WORKING CAPITAL MANAGEMENT

1.0 Basic Concepts

1.1 Working capital management deals with operating activities as they relate to the
profitability and liquidity of the enterprise
1.2 The operating activities include investment in cash for:
1.2.1 inventory procurement;
1.2.2 trade receivables to maintain credit and collection activities;
1.2.3 expenses to distribute products and to administer the business; and
1.2.4 marketable securities to manage variations and uncertainties in thee
operating cash requirements
2.0 Working Capital Investments
2.1 Businesses normally tap short-term credit to finance working capital investments.
2.2 Basically, the net working capital is figured out as follows:
Accounts Amount Explanation
Current Assets Px Total short-term investments to complete the
operating cycle
- Current Liabilities (x) Short-term creditors’ share in financing the
enterprise’s operating cycle
Net Working Capital Px Enterprise’s equity in financing its operating
cycle

3.0 Distinguish a relaxed current asset investment policy and a restricted current asset
investment policy.
3.1 in a relaxed current asset investment policy, a firm holds relatively large amounts
of each type of current assets.
3.2 in a restricted current asset investment policy, the firm holds minimal amounts of
each type of current assets
4.0 Distinguish permanent current assets and temporary current assets
4.1 permanent current assets are those assets that the firm holds even during slack
times
4.2 temporary current assets are additional current assets that are needed during
seasonal or cyclical peaks.
5.0 Describe the moderate, aggressive and conservative approaches to current asset financing
5.1 a moderate policy to current asset financing involves matching, to the extent
possible, the maturities of assets and liabilities, so that temporary current assets are
financed with short-term nonspontaneous debt, and permanent current assets and
fixed assets are financed with long-term debt or equity, plus spontaneous debt
5.2 under the aggressive policy, some permanent current assets, and perhaps even some
fixed assets, are financed with short-term debt.
5.2.1 Advantage of an aggressive policy
5.2.1.1 increases return on equity (profitability) by taking advantage of the
cost differential between long-term and short-term debt
5.2.2 Disadvantages of an aggressive policy
5.2.2.1 exposure to risk arising from low working capital position
5.2.2.2 puts too much pressure on the firm’s short-term borrowing
capacity so that it may have difficulty in satisfying unexpected
needs for funds
5.3 a conservative policy would be to use long-term capital to finance all permanent
assets and some of the temporary current assets
 5.3.1 Advantages of a conservative policy
5.3.1.1 reduces risks of illiquidity
5.3.1.2 eliminates the firm’s exposure to fluctuating loan rates and
potential unavailability of short-term credit
5.3.2 Disadvantage of a conservative policy
5.3.2.1 less profitable because of higher financing costs
6.0 Sources of working capital
6.1 income from current operations, adjusted for noncash expenses such as depreciation
6.2 gain on sale of marketable securities
6.3 proceeds from the sale of non-current assets
6.4 proceeds from long-term borrowings
6.5 investments from owners
7.0 Uses of working capital
7.1 operations (deducted from resources)
7.2 purchase of non-current assets
7.3 retirement/payment of long-term debt
7.4 return of capital owners through
7.4.1 dividend payments
7.4.2 retirement of capital stock
7.4.3 withdrawals
8.0 Working capital policy refers to the firm’s policy regarding:
8.1 target levels for each category of current assets
8.2 how assets will be financed
9.0 Management of the operating cycle
9.1 the operating cycle comprises the activities of buying or producing products, selling
products, and collecting receivables from customers
9.2 the length of time it takes for the enterprise to produce and sell products is reflected in
inventory days
9.3 the length of time it takes for the enterprise to collect credits from customers is
measured by collection period
9.4 the normal operating cycle is the sum of inventory days and collection period
10.0 Significance of working capital management
10.1 working capital represents the margin of safety for short-term creditors
10.2 the amount of working capital represents the extent to which current assets are
financed from long-term sources
11.0 Factors affecting level of current assets
11.1 general nature of the business and product
11.2 effect of sales pattern
11.3 length of manufacturing process
11.4 industry practices
11.5 terms of purchases and sales
 CASH MANAGEMENT
1.0 Basic Concepts
1.1 Cash is a medium of exchange. It is the most convenient way to measure the value of
assets received and assets parted with in an arm’s length transaction
1.2 As a medium of exchange it must be used or invested in a business undertaking to
