Chapter III

Working Capital Management

“You will not reach your destination if you stop and throw stones at every dog that
barks” – Winston Churchill

RECEIVABLES MANAGEMENT

INTRODUCTION
Firms would, in general, rather sell for cash than on credit, but competitive pressures
force most firms to offer credit. Thus, goods are shipped, inventories are reduced, and an
account receivable is created. Eventually, the customer will pay the account, at which time
1. The firm will receive cash; and
2. Its receivables will decline
Carrying receivables has both direct and indirect costs, but it also has an important
benefit – increased sales.
Accounts Receivable constitutes a substantial part of a company’s investment in
working capital. The level of company’s accounts receivables depends on economic conditions
and the company’s established credit policies. A company needs to establish a proper
management of receivable which refers to the formulation and administration of plans and
policies related to credit sales and to ensure the maintenance of accounts receivables at a
predetermined level and the respective collection as planned.

Objective of Receivable Management

The objective of the firm's accounts receivable policy is to encourage sales and gain
additional customers by extending credit. It is therefore the responsibility of the finance
officer to evaluate the pertinent costs and benefits related to credit extension, to finance the
firm's investment in accounts receivable, implement the firm's chosen credit policy, and to
enforce collection.

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CREDIT POLICY
Credit policy is a set of guidelines for extending credit to customers. The success or
failure of a business depends primarily on the demand for its products – as a rule, the higher
its sales, the larger its profits and the higher its stock price. Sales, in turn, depend on a
number of factors, some exogenous but others under the firm’s control. The major
controllable determinants of demand are sales prices, product quality, advertising and the
firm’s credit policy. Credit policy in turn, consists of these four variables:
1. Credit Standards
Credit standards refer to the financial strength and creditworthiness a
customer must exhibit in order to qualify for credit. If a customer does not qualify for the
regular credit terms, it can still purchase from the firm, but under more restrictive terms. For
example, a firm’s “regular” credit terms might call for payment after 30 days, and these terms
might be extended to all qualified customers. The firms credit standards would be applied to
determine which customers qualified for the regular credit terms, and how much credit each
should receive. The major factors considered when setting credit standards relate to the
likelihood that a given customer will pay slowly or perhaps end up as a bad debt loss.
In evaluating potential customers or creditors, regardless of the credit
evaluation process or approach, companies consider the following five “C’s” of credit:
1. Character. Refers to the probability that the customers will pay their debts
or obligations.
2. Capacity. The judgment of customer’s ability to pay as reflected in his
personal cash flows.
3. Conditions. Refer both to general economic trends and to special
developments in certain geographic regions or sectors of the economy that
might affect customers’ abilities to meet their obligations.
4. Capital. Evaluating the assets and earning capacity of the customer
5. Collateral. Represented by assets that customers may offer as security in
order to obtain credit.

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 2. Credit Terms
Credit terms can simply be called the conditions set forth in sales on
credit. It involves both the length of the credit period and the cash discount given. Credit
period is the maximum number of days that payment may be deferred by the client while
Cash discount is the amount of discount as a percentage of sales prices the company can give
to the client if it pays during the given discount period. For example, in the term “2/10, net
30” it means that a 2% discount is given if the bill is paid on or before the tenth day after
the date of invoice; payment is due by the thirtieth day. The credit period, then, is thirty days.
Although the customs of the industry frequently dictate the terms given, the credit period if
lengthened generally results to an increased product demand and vice versa.

3. Collection Policy
Collection Policy refers to the procedures that a firm follows to collect accounts
receivable. For example, a letter might be sent to customers when a bill is 10 days past due;
a more severe letter, followed by a telephone call, would be sent if payment is not received
within 30 days; and the account would be turned over to a collection agency after 90 days.
Credit analysis is instrumental in determining the amount of credit risk to be
accepted. In turn, the amount of risk accepted affects the slowness of receivables and the
resulting investment in receivables, as well as the amount of bad-debt losses. Collection
procedures affect these factors. Within a reasonable range, the greater the relative amount
spent on collection procedures, the lower the proportion of bad debt losses and the shorter
the average collection period, all other things remaining the same. A balance must be struck
between the costs and thee benefits of different collection policies.

4. Delinquency and Default

Whatever credit policies a business firm may adopt, there will be some
customers who will delay and others who will default entirely, thereby increasing the total
accounts receivable costs. Again, the optimal credit policy that should be adopted is the one

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that provides the greatest marginal benefit.

