WORKING CAPITAL MANAGEMENT

Working Capital = CURRENT ASSETS

Net Working Capital = CURRENT ASSETS CURRENT LIABILITIES
Current Assets are cash/cash equivalents or assets that are realizable into cash within 12 months after the
reporting period (non trade current assets) or the normal operating cycle, whichever is LONGER (for trade
current assets); they include CASH, MARKETABLE SECURITIES, TRADE RECEIVABLES,
INVENTORY
Working Capital Management the administration and control of the companys working capital; managing
and financing the current assets and current liabilities of the firm.
Objective of WC Management: To achieve a balance between return (profitability) and risk (illiquidity)
Working Capital Financing Policies:

Conservative (Relaxed) policy. Operation is conducted with TOO MUCH WORKING CAPITAL
- Finance all fund requirements with long-term funds
- Advantages:
o Reduce risks of illiquidity
o Makes more cash available for more profitable undertaking since repayment will be done in
the further future
o The firm is not exposed to fluctuating interest rate and the potential unavailability of funds
- Disadvantages:
o Less profitable because of higher financing cost (interest expense)
o Interest will be paid even the purpose for which the financing is obtained has already been
served.

Aggressive (restricted) policy. Operation is conducted with MINIMUM WORKING CAPITAL

- Short term funds are used to finance both permanent CA needs and temporary CA needs
- Advantages:
o Lower cost of financing
o Increase profitability
- Disadvantages:
o Exposure to risk due to low working capital (risk of illiquidity)
o Puts too much pressure on the firms short 0 term borrowing capacity since payment must be
done the following year.

Matching (Self liquidating or Hedging) Policy. Matching maturity of financing source with specific
financing needs
- Short term assets are financed with short term liabilities
- Long term assets are financed with long term financing sources
Balanced Policy. Balances the tradeoff between risk and return in a manner consistent with its attitude
toward bearing risk

Deciding on an Appropriate Working Capital Policy

Generally it depends on the tradeoff between risk and return and the amount of risk the
management is willing to take.
Asset Mix Decision appropriate mix of current and noncurrent asset
Financing Mix Decision appropriate mix of short term and long term liabilities to finance
current assets

Risk and Return Tradeoff

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1.
2.
3.
4.

The greater the risk = the greater is the potential for larger returns
More current assets = greater liquidity but lower profitability
Fixed assets earn more return than current asset
Long term financing = lower liquidity risk but high financing cost compared to short term financing =
lower profitability

Operating Cycle (or NORMAL OPERATING CYLE)

- The amount of time that elapses from the point when the firm inputs materials and labor into the
production process to the point when the cash is collected from the sale of the finished goods.
Cash Conversion Cycle
- The length of time between when the firm makes payments and when it receives cash inflows.
* Effective working capital management involves shortening the cash conversion cycle as much as possible
without harming operations. This strategy improves profitability because the longer the cash conversion cycle,
the grater the need of financing.
Improving Cash Conversion Cycle:

Turn over inventory as quickly as possible, avoiding stockouts that might result in a loss of sale.
Collect accounts receivable as quickly as possible.
Pay accounts payable as late as possible without damaging the firms credit rating, but take advantage of
any favorable cash discounts.

CASH MANAGEMENT
Involves the maintenance of the appropriate level of cash and investment in marketable securities to meet the
firms cash requirement and to maximize income in idle funds.
Objective: To invest excess cash for a return while retaining sufficient liquidity to satisfy future needs.
Reasons for Holding Cash and Near-Cash Balances:

Transaction balances- cash balance is maintained in order to pay planned expenditures or to conduct the
ordinary business transactions.
Precautionary or Safety Needs- balances are held or temporarily invested in liquid securities that can be
immediately transferred to cash in order to meet emergencies or contingencies, such as funds for strikes,
natural disasters, and cyclical downturns.
Speculative Motive- the balance, oftentimes kept in marketable securities, is intended for taking
advantage of favorable business opportunities that may arise especially taking advantage changes in
prices of materials or equipment.
Compensating Balance Requirement - minimum balance that should be maintained in the checking
account of the company because of (1) certain levels of service or (2) as a requirement of loan
agreements.