facilitate a business cycle or it will give rise to the opportunity costs of holding excess
cash.
1.3 Cash includes currencies, checks, demand deposits, checking accounts and cash
equivalents that are used for working capital operations
1.4 Technically, cash is an idle asset, unless an enterprise has a business purpose of
maintaining it.
1.5 The areas of concern in cash management includes
1.5.1 determining the optimal cash balance to be maintained
1.5.2 the synchronization of cash inflows and outflows
1.5.3 identifying the temporary investments where to place temporary excess
cash
1.5.4 knowing the effective interest rate of borrowing and other short-term
financing
1.5.5 linking cash flows to receivables collection period and inventory
conversion days
2.0 Reasons for maintaining a minimum cash balance
2.1 Transaction Motive – cash is needed to facilitate the normal transactions of the
business, that is, to carry out its purchases and sales activities
2.2 Precautionary Motive – cash may be held beyond its normal operating requirement
level in order to provide for a buffer against contingencies such as unexpected slow-
down in accounts receivable collection, strike, or increase in cash needs beyond
management’s original projections
2.3 Speculative Motive – cash is held ready for profit-making or investment opportunities
that may come up such as a block of raw materials inventory offered at discounted
prices or a merger proposal
2.4 Contractual Motive – a company may be required by a bank to maintain a certain
compensating balance in its demand deposit account as a condition of a loan extended
to it
3.0 The amount of cash to be held normally depends on the following factors:
3.1 cash management policies
3.2 current liquidity position
3.3 management’s liquidity and preferences
3.4 schedule of debt maturity
3.5 the firm’s ability to borrow
3.6 forecasted short and long-term cash flows
3.7 the probabilities of different cash flows under varying circumstances
4.0 Cash receipts management and “deposit float”
4.1 Cash inflows and outflows should be synchronized. Cash inflows should be
accelerated and cash outflows should be slowed down
4.2 One major variable that affects the cash inflow and outflow is the cash float.
4.3 Float means delay. It is the interval from the time check is issued to the point the cash
is transferred to the payee’s account. A float could either be a collection float or a
disbursement float. The collection float should be minimized while the payment float
should be maximized.
 4.4 In the process of realizing checks issued by customers into cash, the enterprise has to
manage a “check to cash conversion float”
4.4.1 A float consists of the following:
4.4.1.1 Mail Float – the time interval from the check is issued to the point
the mail is received by the collecting party
4.4.1.2 Processing Float – it is the time from the date the mail is received
to the point the check is deposited to the payee’s account
4.4.1.3 Clearing Float – it represents the normal banking clearing time of
checks. It is the time from the date of deposit is made up to the
date the cash is already available for withdrawal
4.5 The following is techniques are used in accelerating cash receipts:
4.5.1 high credit standards
4.5.2 efficient and effective billing system
4.5.3 efficient and effective collection policies
4.6 To minimize the mail float, the following techniques may be used:
4.6.1 Lockbox system – applied by renting mail boxes in the post office to
quicken segregation and delivery of mails.
4.6.2 Direct sends
5.0 Cash payments management and “disbursement float”
5.1 The following techniques are used to slow down cash releases”
5.1.1 Controlled disbursement
5.1.2 Playing the float
5.1.2.1 use of draft
5.1.2.2 use of checks
5.1.2.3 issued crossed checks
5.1.2.4 issue check after the cut-off deposit time
5.1.2.5 issue check only on Fridays
5.1.3 Payroll management
6.0 The Optimum Cash Balance
6.1 Ideally, the optimum cash balance is zero. However, because of practical
requirements in business undertakings, cash balance should be maintained.
6.2 Despite the prominence of cash balance in the management of working capital, it
would be unwise for the enterprise not to determine the optimum cash balance that
would give it the lowest cost of carrying cash and transacting in cash.
6.3 Excess cash is invested in temporary investments, while potential cash deficit may be
managed by streamlining operating activities or through borrowings.
6.4 If these activities and notions are to be considered, there appear to have two cash
costs, namely, the transaction costs and the carrying costs. The standard
computations are as follows:

Transaction Cost No. of transactions x Cost per transaction

(Total cash need / Transaction cash size) x Cost per transaction
Carrying Cost Average cash balance x Cost of carrying cash
(Cash balance / 2) Cost of carrying cash)