COSTS ASSOCIATED WITH INVESTMENT IN ACCOUNTS RECEIVABLE

1. Credit analysis, accounting and collection costs

If the firm is extending credit in anticipation of attracting more
businesses, it incurs the cost of hiring a credit manager plus assistants and bookkeepers within
the finance department; of acquiring credit information sources and of generally
maintaining and operating a credit and collection department.
2. Capital costs
Once the firm extends credit, it must raise funds in order to finance it.
The interest to be paid if the funds are borrowed or the opportunity cost of equity capital will
constitute the cost of funds that will be tied up in the receivables.
3. Delinquency costs
These costs are incurred when the customer is late in paying. This delay
adds collection costs above those associated with a normal collection. Delinquency also
creates an opportunity cost for any additional time the funds are tied up after the normal
collection period.
4. Default costs (Bad debts)
The firm incurs default costs when the customer fails to pay at all. In
addition to the collection costs, capital costs and delinquency costs incurred up to this point,
the firm losses the cost of goods sold not paid for. It has to write off the entire sales once it
decides the delinquent account has defaulted and is no longer collectible.

Summary of Trade-Offs in Credit and Collection Policies

Shown below is a summary of the cost-benefit relationship that will result upon
application of factors affecting the credit and collection policies:

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 TRADE-OFFS
BENEFITS COST
a. Increase in credit processing costs
1. Relaxation of credit b. Increase in collection costs
a. Increase in sales and total contribution margin
standards c. Higher default costs (bad debts)
d. Higher capital costs (opportunity costs)
2. Lengthening of credit Higher capital costs (opportunity costs of
a. Increase in sales and total contribution margin a.
period higher investment in Receivables)
3. Granting cash a. Increase in sales and total contribution margin
a. Lesser profit.
discount b. Opportunity income on lower investment in receivable
4. Intensified collection a. Lower default costs (bad debts) a. Higher collection expenses.
efforts b. Lower opportunity cost or capital costs b. Lower sales

Marginal or Incremental Analysis of Credit Policies:

Marginal analysis is performed in terms of a systematic comparison of the incremental
returns and the incremental costs resulting from a change in the firm's credit policy.
Whenever the incremental profit from a proposed change in the management of accounts
receivable exceeds the required return or incremental costs of the additional investment, the
change should be implemented. All things being equal, the decision concerning the change in
credit policy is made using the following rules:
If:

1. Incremental profit credit contribution >  Incremental Cost ; then accept the change in policy
2. Incremental profit credit contribution <  Incremental Cost ; then reject the change in policy
then be indifferent to the
3. Incremental profit contribution Incremental Cost ;
= change in credit policy

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Illustrative Case: Relaxation of Credit Policy
ABC Corporation's product sells for P10 a unit of which P7 represents variable costs
before taxes including credit department cost. Current annual credit sales are P2.4 million. The
firm is considering a more liberal extension of credit, which will result in a slowing in the
average collection period from one month to two months.

The relaxation in credit standards is expected to produce a 25% increase in sales.

Assume that the firm's required rate of return on investment is 20% before taxes. Bad debts
losses will be 5% of incremental sales and collection expenses will increase by P20,000.

Required: Should the company liberalize its credit policy?

Solution:
Incremental contribution margin from P180,000
additional units (60,000* x P3)
Less: Bad debts (P600,000 x 5%) P30,000
Collection expenses 20,000
Total 50,000
Net Incremental Profit P130,000
*P2.4M Credit Sales x 25% increase =P600,000/P10 = 60,000 units

Required return on additional investment:

Present level of receivables
(P2.4 million / 12 mos.) P200,000
Level of receivables after change in
credit policy (P3 million / 6 mos.) 500,000
Additional receivables P300,000

Additional investment in receivables

(P300,000 x 70%) P210,000
Multiply by: Required return 20%
Required return on additional investment P 42,000

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Conclusion:

Inasmuch as the profit on additional sales of P130,000, exceeds the

required return on the additional investment of P42,000, the firm would be well-
advised to relax its credit standards.

