ReSA - THE REVIEW SCHOOL OF ACCOUNTANCY

CPA Review Batch 41  May 2021 CPA Licensure Examination  Week No. 14
MANAGEMENT ADVISORY SERVICES C.P. Lee  E.S Arañas  K.L. Manuel

MAS-12: WORKING CAPITAL MANAGEMENT

 WORKING CAPITAL MANAGEMENT (WCM) involves managing the firm’s current assets and current liabilities
to achieve a balance between risks (liquidity) and returns (profitability).
 The term ‘working capital’ generally r efers to current assets only. For purposes of WCM, ‘working capital’
refers to the difference between current assets and current liabilities (i.e., net working capital):
 The minimum working capital requirement regardless of the seasonal variations in business operations
is called PERMANENT or FIXED working capital.
 When additional working capital is needed during the more active business season, such working capital
is called SEASONAL or VARIABLE or INCREMENTAL working capital.
 WORKING CAPITAL FINANCING refers to optimal level, mix and use of current assets and current liabilities.
Consider the following working capital financing policies:
1) CONSERVATIVE financing strategy a.k.a. relaxed policy : a company seeks to minimize liquidity risk by
maintaining a relatively high level of working capital. This policy reduces liquidity risk but is considered
as less profitable due to more reliance on long-term financing that incurs higher financing costs.
2) AGGRESSIVE financing strategy a.k.a. restricted policy: operations are conducted with a minimum
amount of working capital. This policy enhances profitability by relying more on short-term debts rather
than long-term debts but is considered risky due to higher chances of short-term insolvency.
3) MODERATE financing strategy a.k.a. balanced or semi-aggressive or semi-conservative policy: working
capital maintained is relatively not too high (conservative) nor too low (aggressive).
4) MATCHING financing strategy a.k.a. self-liquidating or hedging policy : this policy is achieved by
matching the maturity of financing source with an asset’s useful life (i.e., short-term assets are financed
with short-term liabilities; long-term assets are funded by long-term financing sources).
 WCM considers the level, liquidity, activity and structural component of working capital. A sound practice of
WCM would normally involve the following:
 Managing cash and its temporary investment efficiently. (Cash & Marketable Securities Management)
 Drafting and implementing effective credit and collection policies. (Receivable Management)
 Seeking favorable terms from suppliers and other short-term creditors. (Short-Term Credit Financing)
 Ensuring efficient manufacturing operations and sound material procurement. (Inventory Management)
[The topic on ‘ Inventory Management’ is well covered in MAS -11 for Week 13]
CASH & MARKETABLE SECURITIES MANAGEMENT
 Four (4) reasons for holding cash: “Why would a firm hold cash when, being idle, it is a non -earning asset?”
1) TRANSACTION motive (Liquidity motive) : cash is held to facilitate normal transactions of the business.
2) PRECAUTIONARY motive (Contingent motive) : cash is held beyond the normal operating requirement to
provide for buffer against contingencies, such as slow-down in collection and possibilities of strikes.
3) SPECULATIVE motive : cash is held to avail of profit-making opportunities (e.g., sudden price drop).
4) CONTRACTUAL motive : cash is held as required by contract provisions (e.g., compensating balance).
 OPTIMAL CASH BALANCE (OCB), a.k.a. Economic Cash Quantity or Economic Conversion Size, is based on
the following formula under the BAUMOL model (named after the American economist William Baumol):