6.5 Carrying cost is the opportunity lost in holding the cash and for not being used in an
investment activity. It is also referred to as opportunity cost.
6.6 Transaction cost consists of the amounts paid to brokers, market regulators agencies
and government agencies in buying and selling securities in the capital market.
6.7 Theoretically, a desired cash balance is the optimal cash balance where the total
relevant cost of cash would be at the minimum. The relevant costs of cash are its
holding cost and opportunity cost.
6.8 A desired cash balance may be established by using the subjective model or
quantitative model.
6.9 In the subjective model, the company sets the desired cash balance based on the
related cash factor. Say, the minimum cash balance is 10% of the following month’s
sale.
6.10 In the quantitative model, we have the Baumol Model or the Miller-Orr Model.
6.11 The Baumol Model
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 MARKETABLE SECURITIES MANAGEMENT
1.0 Basic Concepts
1.1 Marketable Securities are highly liquid, short-term, interest-bearing, government
and nongovernment money market instruments. They can be easily converted into
cash.
1.2 A security have two basic characteristics:
1.2.1 a ready market
1.2.2 a safety of principal
1.3 Reasons for holding marketable securities
1.3.1 They serve as substitute for cash balances
1.3.2 They are held as a temporary investment where a return is earned
while funds are temporary idle
1.3.3 They are built up to meet known financial requirements such as tax
payments, maturing bond issues and so on.
1.4 Risk and maturity influence the choice of marketable securities
1.4.1 Risk
1.4.1.1 Default risk – the issuer may not be able to pay the principal
or the interest at due dates
1.4.1.2 Interest rate risk – the decline in the market values of the
security due to rising interest rates
1.4.1.3 Inflation risk – the future deterioration of the purchasing
power of a currency
1.4.1.4 Marketable or liquidity risk – the security may not be
immediately sold or if sold is made at a substantial price
concessions.
1.4.2 Maturity – it should be aligned with the projected working cash needs
of the business. Convertibility of marketable securities to cash is more
important than yield on maturity.
1.4.3 Marketability – refers to how quickly a security can be sold before
maturity without a significant price concession
1.5 Examples of marketable securities
1.5.1 Marketable securities may be divided into two groups
1.5.1.1 government issues
1.5.1.2 private corporation issues
 ACCOUNTS RECEIVABLES MANAGEMENT
1.0 Basic Concepts
1.0 Accounts receivables management is the formulation and administration of plans and
policies related to sales on account and ensuring the maintenance of receivables at a
predetermined level and their collectability as planned
2.0 Objective: to have both the optimal amount of receivables outstanding and the optimal
amount of bad debts
3.0 Factors in determining accounts receivables policy:
3.1 Credit Standards – criteria that determine which customers will be granted credit
and how much
3.1.1 The credit standard should not be too stringent or too tight which may
eliminate the risk of non-payment, but also eliminate potential sales to
rejected customers; neither should the standards be too loose or liberal,
which may lead to higher sales, but also higher bad debt losses and
collection costs.
3.1.2 The enterprise should always maintain the attitude of conservatism in
processing and approving credit lines. The indispensible 5C’s of credit
should always be followed:
3.1.2.1 Character - a customer’s willingness to pay
3.1.2.2 Capacity – a customer’s ability to generate cash flows
3.1.2.3 Capital – a customer’s financial sources such as collateral
3.1.2.4 Conditions – current economic or business conditions
3.1.3 The effects of the credit standards in the variables of profit and
financials are as follows:

Accounts
Credit Credit Collection Bad Collection
Receivable
Standard Sales Rate Debts Expenses
Balance
Conservative
(Strict)
Aggressive
(Lax)

3.2 Credit Policies – define the credit period and any discount offered for early
payment
3.2.1 Costs and benefits of a credit extension policy
3.2.1.1 cash discounts
3.2.1.2 credit and collection costs
3.2.1.3 bad debt losses
3.2.1.4 financing costs
3.2.2 Some of the popular credit policies are:
3.2.2.1 Credit Class – pertains to the group of customers to whom
merchandise shall be delivered.
3.2.2.2 Credit Cap (Credit Limit) – refers to the maximum, or
ceiling, amount of the credit line allowed to a given customer
depending on his capability to meet trade payments. The higher
the credit risk of a customer, the lower the credit cap is.
 3.2.2.3 Credit Block – refers to the credit department’s actions where
a customer is not granted credit line (his credit line is blocked)
because its current account becomes past due.
3.2.2.4 Credit Period – refers to the entire credit days granted to
customers. A long credit period slows down collection while a
short credit period quickens the receipts of money from
customers.
3.3 Collection Policy
3.3.1 Collection policy covers the effective and efficient billing system and
other collection policies.
3.3.2 Like credit standards, 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 balances.
3.3.3 The effects of collection policy are as follows:
Collection Receivable Collection
Collection
Policy/System Turnover Period
Efficient Faster Higher Shorter
Inefficient Slower Lower Longer