Illustrative Case: Change in Credit Terms

The Roman Shades Company has 12% opportunity cost of capital and currently sells on
terms n/20. It has current annual sales of P10 million, 80% of which are on credit. Current
average collection period is 60 days. It is now considering to offer terms of 2/10, n/30 in
order to reduce the collection period. It expects 60% of its customers to take advantage of
the discount and the collection period to be reduced to 40 days. Use 360-day year.
Required: Should the company change its terms from n/20 to 2/10, n/30?
Solution:
Present Proposed
Opportunity Cost
(ROI x Average Receivables)
Present (12% x P1,333,333)* P160,000
Proposed (12% x P888,000)** P106,667
Sales Discount
(P8 million x 60% x 2%) 96,000
Total P160,000 P202,667

*P8M/360days x 60 days = P1,333,333

** P8M/360days x 40 days = P888,888
Conclusion:

The company would be better off by maintaining the present

credit terms and policy of not granting cash discount because of the
lesser costs involved as shown above.

Illustrative Case: Investment in Accounts Receivable

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 Davis Company sells on terms of net 45 (It means the entire amount of the bill is due
within 45 days from which the bill was invoiced). Its annual credit sales are P912,500
and its Accounts Receivable average 15 days overdue. Assume a 365-day year. What
is Davis’ invest in receivables?
Answer:
The firm’s average daily sales are its annual (credit) sales divided by 365 days.

Average daily sales = ₱912,500/365 days = ₱2,500

The average collection period is the credit period plus the average days past
the due date.

Average collection period = 45 + 15 = 60 days

The average investment in accounts receivable is determined by multiplying the

average daily sales by the average collection period.

Investment in accounts receivable = ₱2,500 x 60 = ₱150,000

INVENTORY MANAGEMENT

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 Inventories, which maybe classified as (1) supplies, (2) raw materials, (3) work-in-
process, and (4) finished goods, are an essential part of all business operations. As in the case
with Accounts Receivable, Inventory levels depend heavily upon sales. However, whereas
receivables build up after sales have been made, inventory must be acquired ahead of sales.
This is a critical difference, and the necessity of forecasting sales before establishing target
inventory levels makes inventory management a difficult task. Also, since errors in the
establishment of inventory levels quickly lead either to lost sales or to excessive carrying costs,
inventory management is as important as it is difficult.

Objective of Inventory Management

Inventory is the stockpile of the product the firm is offering for sale and the
components that make up the product. It is the responsibility of the financial officer to
maintain a sufficient amount of inventory to insure the smooth operation of the firm's
production and marketing functions and at the same time avoid tying up funds in excessive
and slow-moving inventory. The following are the objectives of inventory management:
1. To reduce inventories while maintaining customer service level and quality. The
firm can free needed cash to finance both internal and external growth. This
involves a delicate balance between ordering costs, carrying or holding costs and
shortage costs.
2. To establish production and inventory control. Proper control system must be set
up such as stock cards and other records to monitor physical movements of
inventories.
3. To ensure that proper communication on the information of inventory levels are
not only in place but also must be on time to avoid stock out.
4. To ensure the proper valuation of inventories on hand.

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Functions of Inventories
1. Pipeline or transit inventories
These are inventories which are being moved or transported from one
location to another and they fill the supply pipelines between stages of
the entire production-distribution system.
2. Organizational or decoupling inventories
These are inventories that are maintained to provide each link in the
production-distribution chain a certain degree of independence from
the others. These will also take care of random fluctuations in demand and/or
supply.
3. Seasonal or anticipation stock
These are built in anticipation of the heavy selling season or in
anticipation of price increase or as part of promotional sales campaign.
4. Batch of lot-size inventories
These are inventories that are maintained whenever the user makes or
buys materials in larger lots than are needed for immediate purposes.
5. Safety or buffer stock
These inventories are maintained to protect the company from
uncertainties such as unexpected customer demand, delays in delivery of goods
ordered, etc.

Inventory Management Techniques

Inventory Planning
Inventory Planning involves the determination of what inventory quality,
quantity, timing, and location should be in order to meet future business requirements. The
approach and mathematical techniques that may be used in determining inventory order
size, timing, etc. includes the Economic Order Quantity (EOQ) Mode, Reorder point.
Economic Order Quantity is the order size or the appropriate number of units

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that must be ordered at the least cost. It can also be defined as the optimal number of units to
be ordered to maintain the minimum cost or the quantity of stock where the total ordering or
carrying cost are at its minimum. The basic assumptions of using EOQ in inventory planning
are:
a. prices are stable.
b. supply of goods is stable.
c. demand or use in a given period is uniform.