CASH MANAGEMENT TECHNIQUES:

1. Speeding Up Collections reduce negative float
Bill customers promptly
Offer cash discounts for prompt payment
Concentration banking.
o Customers in an area make payments to a local branch office rather than firm
headquarters. The local branch makes deposits in an account at a local bank. Then,
surplus funds are periodically transferred to the firms concentration or disbursing
bank. (DEPOSITORY BANK)
o Use of automatic fund transfer or Electronic Fund Transfer (EFT)
Lockbox system. In a lockbox system, customer payments are sent to a post office box that is
maintained by a bank. Bank personnel retrieve the payments and deposit them into the firms
bank account.
Direct send. Firms that have received large checks drawn on distant banks or large number of
checks drawn on banks in a given city may arrange to present those checks directly for
payment to the bank on which they are drawn.
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2. Slowing Down Disbursements

Stretch payable by paying as late as possible within the credit period
Maintain zero balance accounts (ZBA) checks are written from special disbursement
accounts having zero peso balance (no minimum maintaining cash balance required)
Playing the float Increase the positive float
Less frequent payroll and schedule issuance of checks to suppliers
3. Reduce the need for precautionary cash balance
More accurate cash budgeting
Have ready lines of credit
Invest idle cash in highly liquid, short term investments instead of holding idle
precautionary cash balance
CASH FLOW MANAGEMENT
1. Preparing cash budget
2. Preparing cash break even chart
3. Determining the optimal cash balance using the Baumol Cash Management Model
CASH BUDGET
Cash balance, beginning
Add receipts
Total cash available before current financing
Less disbursements
Excess (deficiency) of cash available over
cash disbursement
Financing
Cash balance, ending

xx
xx
xx
xx
xx
xx
xx

CASH BREAK EVEN CHART

1. CASH BREAK EVEN POINT the amount of sales in pesos or the number of units to be sold so that
the total cash inflows is equal to the cash outflows
2. IT SHOWS THE AMOUNT OF CASH DEFICIENCY when sales is below the cash break even point,
or the amount of excess cash when sales is above the cash break even point
sales or cash inflows
total cash costs or cash outflows

Excess cash
SALES IN PESOS

Cash breakeven point

cash deficiency

CASH FIXED COST

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 the minimum
MANAGEMENT OF MARKETABLE SECURITIES
Short term money market instruments that can be easily converted to cash.
Includes: government securities (T- Bills and CB Certificates) and commercial papers
Reasons for holding marketable securities (MS):
1. MS serve as sustainable for cash (transaction, precautionary and speculative) balance

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2. MS serve as a temporary investment that yields return while funds are idle
3. Cash is invested in MS to meet known financial obligations such as tax payments and loan amortizations
Decision criteria for Marketable Securities
1. Risk
a. Default Risk chances that the issuer may not be able to pay the interest or principal on time or
not at all
b. Interest rate risk fluctuations in securities price caused by changes in market interest rates
As rate change, the value of a debt security changes in the opposite direction.
c. Inflation risk risk that inflation will reduce the real value of the investment
2. Marketability refers to how quickly a security can be sold before maturity without significant price
concession
3. Term of Maturity maturity dates of marketable securities held should coincide, when possible, with the
date at which the firm needs cash, or when the firm will no longer have cash to invest

MANAGEMENT OF ACCOUNTS RECEIVABLES

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.
Objective: to have both optimal amount of receivables outstanding and the optimal amount of bad debts.
This balance requires the tradeoff between:
a. The benefit of more credit sales
b. The cost of accounts receivable such as collection, interest and bad debt cost
Factors in Determining Accounts Receivable Policy
1. CREDIT STANDARDS the criteria that determine which customers will be granted credit and how
much
Not too stringent or too tight may eliminate risk of non payment but eliminate potential sales
to rejected customers
Not too lose or too liberal may lead to higher sales, but also higher bad debt losses and
collection loss
Factors to consider in establishing credit standards: THE FOUR Cs OF CREDIT
A. CHARACTER customers willingness to pay
B. CAPACITY customers ability to generate cash flows
C. CAPITAL customers financial sources such as collateral
D. CONDITION current economic or business conditions
2. CREDIT TERMS define the period and any discount offered for early payment
Credit period- the length of time buyers are given to pay for their purchases.
Discount- percentage provided and period allowed for discount for early payment.
Credit criteria- required financial strength of acceptable credit customers.
Collection policy- diligence used to collect slow-paying accounts.

