San Sebastian College Recoletos

Canlubang Campus

Management Advisory Services

WORKING CAPITAL MANAGEMENT

WORKING CAPITAL MANAGEMENT refers to the administration and control of current assets and
current liabilities to maximize the firms value by achieving a balance between profitability and risk

WORKING CAPITAL FINANCING POLICIES

1. Matching Policy (also called self-liquidating policy or hedging policy) matching the maturity of a
financing source with an assets useful life

short-term assets are financed with short-term liabilities

long-term assets are funded by long-term financing sources

2. Conservative (Relaxed) Policy operations are conducted with too much working capital; involves
financing almost all asset investments with long-term capital

3. Aggressive (Restricted) Policy operations are conducted on a minimum amount of working capital;
uses short-term liabilities to finance, not only temporary, but also part or all of the permanent current asset
requirement

4. Balanced Policy balances the trade-off between risk and profitability in a manner consistent with its
attitude toward bearing risk.

WAYS OF MINIMIZING WORKING CAPITAL REQUIREMENT

1. Managing cash and raw materials efficiently.

2. Having efficiency in making collections and in the manufacturing operations.
3. Implementing effective credit and collection policies.
4. Reducing the time lag between completion and delivery of finished goods.
5. Seeking favorable terms from suppliers and other creditors.

FORECASTING FINANCIAL STATEMENT VARIABLES

ASSUMPTIONS:

1. All variables are tied directly with sales

2. The current levels of most balance sheet items are optimal for the current sales level.

STEPS:

1. Identify assets and liabilities that vary spontaneously with sales

2. Estimate the amount of net income that will be retained
3. Compute the amount of External Financing Needed (EFN) by subt-acting increase in spontaneous
liabilities and income retained from increase in toaI financing required (increase in assets due to increase
in sales)

( ) ( ) > x <1 Payout%>)

Where: LA/S0 = percentage relationship of spontaneous assets (variable assets) to sales at period 0.

SL/S0 = percentage relationship o spontaneous liabilities (variable liabilities) to sales at period 0.

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 CASH MANAGEMENT

CASH MANAGEMENT involves the maintenance of the appropriate level of cash and investment in
marketable securities to meet the firms cash requirements and to maximize income on idle funds.

REASONS FOR HOLDING CASH

1. Transaction Purposes firms maintain cash balances that they can use to conduct the ordinary business
transactions; cash balances are needed to meet cash outflow requirements for operational or financial
obligations.
2. Compensating Balance Requirements a certain amount of cash that a firm must leave in its checking
account at all times as part of a loan agreement. These balances give banks additional compensation
because they can be relent or used to satisfy reserve requirements.
3. Precautionary Reserves firms hold cash balance in order to handle unexpected problems or contingencies
due to the uncertain pattern of cash inflows and outflows.
4. Potential Investment Opportunities excess cash reserved are allowed to build up in anticipation of a
future investment opportunity such as a major capital expenditure project.
5. Speculation firms delay purchases and store up cash for use later to take advantage of possible changes
in prices of materials, equipment, and securities, as well as changes in currency exchange rates.

THE CONCEPT OF FLOAT IN CASH MANAGEMENT

Float difference between the banks balance for a firms account and the balance that the firm shows on its
own books.

Types of Float:

1. Mail Float peso amount of customers payments that have been mailed by a customer but not yet
received by the sellers.
2. Processing Float peso amount of customers payments that have been received by the seller but not yet
deposited.
3. Clearing Float peso amount of customers check that have been deposited but not yet cleared.

CASH MANAGEMENT STRATEGIES

1. Accelerate cash collections- reduce negative (mail and processing) float

2. Control (slow down) disbursements
3. Reduce the need for precautionary cash balance

Operating cycle The amount of time that elapses from the point when the firm inputs materials and labor into
the production process to the point when cash is collected from the sale of the finished goods. Its two
components are: average age of inventories and average collection period of receivables. When the average
age of accounts payable is subtracted from the operating cycle, the result is called cash conversion cycle.

Economic Conversion Quality (Optimal Transaction Size) the amount of marketable securities that must be
converted to cash (or vice versa), considering the conversion costs and opportunity cost involved.

Conversion cost the cost of converting marketable securities to cash

Opportunity cost the cost of holding cash rather than marketable securities (rate of interest that can be earned
on marketable securities)

MARKETABLE SECURITIES

MARKETABLE SECURITIES short term money market instruments that can be easily be converted to
cash

REASONS FOR HOLDING MARKETABLE SECURITIES (MS):

1. MS serve as substitute for cash (transaction, precautionary and speculative) balances.

2. MS serve as a temporary investment that yields return while funds are idle.

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3. Cash is invested in MS to meet known financial obligations such as tax payments and loan amortizations.

