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Chapter 4: Working Capital

Management
- refers to the efficient and effective
utilization of working capital to attain
predetermined objectives of an organization.
- administration and control of current
assets and current liabilities to maximize a
firm’s value thru balancing between balance
and risk.
Analysis of Working Capital
1. Appropriate Level of Working Capital
- refers to the adequacy thereof to enable
a business entity to operate efficiently towards
the attainment of objectives.
2. Structural Health of working capital
- refers to how much is in cash,
receivables, inventories, etc, and the ability of
the business organization to meet financial
requirements.
Analysis of Working Capital
3. Circulation of Working Capital
- refers to the flow thereof from one
current asset item to another in the process of
conducting operations and the rate of such flow.
4. Liquidity of Working Capital
- give emphasis on cash and
marketable securities and how soon the noncash
items among the current assets be converted into
cash.
Financing Requirements of a Firm
1. Permanent Financing Requirement
2. Seasonal Financing Requirement
Total Financing Requirement = Permanent Financing
Requirement + Temporary Requirement
= (Fixed Assets + Permanent Current Assets) +
Temporary Current Assets.
Example:
The permanent requirement financing of DGC Corp. is
80,000 consisting of fixed assets (50,000) and current
assets (30,000). Because of seasonal changes in the
demand for its product, the total current assets for the
first, second, third and fourth quarter 0f 19B have been
estimated at 80,000, 45,000, 30,000 and 42, 000
respectively
Throughout the year, the total financing
requirement is 80,000 with additional
financing requirement of 8,000, 15,000 and 12,
000 for the first, second and fourth quarters,
respectively.
1. Aggressive Financing Strategy
- operations are conducted on a minimum
amount of working capital.
- bases of long term is the lowest amount
Example:
Applying the aggressive financing strategy in the
given example the permanent financing requirement of
80,000 must be from long term sources with temporary
financing requirements (ranging from 0 to 15,000. under
this strategy working capital is 30,000 only.
1 2 3 4 5
Total Long Short Working Excess
Require term Term Capital Working
ment Funds Funds (2) –( FA) Capital
(FA + (1) –( 2) (4) –( CA)
CA)

1st 88,000 80,000 8,000 30,000 0


2nd 95,000 80,000 15,000 30,000 0
3rd 80,000 80,000 0 30,000 0
4th 92,000 80,000 12,000 30,000 0
2. Conservative Financing Strategy
- provides long term funds based on the
maximum requirement with unexpected needs
financed by short term sources.
- results in more financing charges aside from
the opportunity cost of too much capital tied up in
current assets.
1 2 3 4 5
Total Long Short Working Excess
Requiremen term Term Capital Working
t (FA + CA) Funds Funds (2) –( FA) Capital
(1) –( 2) (4) –( CA)

1st 88,000 95,000 - 45,000 7,000


2nd 95,000 95,000 - 45,000 0
3rd 80,000 95,000 - 45,000 15,000
4th 92,000 95,000 - 45,000 3,000
Analysis:
- the maximum capital would be made
available throughout the year, financed by long term
funds. Working capital would be 45,000 and during
the 1st, 3rd and 4th quarters, there would be excess
funds.
3. Semi – Aggressive or Semi
Conservative Strategy
- the long - term funds is the average amount
between the highest and lowest total requirements
1 2 3 4 5
Total Long Short Working Excess
Requireme term Term Capital Working
nt (FA + Funds Funds (2) –( Capital
CA) (1) –( 2) FA) (4) –(
CA)

1st 88,000 87,500 500 37,500 -


2nd 95,000 87,500 7,500 37,500 -
3rd 80,000 87,500 - 37,500 7,500
4th 92,000 87,500 4,500 37,500 -
Analysis:
Under this strategy, working capital averages 37,500.
during the 3rd quarter excess funds of 7,500 may be
expected.
Seasonal Variation in Working
Capital
- for every season the working capital will change
or vary during in peak season the working capital will
increase while during lean season the working capital
will decrease.
Ways in Minimizing your working
capital
1. efficiency in cash and raw materials
management
2. efficiency in collection
3. efficiency in manufacturing process
4. effective credit and collection policies
5.reduction of time lag between completion and
shipment of finished goods.
6. favorable terms from suppliers
7. accepting deliveries on consignment
Cash Management Strategies
1. Accelerating collections of receivables

Ex. A corporation collects its receivable after


25 days on the average so that they mount to
75,000. The proposal is to shorten the credit
term to 20 days or by 5 days. Said proposal
will reduce receivables by 15, 000 and it is
computed as follows:
Collected receivables after 25 days - 75,000
Collected receivables after 20 days :
Average sales per day (75000/25 days) 3, 000
Multiply by 20 days
60,000
Decrease in receivables (and in operating
cash requirement) 15,ooo
Collection Techniques:
1. Direct sends – the money received as part of
collections are sent directly to the banks . This reduces
the clearing float for the said checks since it will pay
immediately to the company that is making the
collection.
2. Concentration banking – bank accounts are
maintained for provincial sales outlet so that they may
collect from customers and deposit their collections
with the local banks.
- this practice reduces both mailing
and clearing floats.
3. Lockbox system – customers will send
remittances to a post office box w/c is serviced by the
company’s bank. This system shortens mailing,
processing and clearing floats.
4. Direct payment to depository banks – special
arrangement with the banks to accepts payments from
customers w/ collections directly credited to company’s
bank account.
5. Direct deposits to Company’s bank account
– customer’s may be allowed to make deposits to
the main office bank account through the bank’s
provincial branches provided the latter are “online”.
2. Stretching Payables
- postponing payment of bills to their due dates or
last date of discount period to shortens the cash
cycle.