2DT Where: D  Annual Demand for Cash

OCB = T  Costs per Transaction
O O  Opportunity Cost of Holding Cash
Opportunity Costs = (OCB ÷ 2) x O Where: (OCB ÷ 2)  average cash balance
Transaction Costs = (D ÷ OCB ) x T Where: (D ÷ OCB )  number of transaction per year
 “OCB” is the optimal amount of cash to be raised by selling marketable securities or by borrowing
 “D” is total amount of new cash needed for transactions during the year
 “T” refers to the fixed costs of trading securities or cost of borrowing
 “O” refers to the rate of return foregone on marketable securities or the cost of borrowing
 The Baumol model , like its pattern EOQ [covered in MAS-10 under inventory management], is based on the
assumption that the demand for cash is spread evenly throughout the year. When there is an irregularity of
cash payment, OCB is computed using another formula based on the MILLER-ORR model where OCB or
‘cash return point’ is achieved when the level of cash reaches an upper limit/maximum amount or a lower
limit/minimum amount.
 CASH BREAK-EVEN POINT (BEP) is the sales level at which total cash inflows is equal to total cash outflows.
 Cash BEP in Unit Sales = Fixed Payments ÷ Unit Contribution Margin
 Cash BEP in Peso Sales = Fixed Payments ÷ Contribution Margin Ratio
 CASH CONVERSION CYCLE (CCC) a.k.a. cash flow cycle is the average time from the point cash is used to
pay for raw materials until cash is collected on the accounts receivable associated with the goods produced
with those raw materials. CCC must be distinguished from the NORMAL OPERATING CYCLE (NOC), which is
the length of time within which the firm purchases or produces inventory, sells it and receives cash .
NOC = Average Age of Inventory + Average Age of Receivable
CCC = Average Age of Inventory + Average Age of Receivable – Average Age of Payable
(Alternative: CCC = NOC – Average Age of Payable)
Where: Formula Other Name(s)
Average Age of Inventory Inventory ÷ CGS* per day Inventory Conversion Period, Days Sales in Inventory
Average Age of Receivable Receivables ÷ Sales per day Receivable Collection Period, Days Sales Outstanding
Average Age of Payable Payables ÷ Purchases per day Payable Deferral Period, Days Payables Outstanding
* “Sales per day” may be used in lieu of CGS per day -- the intention is to use an amount in proportion to unit sales.
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‘Average age ’may also be computed using TURNOVER ratios [to be covered in MAS-15 on FS Analysis during Week 18].
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ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY MAS-12
Week No. 14 : WORKING CAPITAL MANAGEMENT

 CASH MANAGEMENT STRATEGIES that help shorten the CCC:

 Accelerating collections (e.g., prompt billing, cash discounts, online collection , lockbox)
 LOCKBOX SYSTEM requires customers to mail payments to a post office box in a specific city, a local
bank then collects the checks from the box and deposit them promptly in the client’s account.
 Reducing precautionary idle cash (e.g., readily available line of credit, well-thought cash budgeting)
 LINE of CREDIT is a predetermined borrowing limit that an entity can use at any time -- the
borrower can take money out as needed until the limit is reached, and as money is repaid, it can be
borrowed again in the case of an open line of credit.
 Slowing disbursements (e.g., payment thru drafts , zero-balance accounts, playing the float)
 ZERO-BALANCE ACCOUNTS (ZBA) requires checks to be written from special disbursement accounts
having zero peso balance with no minimum maintaining balance required. Funds are automatically
transferred from a master account when a check drawn from a ZBA is presented.
 FLOAT is the difference between cash balance per BANK and cash balance per BOOK as of a certain period,
primarily due to outstanding checks and other similar reasons. Two types of float are:
 POSITIVE or DISBURSEMENT Float: bank balance > book balance
Possible cause: Outstanding checks issued by the firm that have not cleared yet.
 NEGATIVE or COLLECTION Float: book balance > bank balance
1. MAIL Float – a mount of customers’ payments that have been mailed by customers but not yet
received by the seller-company
2. PROCESSING Float – amount of customers’ payments that have been received by the seller but not
yet deposited.
3. CLEARING Float – amount of customers’ checks that have been deposited but have not cleared yet.
NOTE: Good cash management suggests that positive float should be maximized while negative float be
minimized or, if possible, eliminated.
 MARKETABLE SECURITIES are short-term money market instruments that can easily be converted to cash.
Some of the common examples where an entity may invest its temporary idle funds:
 CERTIFICATES of DEPOSITS (CD) – savings deposits at financial institutions (e.g., time deposit)
 MONEY MARKET FUNDS – shares in a fund that purchases higher-yielding bank CDs, commercial paper,
and other large-denomination, higher-yielding securities
 GOVERNMENT SECURITIES
 Treasury bills – debt instruments representing obligations of the National Government issued by the
central bank and usually sold at a discount through competitive bidding
 CB Bills or Certificates of Indebtedness (CBCIs) – represent indebtedness by the Central Bank.
 COMMERCIAL PAPERS – short-term, unsecured, material promissory notes issued by private
corporations of very high credit standing.
 REPURCHASE AGREEMENTS (Repos) – investment in loans with a commitment to resell the security at
the original contract price plus an agreed interest income for the holding period.
 BANKERS’ ACCEPTANCES – a draft drawn on a specific bank by a firm that has an account with the
bank, which if accepted by the bank becomes a negotiable instrument and is available for investments.
 Factors considered in choosing marketable securities include:
 RISKS
 Default risk – chances that issuer may not be able to pay interest or principal on time.
 Inflation risk – danger that inflation will reduce the investment’s real value.
 Interest rate risk – fluctuations in prices caused by changes in market interest rates.
 MARKETABILITY – refers to how quickly a security can be sold before maturity date without a significant
price concession.
 RETURNS – an entity is willing to assume more risks given a higher expected return on investment.
 TERM or MATURITY – maturity dates should coincide, whenever possible, with the date at which the firm
needs cash, or when the firm will no longer have cash to invest.
 TAXES – some marketable securities do not require payment of taxes, such as municipal bonds.
RECEIVABLES MANAGEMENT
 Receivable management refers to the set of policies, procedures, and practices employed by a company
with respect to managing sales on account or credit sales.
 Receivable management encompasses the evaluation of customer’s credit worthiness and risk, establishing
sales terms and credit policies, and designing an appropriate receivable collection process.
 CREDIT STANDARD: Which customer will be granted credit? How much is the credit limit? Have we
considered the 5 C’s of Credit?
 Character – customers’ willingness to pay
 Capacity – customers’ ability to generate cash flows
 Capital – customers’ financial sources (i.e., net worth)
 Conditions – current economic or business conditions
 Collateral – customer pledges to secure debt.
 CREDIT TERM refers to the credit period offered to encourage customer sales and discount offered for
customer’s prompt payment. The costs associated with credit terms that must be considered include
cash discounts, credit analysis and collections costs, bad debt losses and financing costs.
 COLLECTION PROGRAM: shortening the average collection period means less investment in receivable
(low opportunity costs) and less chances of delinquency and defaults, but may result to loss of
customers due to less friendly terms.
Meaningful ratios useful in receivable management include receivable turnover, receivable collection period or days
sales outstanding .[These ratios shall be covered in MAS-15 on FS Analysis during Week 18].