EOQ is computed as follows:

𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑚𝑎𝑛𝑑 𝐶𝑜𝑠𝑡𝑠

𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐶𝑜𝑠𝑡𝑠
2x in units x per order
EOQ = ᴠ
per unit

Where:
Annual Demand (AD) refers to the total estimated demand for the given product.
Ordering Costs (OC) refer to costs incurred in placing an order for a certain product. It
includes:
 Cost of preparing purchases or production orders;
 Transportation and receiving cost (i.e., unloading, unpacking
and inspecting);
 Costs of processing related documents of the order; and
 Cost of mailing, stationeries, telephone bills/ cell phone loads,
clerical and other costs that may be involved in placing an order.

Carrying Costs (CC) refer to costs incurred in holding or carrying an inventory. It

includes:
 Storage space costs (i.e., warehouse rental or depreciation and
security costs);

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12
  Property taxes and insurance costs on carrying such inventory;
 Risk of obsolescence, spoilage, theft and deterioration; and
 Desired rate of return on inventory investment (foregone interest
on working capital tied up in inventory)

Total Inventory Costs is the sum of total ordering costs and total carrying costs of an
inventory. It is computed as:

𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐶𝑜𝑠𝑡𝑠 = 𝑇𝑜𝑡𝑎𝑙 𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 + 𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐶𝑜𝑠𝑡

Where:

Total Ordering Costs refer to the total cost incurred in placing an order. It is equal to the
number of orders placed per year multiplied by the fixed cost of placing an order. It is
computed as:

𝑇𝑜𝑡𝑎𝑙 Ordering 𝐶𝑜𝑠𝑡𝑠 = Annual Demand in Units/EOQ x Ordering Costs per order

Total Carrying Costs refer to the total costs of carrying or holding inventory. It is the average
inventory multiplied by the cost of carrying inventory. It is computed as:

𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐶𝑜𝑠𝑡𝑠 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑥 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐶𝑜𝑠𝑡𝑠 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

Average Inventory = EOQ or order size /2

Another use of the EOQ model is to help the management in deciding how much to
order at one time and when to order and this is known as the re-order point.

Re-order Point represents the level of inventory where the order must be placed for the

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quantity size as predetermined in the EOQ. It is computed as:

𝑅𝑒 − 𝑜𝑟𝑑𝑒𝑟 𝑃𝑜𝑖𝑛𝑡 = 𝐿𝑒𝑎𝑑 𝑇𝑖𝑚𝑒 𝑈𝑠𝑎𝑔𝑒 + 𝑆𝑎f𝑒𝑡𝑦 𝑆𝑡𝑜𝑐𝑘

Where:
Lead Time Usage refers to the interval of use of inventory between placing an order and
receiving delivery.
𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑚𝑎𝑛𝑑
𝐿𝑒𝑎𝑑 𝑇𝑖𝑚𝑒 𝑈𝑠𝑎𝑔𝑒 = 𝑥 𝐿𝑒𝑎𝑑 𝑇𝑖𝑚𝑒
𝐸𝑠𝑡. 𝑛𝑜. 𝑜𝑓 𝑤𝑒𝑒𝑘𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟

Illustrative Case I:

Assume that a local gift shop is attempting to determine how many sets of wine glass to order.
The store feels it will sell approximately 800 sets in the next year at a price of P18 per set.
The wholesale price that the store pays per set is P12. Costs of carrying one set of wine glasses
are estimated at P1.50 per year while ordering costs are estimated at P25.
a. Determine the economic order quantity for the sets of wine glasses.
Answer:

2 x 800 x 25
EOQ = ᴠ
P1.50

= 163 units per order

b. Determine the annual inventory costs for the firm if it orders in this quantity.
Answer:
𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐶𝑜𝑠𝑡𝑠 = 𝑇𝑜𝑡𝑎𝑙 𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 + 𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐶𝑜𝑠𝑡
𝑇𝑜𝑡𝑎𝑙 Ordering 𝐶𝑜𝑠𝑡𝑠 = Annual Demand in Units/EOQ x Ordering Costs per order
𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐶𝑜𝑠𝑡𝑠 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑥 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐶𝑜𝑠𝑡𝑠 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

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Average Inventory = EOQ or order size /2

Total Inventory Cost = 800 163

P25 + P1.50
163 2

= P244.95

Illustrative Case II:

Given the following inventory information and relationships for the Baguio Corporation:
1. Orders can be placed only in multiples of 100 units.
2. Annual unit usage is 300,000. (Assume a 50-week year in your calculations.)
3. The carrying cost is 30 percent of the purchase price of the goods.
4. The purchase price is P10 per unit.
5. The ordering cost is P50 per order.
6. The desired safety stock is 1,000 units. (This does not include delivery- time
stock.)
7. Delivery time is two weeks.
Given this information:
a. What is the optimal EOQ level?
b. How many orders will be placed annually?
c. At what inventory level should a reorder be made?
Answer:
a.