RECEIVABLE MANAGEMENT

ACCOUNTS RECEIVABLE MANAGEMENT formulation and administration of plans and policies

related to sales on account and ensuring the maintenance of receivables at a predetermined level and their
collectibility as planned.

WAYS OF ACCELERATING COLLECTION OF RECEIVABLES

1. Shorten credit terms.

2. Offer special discounts to customers who pay their accounts within a specified period.
3. Speed up the mailing time of payments from customers to the firm.
4. Minimize float, that is, reduce the time during which payments received by the firm remain uncollected
funds.

AIDS IN ANALYZING RECEIVABLES

1. Ratio of receivables to net credit sales
2. Receivable turnover
3. Average collection period
4. Aging of accounts

INVENTORY MANAGEMENT

INVENTORY MANAGEMENT formulation and administration of plans and policies to efficiently and
satisfactory meet production and merchandising requirements and minimize costs relative to inventories.

INVENTORY MODELS

A basic INVENTORY MODEL exists to assist in two inventory questions:

1. How many units should be ordered?
2. When should the units be ordered?

Economic Order Quantity the quantity to be ordered, which minimizes the sum of the ordering and carrying
costs.

Economic Order Quantity may be computed as follows:

Where: a cost of placing one order (or ordering cost)

D annual demand in units
K annual costs of carrying one unit in inventory for one year

Assumptions of the EOQ model

1. Demand occurs at a constant rate throughout the year

2. Lead time on the receipt of the orders is constant
3. The entire quantity ordered is received at one time
4. The unit costs of the items ordered are constant; thus there can be no quantity discounts
5. There are no limitations on the size of the inventory.

When applied to manufacturing operations, the EOQ formula may be used to compute the Economic Lot
Size (ELS)

Where: a set up cost

D annual production requirement
K annual costs of carrying one unit in inventory for one year

When the EOQ is available, the average inventory is computed as follows:

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 When to Reorder:
When to reorder is a stock out problem. i.e., the objective is to order at a point in time so as not to run
out of stock before receiving the inventory ordered but not so early that an excessive quantity of safety
stock is maintained.

Lead time period between the time the order is placed and received
Normal time usage = normal lead time x average usage
Safety stock = (maximum lead time normal lead time) x average usage
Reorder point if there is NO safety stock required = normal lead time usage

Safety stock + Normal lead time usage

Reorder point if there is safety stock required or
Maximum lead time x Average usage

SHORT TERM FINANCING

1. ACCOUNTS PAYABLE the major source of unsecured short term financing.

a. Credit terms: credit periods, cash discount, cash discount period
b. Analysis of credit terms:
Taking the cash discount If cash discount is to be taken, a firm should pay on the last day of the
discount period.
Giving up cash discount If the firm has to give up the cash discount, it should pay on the last
day of the credit period.
Cost of giving up cash discount = [CD/(100% - CD)] x (360/N)
Where: CD = cash discount percentage
N = number of days payment can be delayed by giving up the cash discount
The above formula assumes that a firm gives up only one discount during the year. If a firm continually gives
up the discount during the year, the annualized cost is calculated as follows:

nnualized cost of giving up cash discount - ]

c. Stretching Accounts Payable: A firm should pay the bills as late as possible without damaging its
credit rating. When a firm can stretch the payment of accounts payable, the cost of foregoing the
discount is reduced.

2. Bank Loans
a. Single-payment notes If the interest is payable upon maturity, the effective interest rate is equal to
the nominal rate.
b. Discounted Note The effective interest rate is higher than the nominal rate.

If the term is less than a year, the interest rate is annualized.

c. Compensating Balance an arrangement whereby a borrower is required to maintain a certain

percentage of amount as compensating balance in the current account of the borrower.

EXERCISES:

1. FORECASTING Nanaynor orporations sales are expected to increase by 2 in 2 4 from P3

million in 2013. Its financial records show the following information as of the end of 2013:
Total assets P1,800,000
Current liabilities 675,000
The corporation is at full capacity, so its assets must grow in proportion to projected sales. Its current liabilities
include Notes Payable amounting to P375,000. The projected after tax profit margin is 12% and the forecasted
profit retention is 30%.

REQUIRED:
a. How much is Nanaynor orporations additional funds (AFN) needed for the coming year? What was the
capital intensity ration in 2013?
b. What would the additional funds needed be if the corporations year-end 2013 assets had been
P1,350,000? Assume that all other numbers are the same. What is the corporations new capital intensity
ratio?

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2. FINANCING STRATEGY Josh Inc.s total assets are composed of the following:

Current assets:
Permanent P1,800,000
Temporary 1,200,000 P3,000,000
Fixed assets 4,500,000
Total P7,500,000

The companys earnings before interest and taxes EBIT is P9 , . Josh pays the prevailing corporate
income tax rate. ompute Joshs earnings after tax under each of the following financing plans:
a. Finance all fixed assets and half of the permanent current assets with long term financing costing 12%.
Short term financing currently costs 7%.
b. Finance all fixed assets and permanent current assets plus half of its temporary current assets with
long term financing costing 12%. Short term financing currently costs 7%.