Ways of Accelerating Collection of Receivables:

1.
2.
3.
4.

Shorten credit terms

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

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MANAGEMENT OF INVENTORY
Formulation and administration of plans and policies to efficiently and satisfactorily meet production and
merchandising requirements and minimize cost relative to inventories.
Objective: Maintain a level of inventory that best balances the estimates of actual savings, the cost of carrying
additional inventory, and the efficiency of inventory control.
INVENTORY MANAGEMENT TECHNIQUES
1. INVENTORY PLANNING determination of the quality and quantity and location of inventory, as well
as the time of ordering, in order to meet future business requirements
a. EOQ model
b. Reorder point
c. Just In Time (JIT)
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
a. Fixed Order Quantity System an order for a fixed quantity placed when the inventory level
reaches the reorder point
b. Fixed Reorder Cycle System (periodic review or replacement system) orders are made after a
review of inventory levels has been done at regular intervals.
c. Optional Replacement System
d. ABC Classification system Inventory is divided into three categories of descending importance
based on the peso investment in each.
i. A items high value items requiring highest possible control
ii. B items medium cost items requiring normal control
iii. C items low cost items requiring the simplest possible control
3. MODERN INVENTORY MANAGEMENT often applied in the context of automated manufacturing
a. 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.
b. Manufacturing Resource Planning (MRP II) a closed loop system that integrates all facets of a
business, including inventories, production, sales, and cash flows.
c. Enterprise Resource 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.
INVENTORY MODELS A basic inventory model exists to assist in two inventory questions:
a. How many units should be ordered?
b. When should the units be ordered?
Economic Order Quantity (EOQ) model. Inventory management technique for determining items optimal
order quantity, which is the one that minimizes the total of its order and carrying costs.
a. Order cost (A) - fixed clerical costs of placing and receiving an order.
i. Transportation (delivery cost)
ii. Administrative cost of purchasing and cost of receiving and inspecting goods
b. Carrying costs (K)- variable costs per unit of holding an item in inventory for a specified time period;
include storage, insurance, deterioration and obsolescence, opportunity costs of tying up funds in
inventory.
c. Annual Demand (D) this is the yearly demand in units for the product/goods

EOQ=

2 AD
K

Inventory costs = (ordering cost x number of order per year) + [(order size/2 + safety stock) x carrying cost per
unit]
Average Inventory = EOQ/2

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Reorder Point Reordering: the objective is to order at a point in time so as to avoid stockouts but not so early
that an excessive safety stock is maintained. When the order point is computed, there may be a stock out
situation if:
1. demand is greater than expected during the lead time, or
2. the order time exceeds the lead time.
Lead time = period between the time the order is placed and received
Nor mal Lead Time Usage = Normal Lead time x Average usage
Safety stocks = maybe used to guard against stock outs; they are maintained by increasing the lead time (the time
that elapses from order placement until order arrival). Thus, safety stocks decrease stockout costs but increase
carrying costs.
= (Maximum Lead time Normal Lead time) x Average usage
Reorder Point (no safety stock required) = Normal lead time usage
Reorder Point (with Safety stock required) = Normal lead time usage + safety stock; or
= Maximum lead time x average usage
Just-in-time (JIT) purchasing- a demand-pull inventory system which maybe applied to purchasing so that raw
material arrives just as it is needed for production. The primary benefit of JIT is reduction of inventories, ideally
to zero. Because of its non-value-added nature, inventory is regarded as undesirable. In a JIT system suppliers
inspect their own goods and make frequent deliveries of materials, which are placed into production immediately
upon receipt. This process eliminates the need for incoming inspection and the storeroom. Suppliers all along the
supply chain are informed through specialized software (e.g., enterprise resource systems) about the forecasted
demand for their products allowing them to plan to supply the items when needed.

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