount, and that the average
collection period will fall to 30 days. If the firms required

rate of return is 25%, determine the net benefit (cost) of

offering a cash discount (assume a 360-day year.)
3. The Sales Director of Cerenio Corporation is suggesting
that certain terms be modified. He estimates the following
effects:

Sales will increase by at least 20%

Accounts receivable turnover will be reduced to 8
times from the present 10 times.
Bad debts, now at 1% of sales will increase to 1.5%.
Sales before the proposed changes are at PHP
900,000. Variable cost ratio is 55% and desired rate
of return is 20%. Fixed expenses amount to PHP
150,000.

Determine the net advantage/disadvantage of changing the

credit terms.
Short-term Financing
Facts. Sunrise Company, a real estate developer, has a
need to finance its operations for the current year. The
financial manager has provided the following alternatives
to raise PHP 2 Million fund requirement:
The Company has an existing PHP 4 Million revolving
credit agreement with Bank of Manila. Its average
borrowing under the agreement for the past year was
PHP 1.5 Million. The bank charges a commission fee
of 1%. The nominal rate on used fund is 12%.
The Company may issue PHP 10 Million worth of
commercial paper that has a 90-day maturity and
sells for PHP 9.85 Million. The securities are to be
redeemed at par value on its maturity date.
The Company has a total of PHP 5 Million worth of
trade receivables. It is contemplated to be factored

with a 15% reserve, 2% factoring fee charged and

deducted from the book value of the receivables, and
a charge of 1% per month of interest on cash
advances.
Determine the individual effective financing rate.
Recommend the best alternative under the aforecited
modes of financing.
Inventory Management
Facts. Maine Corporation has been buying product AAA in
lots of 7,500 units which covers its three-month supply. The
cost per unit is PHP 220. The order cost is PHP 750 per
order; and the annual inventory carrying cost per unit is PHP
20. Assume that the units will be required evenly
throughout the year.
Additional information:
Working days in a year
300 days
Normal lead time
12 days
Maximum lead time
19 days
Maximum usage per working days
125 units
Stockout costs per occurrence
PHP 3,500
Determine the following:
1. EOQ
2. Number of orders in a year
3. Average inventory based on economic order quantity
4. Total carrying costs, and relevant inventory costs at EOQ
5. Reorder point
6. Average inventory
7. Maximum inventory