3. OPTIMAL TRANSACTION SIZE Assume that the fixed cost of selling marketable securities is P10
per transaction and the interest rate on marketable securities is 6% per year. The company estimates that it
will make cash payments of P144,000 over a one-year period.

Required: Compute the (a) Optimal level of cash balance or Optimal transaction size, (b) the average cash
balance, (c) the total cost of converting marketable securities to cash, and (d) the total carrying cost of cash.

4. OPERATING AND CASH CONVERSION CYCLES Conside the following data for Cycles
Corporation:

Sales (all on account) P13,500,000

Cost of goods sold 6,480,000
Credit purchases 14,400,000
Average accounts receivable 1,500,000
Average inventory 450,000
Average accounts payable 480,000

The firm spends P19,400,000 on operating cycle investments each year, at a constant rate. Assume a 360-day
year.
a. alculate the firms operating cycle
b. alculate the firms cash conversion cycle
c. Calculate the amount of resources needed to support the firms cash conversion cycle.

5. WORKING CAPITAL INVESTMENT The Alabang Corporation is a leading manufacturer of dolls

popularly known as labang Girls. The corporation turns out ,5 dolls a day at a cost of P6 per doll
for materials and labor. It takes the firm 22 days to convert raw materials into a doll. Alabang allows its
customers 40 days in which to pay for the dolls, and the firm generally pays its suppliers in 30 days.

a. What is the length of labangs cash conversion cycle?

b. At a steady state in which Alabang produces 1,500 dolls a day, what amount of working capital
must be finance?
c. By what amount could Alabang reduce its working capital financing needs if it was able to stretch
its payables deferral period to 35 days?
d. labangs management is trying to analyze the effect of a proposed new production process on
the working capital investment. The new production process would allow Alabang to decrease its
inventory conversion period to 20 days and to increase its daily production to 1,800 dolls.
However, the new process would cause the cost of materials and labor to increase to P7.
Assuming the change does not affect the receivables collection period (40 days) or the payables
deferral period (30 days), what will be the length of the cash conversion cycle and the working
capital financing requirement if the new production process is implemented?

6. Animatrix Incorporated currently sells in credit but offers no cash discount. The firm is considering a 3
percent cash discount for payment within days. The firms current average collection period is 9 days,
sales are 800 films per year, selling price is P50,000 perm film, variable cost per film is P37,500 and the
average cost per film is P42,000. The firm expects that the change in credit terms will result in a minor
increase in sales of 20 films per year, that 75 percent of the sales will take the discount, and the average
collection period will drop to 3 days. The firms bad debt expense is expected to become negligible under
the proposed plan. The bad debt expense is currently 0.5 percent of sales. Collection cost is normally 2%
of sales. The firms required return on equal risk investments is 20 percent. Assume 360-days in a year.

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REQUIRED:
1) How much is the incremental contribution margin?
2) How much is the incremental investment on accounts receivable?
3) How much is the incremental capital cost?
4) How much is the incremental collection cost?
5) How much is the incremental delinquency cost?
6) How much is the incremental discounts?
7) How much is the incremental profit from the revised policy?

7. Wasting Resource Co. has annual credit sales of P4 million. Its average collection period is 40 days and
bad debts are 5% of sales. The credit and collection manager is considering instituting a stricter collection
policy, whereby bad debts would be reduced to 2% of total sales and the average collection period would
fall to 30 days. However, sales would also fall by an estimated P500,000 annually. Variable costs are 60%
of sales and the cost of carrying receivables is 12%.

REQUIRED: Assuming a tax rate if 35% and 360 days a year.

1) How much is the incremental contribution margin?
2) How much is the incremental investment on accounts receivable? Incremental capital cost?
3) How much is the incremental delinquency cost?
4) How much is the incremental profit from the revised policy?

8. XYZ Company believes that its collection costs could be reduced through modification of collection
procedures. This action is expected to result in a lengthening of the average collection period from 28 days
to 34 days; however, there will be no change in uncollectible accounts. The companys budgeted credit
sales for the coming year are P27,000,000 and short-term interest rates are expected to average 8%. (Use a
360-day year).

Required: The minimum savings in collection costs for the current year to make the changes in collection
procedures cost beneficial.

9. Italia Pizzeria is a popular pizza restaurant near a college campus. Brandon Thayn, an accounting student,
works for Italia Pizzeria. After several months at the restaurant, Brandon began to analyze the efficiency
of the business, particularly inventory practices. He noticed that the owner had more than 50 items
regularly carried in inventory. Of these items, the most expensive to buy and carry was cheese. Cheese
was ordered in blocks at P17.50 per block. Annual usage totals 14,000 blocks.