3.3.4 Ways of accelerating collection of receivables

3.3.4.1 Shorten credit terms
3.3.4.2 Offer special discounts to customers who pay their accounts
within a specified period
3.3.4.3 Speed up the mailing time of payments from customers to the
firm
3.3.4.4 Minimize float, that is, reduce the time during which payments
received by the firm remain uncollected funds.
4.0 Determinants of the size of receivables
4.1 Terms of sales
4.2 Paying practices of customers
4.3 Collection policies and practices
4.4 Volume of credit sales
4.5 Credit extension policies and practices
4.6 Cost of capital
5.0 Aids in analyzing receivables
5.1 Ratio of receivables to net credit sales
5.2 Receivable turnover
5.3 Average collection period
5.4 Aging of accounts
 INVENTORY MANAGEMENT
1.0 Basic Concepts
1.1 Inventory Management – formulation and administration of plans and policies to
efficiently and satisfactorily meet production and merchandising requirements and
minimize costs relative to inventories.
1.2 Objective – 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.
2.0 Inventory costs may be classified as follows:
Net Purchase Price Quoted price, shipping charges, discounts and similar items are to be
deducted
Production Costs Direct materials, direct labor, traceable overhead, and allocated fixed
overhead
Ordering Costs Invoice preparation, goods receipt and inspection, payment, forms,
clerical processing
Set-up Costs Labor time, machine downtime, scheduling, move time
Carrying Costs Storage, handling, insurance, property taxes levied on the inventory
cost or value, losses form obsolescence, damage or theft, opportunity
costs of invested capital
Stock out costs Lost contribution margin, lost customer goodwill, ordering and
shipping charges from filling special orders, setup costs for rescheduled
production

3.0 Inventory Management Techniques

3.1 Inventory Planning – determination of the quality and quantity and location of
inventory, as well as the time of reordering, in order to meet future business
requirements
3.1.1 The Economic Order Quantity (EOQ) Model – the quantity to be
ordered, which minimizes the sum of ordering and carrying costs.
3.1.1.1 To compute for the EOQ, the following formulas are followed:

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Total Inventory Total Ordering Costs + Total Carrying Costs

Costs
Annual demand in units x Ordering
Total Ordering Costs
EOQ or order size Costs per Unit
Total Carrying Costs Average Inventory +Ordering Costs per Order
EOQ or order size
Average Inventory
2

3.1.2 Reorder Point

Reorder Point Lead Time Usage x Safety Stock

Lead Time Normal Usage x Normal Lead Time
Safety Stock Safety stock (in usage) + Safety Stock (in time)
Safety Stock (in usage) (Maximum usage – Normal Usage) x Normal Lead Time
Safety Stock (in time) (Maximum Lead Time – Normal Lead Time) x Normal Usage
 3.1.2.1 Lead Time refers to the waiting time from the date the order is
placed until the date the delivery is received.
3.1.2.2 Lead Time Quantity represents the normal usage during the lead
time period.
3.1.2.3 Normal Usage means the average usage of inventory during a
given specific period of time
3.1.2.4 Safety Stock is established to serve as an allowance in case of
variations in normal usage and normal lead time.
3.2 Inventory Control – regulation of inventory within predetermined level; adequate
stocks should be available to meet business requirements, but the investment in
inventory should be at the minimum
3.2.1 Fixed Order Quantity System – an order for a fixed quantity is placed
when the inventory level reaches the reorder point
3.2.2 Fixed Reorder Cycle System – orders are made after a review of
inventory levels has been done at regular intervals
3.2.3 Optional Replacement System
3.2.4 ABC Classification System – inventories are classified for selective
control:
A Items High value items requiring highest possible control
B Items Medium cost items requiring normal control
C Items Low cost items requiring the simplest possible control

3.3 Modern Inventory Management – often applied in the context of automated

manufacturing
3.3.1 Materials Requirement Planning (MRP) – designed to plan and control
raw materials used in production. The demand for materials, which is
assumed to be dependent on some factors, is programmed into a computer.
3.3.2 Manufacturing Resource Planning (MRP II) – a closed loop system
that integrates all facets of a business, including inventories, production,
sales, and cash flows.
3.3.3 Enterprise Resources Planning (ERP) – integrates the information
systems of the whole enterprise. All organizational operations are
connected and the organization itself is connected with its customers and
suppliers.