Example; Despite the fact that suppliers give A


corporation 30 days to pay for its purchases, the latter
pays after 22 days so that its payables average 60,000.
By delaying payments to the 30th day, A corp. is
expected to increase its payable by 24,000 or 90,000
computed as follows;
Average payables w/ payment made
after 22 days 66, 000
Average payables with payments
to be made after 30 days:
Average purchase/day 66,000/22days = 3,000
Multiply 30 days
90,000
Increase in payables (decrease in
Cash requirement) 24,000

*Assuming the cost of money is 15%, the


company must be expected to save 3, 600 (24,000 x 15%)
or earn said amount in other forms of investment.
3. Accelerating Inventory Turnover
- reducing inventory level in proportion to sales volume.

Example:
A corp. maintains its inventory at a level equal to 15 days’
sales. This means that on the average, goods purchased remain
in the form of inventory for 15 days before they are sold. Cost
of sales amount to 468,000 per annum so that its inventory
must be 19,500 (that is 468,000/360 days x 15 days). Should the
company decide to reduce inventory level to take care of 12
days’ sales ( or reduce it by 3 days’ sales) the decrease in
inventory must be equal to 3, 900 computed as follows:
Solutions:

468,000/360 days x 3 days = 3, 900

The 3,900 decrease in inventory


requirement would also release an equal
amount from operating cash requirement
thereby saving the company the
corresponding financing charges or eliminate
opportunity cost and a proportionate amount
of handling cost.
Alternatives for Idle Funds
1. Marketable Securities - are
short term money market
instruments that can be easily
converted into cash.
Requisites of true Marketable:
a. existence of a ready market
b. safety of principal
2. Government Securities – these are
government stocks from government corporation.

- these are classified as the safest


investment instrument because it is guaranteed by
the national government. It is also the most liquid as
you can sell it any time and there are always buyers.

a. Treasury bills – are certificates of


indebtedness that mature within one year. The
tenures are the following: 91 – day, 182 – day, and
364 – day.
- treasury bills which mature in less
than 91 – days are called cash
management bills (e.g. 35 – day, 42 –
day)
b. Treasury bonds – are certificates
of indebtedness that mature beyond one
year.
- 5 maturities of
bonds: 2 – year, 5 – year, 7 – year, 10 –
year and 20 - year. It is payable semi
annually.
c. CB Bills or Central Bank
Certificates of Indebtedness - a government
stock which has the same scale with the
treasury bills.

d. Commercial Papers - these are


short term, unsecured promissory notes
issued by the corporations with a very high
credit standing. They are issued based on the
approval by the SEC.
Receivable Management
- refers to the formulation and administration
of plans and policies related to sales on account and
ensuring the maintenance of receivables and
collectability as planned.
Objective of Receivable Management:
1.Maintain receivables (not high or low) where
the turnover and profit rates will maximize the
overall ROI in the business.
Determinants of the Size of
Receivables
1. Terms of Sale – on credit and on cash
2. Paying practices of customers
– installment, full
3. Collection policies and practices
4. Volume of Credit Sales
5. Credit extension policies and
practices
6. Cost of capital
Aids in Analyzing Receivables
This aids will help to determine the
adequacy, over or under time investment in
receivables and the effectiveness of the
company’s credit and collection policies.
A. Ratio of receivables to net credit sales.
B. Receivable Turnover
C. Average collection period
D. Aging of Accounts – the older the
accounts the greater is the exposure of the
company to bad debts. Thus, closer attention
to big and older accounts.
Example:
Total sales of Corp. A amount to 1, 200,000 w/
credit sales to 1, 080,000. Receivables average
75,000. the computation using the first 3 Aids;
A. ratio of receivables to credit sales = 75,000
= Ave. Receivables 1, 080,000
Credit Sales = 6.9%
B. Receivable Turnover = Net credit sales 1,080,000
Ave. receivables of 75,000
= 14.4x – this means that
receivables of 75,000 are collected 14.4 times in a
year.
C. Ave. Collection Period = 360 days
Receivable turnover
= 360
14.4
= 25 days – thus
on the average, receivables are collected after
25 days. Now, if it is the practice of the
company to grant credit only for 20 days, it
may be concluded that receivables are 5 days
overdue on the average.
Inventory Management
- refers to the formulation and
administration of plans and policies
to efficiently and satisfactorily meet
manufacturing and merchandising
requirements and minimize costs
therein.
Aids in Analyzing Inventory
1. Ratio of Average Inventory = Average inventory
to Sales Sales
2. Inventory turnover = Cost of Goods Sold
Average Inventory
3. Number of day’s sales = No. of days in 1 year
in inventory Inventory Turnover
Example: A corp. Has a sales of 1,080,000, cost of sales
648,000 and inventory as of Jan. 1 which is 38,000 and
Dec. 31 inventory of 34,000.