Upon questioning the owner, Brandon discovered that the owner did not use any formal model for
ordering cheese. It took five days to receive a new order when placed, which was done whenever the
inventory of cheese dropped to 200 blocks. The size of the order was usually 400 blocks. The cost of
carrying one block of cheese is 10 percent of its purchase price. It costs P40 to place and receive an order.
Italia Pizzeria stays open seven days a week and operated 50 weeks per year. The restaurant closes for the
last two weeks of December.

Required:
1) Compute the total cost of ordering and carrying the cheese inventory under the current policy.
2) Compute the total cost of ordering and carrying cheese if the restaurant were to change to the
economic order quantity. How much would the restaurant save per year by switching policies?
3) If the restaurant uses the economic order quantity, when should it place in order? (Assume that the
amount of cheese used per day is the same throughout the year.) How does this compare with the
current reorder policy?
4) Suppose that storage space allows a maximum of 600 blocks of cheese. Discuss the inventory policy
that should be followed with this restriction.
5) Suppose that the maximum storage is 600 blocks of cheese and that cheese can be held for a
maximum of 10 days. The owner will not hold cheese any longer in order to ensure the right flavor
and quality. Under these conditions, evaluate the owners current inventory policy.

10. The RSP Company purchases 48,600 units of bleaching soap per year. The average purchase lead time is 3
working days. Maximum lead time is 7 working days. The company works 360 days per year.

Required:
a. Units of safety stock that the company should carry
b. The reorder point for bleaching soap
c. Assume that the lead time is always 3 days and no delay in delivery has been experienced by the
company. What is the reorder point? How many units of safety stock must be kept by the company in
this case?

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11. The emergency room of the Wyandotte County Medical Center uses an EOQ model to order supplies.
Lately, several physicians have complained about the availability of a particular medication to treat
patients suffering from heart attacks. During the past three months, emergency room physicians, on
occasion, have had to use a substitute medicationone that is known to be less effective. Because of the
problem, the supply officer as decided to review the current inventory policy. The following data have
been gathered.

Cost of placing ad receiving an order P100

Cost of carrying one package P5.50
Average usage per day 30 vials
Maximum usage per day 35 vials
Lead time for an order 4 days
Annual demand 10,571 vials

The emergency room currently does not carry any safety stock. The emergency room operates 365 days each
year.

Required:
1) Compute the economic order quantity and the reorder point. What is the total ordering and carrying
cost for the emergency rooms current inventory policy?
2) Assume that the emergency room has decided to carry safety stock for the indicated medication.
Compute how much should be carried to ensure no stockouts. Compute the total ordering and carrying
cost for this policy. Will the reorder point change? If so, what is the new reorder point?

12. FOREGOING DISCOUNTS ON PURCHASES. Sakana Bayad Company purchases raw materials on
terms of 3 , net 6 . review of the companys records by the owner, Mr. Sakana, revealed that
payments are usually made 40 days after purchases are received. When asked why the firm did not take
advantage of its discounts, the bookkepper, Mr. Tinidor de Libro replied that it costs only 3% for these
funds, whereas the bank loan would cost the firm 12 percent.

Required:
a. What is the real cost of not taking advantage of the discount?
b. What mistake is de Libro making?
c. If the firm could not borrow from the bank and was forced to resort to the use of trade credit funds,
what suggestion might be made to de Libro that would reduce the annual interest?

13. STRETCHING PAYABLES. Maagap orporations suppliers sell merchandise to Maagap on terms of
60 days. Despite this fact, the corporation pays its accounts, on the average, in 50 days, so that its accounts
payables average P500,000.

The corporation is now considering payment of its payable to the end of the term in order to decrease its
cash requirements.

Required: How much is the expected increase in accounts payable if payments are delayed to the 60th
day?

14. COST OF BANK LOANS. King Company is negotiating with EnBank for a P2 million, one-year loan.
EnBank has offered King Company the following alternative. Calculate the effective annual interest rate
for each alternative. Which alternative is the most attractive?

a. A 10% annual rate on a s simple interest loan, with no compensating balance required and interest due
at the end of the year.
b. An 8% annual rate on a simple interest loan, with a 25% compensating balance required and interest
due at the end of the year.
c. A 10% annual rate on a discounted loan, with a 20% compensating balance.
d. An 8% add-on annual interest, payable in equal monthly installments.

15. A company obtained a short term bank loan of P5 million at an annual interest rate of 10%. As a condition
of the load, the company is required to maintain a 20% compensating balance in its checking account. The
checking account earns interest of 5% per annum. Before the loan was granted, the company maintained a
balance of P100,000 in its checking account. Compute the effective interest rate for this loan.

***END***

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