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 2 x 300,000 x P50
EOQ = ᴠ
10 x 0.30

= 3,162 units but since

orders must be placed
in multiples of 100 units,
the eeff ective EOQ
becomes 3,200.

b. Number of Orders = Annual Demand/EOQ

= 300,000/3,200 = 93.75 orders per year
c. 𝑅𝑒 − 𝑜𝑟𝑑𝑒𝑟 𝑃𝑜𝑖𝑛𝑡 = 𝐿𝑒𝑎𝑑 𝑇𝑖𝑚𝑒 𝑈𝑠𝑎𝑔𝑒 + 𝑆𝑎f𝑒𝑡𝑦 𝑆𝑡𝑜𝑐𝑘

𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑚𝑎𝑛𝑑
𝐿𝑒𝑎𝑑 𝑇𝑖𝑚𝑒 𝑈𝑠𝑎𝑔𝑒 = 𝑥 𝐿𝑒𝑎𝑑 𝑇𝑖𝑚𝑒
𝐸𝑠𝑡. 𝑛𝑜. 𝑜𝑓 𝑤𝑒𝑒𝑘𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟

300,000
Re-order Point = x 2 + 1,000
50

= 13,000 units

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Inventory Control Systems

Inventory control is the regulation of inventory within predetermined limits. Effective

inventory management should provide adequate stocks to meet the requirements of the
business, while at the same time keeping the required investment to a minimum. Various
systems and techniques have been developed to provide effective control over inventories.

1. Fixed Order Quantity System

This is a system wherein each time the inventory goes down to a predetermined level known
as the reorder point, an order for a fixed quantity is placed. This system requires the use of
perpetual inventory records or the continuous monitoring of the inventory level. Example of
the application of this type of control is the two-bin system under which reorder is placed
when the contents of the first bin are used up.

2. Fixed Reorder Cycle System

This is also known as the periodic review or the replacement system where orders are made
after a review of inventory levels has been done at regular intervals. An order is placed if at
the time of the review the inventory level had gone down since the preceding review. The
quantity ordered under this system is variable depending on usage or demand during the
review period.
Replenishment level is computed by the following formula:

M = B + D (R + L)

Where:
M = Replenishment level in units
B = Buffer stock in units
D = Average demand per day
R = Time interval in days, between reviews
L = Lead time in days

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3. Optional Replenishment System
This system represents a combination of the important control mechanisms of the other
systems described above. Replenishment level is computed by the use of the following
equation:

P = B + D (L + R/2)

Where:
P = Reorder point in units
B = Buffer stock in units
D = Average daily demand in units
L = Lead time in days
R = Time between review in days

4. ABC Classification System

Under this system, segregation of materials for selective control is made. Inventories are
classified into “A” or high-value items, “B” or medium cost items and “C” or low cost items.
Control may be exercised on these items as follows:
1. A Items
Highest possible controls, including most complete, accurate records, regular
review by top supervisor, blanket orders with frequent deliveries from vendor, close
follow-up through the factory deliveries from vendor, close follow-up through the
factory to reduce lead time, careful and accurate on determination of order quantities
and order point with frequent review to reduce, if possible.
2. B Items
Normal controls involving good records and regular attention; good analysis for
EOQ and order point but reviewed quarterly only or when major changes occur.
3. C Items
Simplest possible controls such as periodic review of physical inventory with no
records or only the simplest notations that replenishment stocks have been ordered;
no EOQ or order point calculations.

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FM112 – Working Capital Management CHAPTER III

REFERENCES

REFERENCES:

1. Cabrera, Ma. Elenita B. and Cabrera, Gilbert Anthony B. (2019-

2020 Edition) Financial Management Comprehensive Volume. GIC
Enterprises & Co. Inc.
2. Brigham, Eugene F. and J.F. Houston (2019) Fundamentals of
Financial Management. Singapore: Thomson Learning Asia.

Chapter III – Working Capital 19

Management