1. Ratio of Average = (38,000 + 34,000)/2 = 3.3%


inventory to sales 1,080,000
2. Inventory turnover = 648,000 = 18x
(38,000 + 34,000)/2
3. No. of days’ sales = 360 days/18 = 20 days

Inventory is 3.3% of sales, inventory turnover


is 18 times in one year and that is equal to 20 days’
sales.
Inventory Control System
A. Two – bin System
- for each inventory item, two
bins or containers are provided. One contains
enough stocks to cover requirements from the
time an order is placed until the goods are
received. The other bin contains the expected
requirements before orders are placed. As
soon as the 2nd container becomes empty, the
order for replenishment is placed.
B. Min- max System
- minimum and maximum
inventory levels are established for each item
in inventory. The minimum balance is
expected to take care of the requirement for
the period from the time an order is placed up
to the receipt of the goods.
C. ABC System
- items in the inventories are
classified into three classes, A, B, and C,
based on their usage value.
D. Order cycling System
- inventory items are reviewed
one at a time at periodic intervals to
determine when replacement should be
made.
E. Budgetary Control System
- your inventory should
conformed with budget.
F. Explosion Method
- your inventory is based on
forecast.
G. Perpetual Inventory Control System
- facilitate inventory management
and recorded pending orders, reserved quantities,
minimum and maximum balances.
H. Turnover Rates
- ensure that the actual flow and
levels of inventory are kept within limits of the
predetermined standard turn over rates.
I. Statistical Inventory Control System
- economic order quantity and
reorder point are employed in inventory
management.
Relevant Costs in Inventory
Management
1. Ordering Cost – are those incurred every
time an order is placed
Example:
clerical cost, cost of man hours, freight – in
cost
2. Carrying Cost – the costs in maintaining
inventories
Example:
warehousing and storage costs, property taxes,
insurance in inventory, interest and opportunity
costs and handling cost.
3. Stock out Costs – refers to the
total effect of a company’s failure to
service customers or fill their orders or
conduct operations smoothly arising
from stock outs.
Examples:
cost of idle time and overtime,
imputed value on lost customers’
goodwill and nonrealization margin on
lost sales.
Economic Order Quantity
- refers to the order size that will minimize the relevant
costs (ordering and carrying costs).
- for a manufacturing firm, it is called as the “optimum
production run or economic lot size.”

Economic Order = 2 x Annual Usage x Ordering Cost/order


Quantity Carrying Cost per Unit

Optimum Prod’n. = 2 x Annual usage x Set up cost/order


Run Carrying Cost per Unit
Sample Problem:
1. Annual usage is 10, 600 units, ordering cost per
order is 15.90. Carrying cost is 10% and unit cost 3.00.
The economic order quantity and optimum number of
orders are computed as follows:

EOQ = 2 x 10, 600 x 15.90 = 1,060


10% x 3
Optimum No. of Orders = Annual Usage = 10,600 = 10
EOQ 1, 060
The total relevant costs based on 12, 10 and 8
orders are computed as follows:

No. of Orders 12 10 8
Order Size (annual usage/no. of 883 1,060 1,325
orders
Average inventory (order size/2) 442 530 662
Ordering cost(No. of orders x 15.90) 191 159 127
Carrying Cost (Ave. Invty. X .30) 133 159 199
Total Relevant Cost 324 318 326
Graphical Representation of
Relevant Cost in EOQ Determination
Total Cost

P
Carrying Cost

Minimum
Cost

Ordering cost

EOQ order size (in units)


Lead Time – refers to the length of
period it takes to order and receive goods. It is
also called the reorder point.
Safety Stock – the additional quantity
of goods in stock at the time an order is
placed to minimize the probability of stock
outs.
Reorder Point – is the inventory level at
the time an order is placed. It is equal to lead
time usage plus safety stock.
Sample Problem:
1. Normal usage for Feeds is 5 units per day.
Maximum usage is 8 units per day. It takes one week to
order and receive the feeds.

Lead Usage: 5 units x 7 days = 35 units


Safety Stock: Additional Units per day is 3 x 7
days = 21 units
Reorder Point: lead time usage Safety Stock
= 56 units
Determining Safety Stock Level
Frequency Distribution Method:
- this method will
determine the desired safety percentage
from stock outs, considering the
frequency distribution for usages during
lead time.
Problem:
1. For Feeds, the normal usage during lead time of
7 days is 35 units. However, during lead time varies as
follows:
Usages during lead time Frequency
10 8
25 25
35 40
45 20
56 7
100
The different usages are assumed to be possible
reorder points. The percentages of safety from, and
risk of stocks are as follows:

Usages during
lead time Frequency Safety % Risk %
10 8 8% 92
25 25 33% 67
35 40 73% 27
45 20 93% 7
56 7 100% 0
100

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