Financial Management 501 Mailene Claire N.

Mapa, CPA
Working Capital Management

WORKING CAPITAL
For financial analysts, working capital equals current assets.
For accountants, working capital equals current assets minus current liabilities.

WORKING CAPITAL FINANCING POLICIES

1. Conservative (Relaxed) Policy – operations are conducted with too much working capital; involves financing
almost all asset investments with long-term capital.
ADVANTAGES: - Reduced risk of illiquidity
- Eliminates the firm’s exposure to fluctuating loan rates and potential unavailability of
short-term credit.
DISADVANTAGE: - Less profitable because of higher financing costs.

2. 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.
ADVANTAGE: - Increases return on equity (profitability) by taking advantage of the cost differential
Between long-term and short-term debt.
DISADVANTAGES: - Exposure to risk arising from low working capital position.
- Puts too much pressure on the firm’s short-term borrowing capacity so that it may
have difficulty in satisfying unexpected needs for funds.

CASH CONVERSION CYCLE

- The length of time it takes for the initial cash outflows for goods and services (materials, labor, etc.) to be
realized as cash inflows from sales (cash sales and collection of accounts receivable).

Cash Conversion
Cycle = Inventory Conversion Period + Receivables Collection Period + Payable Deferral Period
or or or
Average age of Inventories + Average age of Receivables + Average age of Payables

Inventory Conversion Period = Number of days in a year (360 days)

Inventory Turnover
Receivables Collection Period = Number of days in a year (360 days)
Receivable Turnover
Payable deferral period = Number of days in a year (360 days)
Accounts Payable Turnover*

* Net Credit Purchases____

Average Accounts Payable

CASH MANAGEMENT

Reasons for holding cash

1. Transaction purposes – firms maintain cash balance that they can use to conduct the ordinary business
transactions.
2. Compensating balance requirements – a certain amount of cash that a firm must leave in its checking account at
all times as part as part of a loan agreement.
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 reserves 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.

Concept of Float in Cash Management

Float – difference between the bank’s balance for a firm’s account and the balance that the firm shows on its own books
Types of Float
1. Negative Float – book balance exceeds the bank balance, which means that there is more cash tied up in the
collection cycle and it earns a 0% rate of return.
 Mail Float
 Processing Float
 Clearing Float
Good cash management dictates that above floats must be minimized, if not eliminated.
2. Positive Float (Disbursement) – firm’s bank balance exceeds its book balance (example: checks written/issued by
the firm that have not yet cleared). Management should increase this type of float.

Sample Situation:
Belle Company’s average monthly cash receipts is P1,500,000. Its average collection period is ten (10) days. A collection
agency has offered to the company’s collector and shorten collection period to four (4) days for a monthly fee of P1,500.
The company can invest its excess funds in money market placement at a rate of 8%.

If the collection agency’s offer is accepted, Belle Company’s net annual benefit (loss) is__________.

Solution:
Average collection period 10 days
Collection period after improvement 4 days
Number of days eliminated 6 days
Times: Ave. daily collection (1.5 M/30 days 50,000
Increase in cash collection 300,000
Multiply by interest rate 8%___
Interest income that could be earned 24,000
Annual cost of service fee (1500x12 months) 18,000
Annual benefit 6,000

* The entity should accept the offer because it will give them 6,000 net benefit.

Baumol Cash Management Model – an EOQ-type model which can be used to determine the optimal cash balance where
the costs of maintaining and obtaining cash are at the minimum.

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

MANAGEMENT OF ACCOUNTS RECEIVABLES

- objective is to have both the optimal number of receivables outstanding and the optimal amount of bad debts

This balance requires the trade-off between:

1. The benefit of more credit sales
2. The cost of accounts receivable such as collection, interest, and bad debts cost

MANAGEMENT OF INVENTORIES
- objective is 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.

Economic Order Quantity (EOQ) – the quantity to be ordered, which minimizes the sum of the ordering and carrying costs.
The total inventory cost function includes:
1. Carrying Costs (which increase with order size)
a. storage costs
b. interest costs
c. spoilage
 d. insurance

2. Ordering Costs (which decrease with order size)

a. transportation cost
b. administrative cost of purchasing and costs of receiving and inspecting goods

EOQ Formula

EOQ = 2Ad
K
a = cost of placing one order
D = annual demand in units
K = annual costs of carrying one unit in inventory for one year

Computation of annual ordering cost

Ordering Cost = (Annual demand in units / Number of units in 1 order) X Cost per order
Carrying Cost = Average Inventory* X Carrying cost per unit
* Number of units in 1 order / 2

NOTE: You have the EOQ if annual ordering cost is equal to annual carrying cost

Sample Situation:
Emil Traders, Inc. sells cellphone cases which it buys from a local manufacturer. Emil Traders sells 24,000 cases evenly
throughout the year. The cost of carrying one unit in inventory for one year is P11.52 and the order cost per order is
P38.40.

1. What is the EOQ? Answer: 400 units

A = 38.40
D = 24,000
K = 11.52

2. Under EOQ, how much is annual ordering costs? Answer: P2,304

Solution:
Annual demand 24,000 units
Divided by EOQ 400 units__
Number of times of order in a year 60 times
Ordering cost 38.40_____
Annual order cost P2,304

On the other hand, annual carrying cost is computed:

EOQ 400 units
Divided by 2______
Average inventory 200 units
Carrying cost per unit 11.52___
Annual carrying cost P2,304

Reorder point
When to order 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
Safety Stock = (Maximum lead time – Normal lead time) x Average usage

Sample Situation:
The following information is available for Edgar Corporation’s Material X
Annual usage 12,600 units
Working days per year 360 days
Normal lead time 20 days
1. What is the reorder point? Answer: 700 units
Daily Usage (12,600 units/360 days) 35 units
Normal lead time 20 days
700 units

2. Assuming occasionally, the company experiences delay in the delivery of Material X, such that the lead time
reaches a maximum of 30 days, how many units of safety stock should the company maintain and what is the
reorder point? Answer: 1,050 units
Normal time usage (refer above) 700 units
Maximum lead time 30 days
Normal lead time 20 days
10 days
Daily usage 35 units
350 units__
Reorder point 1,050 units