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ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY MAS-12
Week No. 14 : WORKING CAPITAL MANAGEMENT

SHORT-TERM CREDIT FINANCING

 Common sources of short-term funds include:
 UNSECURED CREDITS (e.g., accruals, trade credit and commercial papers)
 SECURED LOANS (e.g., receivable financing – pledging and factoring)
(e.g., inventory financing – blanket lien, trust receipts, warehouse receipts)
 BANKING CREDITS (e.g., term loan, line of credit, revolving credit agreement)
 Factors considered in selecting sources of short-term funds:
 COST – the effective costs of various credit sources.
 AVAILABILITY – the readiness of credit as to when needed and how much is needed.
 INFLUENCE –the influence of use of one credit source and availability of other sources of financing.
 REQUIREMENT – additional covenants unique to various sources of financing (e.g., loans).
 Cost of short-term funds:
 Cost of TRADE CREDIT with supplier*:
Discount Rate 360 Days
COST = X
100% - Discount Rate Credit Period - Discount Period
* This type of financing cost is caused by foregoing cash discounts (opportunity cost).
 Cost of BANK LOANS (Effective Annual Rate):
Interest 360 Days
COST = X
Net Proceeds Loan Term
 If loan does not require a compensating balance:
 Non-discounted: net proceeds = face value
 Discounted: net proceeds = face value less interest
 If loan requires a compensating balance (CB):
 Non-discounted: net proceeds = face value less CB
 Discounted: net proceeds = face value less interest less CB
 Cost of COMMERCIAL PAPERS
Interest + Issue Costs 360 Days
COST = X
Face value – Interest – Issue Costs Paper Term
 Cost of FACTORING RECEIVABLES
Interest + Factor’s Fee 360 Days
COST = X
Face value – Interest – Factor’s Fee – Factor’s Holdback Remaining Maturity Period

EXERCISES: WORKING CAPITAL MANAGEMENT

1. Working Capital & Liquidity Ratios

Given the partial balance sheet information of Mental Health Support Group Company:
Cash P 17,000 Accounts Payable P 10,000
Accounts Receivable 13,000 Accrued Payroll 6,000
Inventory 20,000 Current Tax Liability 4,000
Fixed Assets 70,000 Bonds Payable 30,000
NOTE: Bonds will mature in 10 years.
REQUIRED:
A) Determine the: (1) net working capital (2) current ratio (3) quick or acid-test ratio
B) If the entire accounts payable are paid in cash, what is the new current ratio?
C) If a short-term loan of P 10,000 is obtained from a bank, what is the new current ratio?

2. Working Capital Policy: Conservative vs. Aggressive

MHSG Company has P 1,000,000 in current assets, 40% of which are considered permanent current assets.
In addition, the firm has P 600,000 invested in fixed assets. In the current year, the company reported
earnings of P 200,000 before considering the following interests and tax charges:
 Short-term financing: 5%
 Long-term financing: 10%
 Tax rate: 30%
Plan A – MHSG finances all fixed assets and half of its permanent current assets with long-term financing.
Plan B – MHSG finances all fixed assets and permanent assets plus half of its temporary current assets with
long-term financing.
REQUIRED:
A) How much is the difference in earnings after tax between Plan A and Plan B?
B) Which working capital policy between Plan A and Plan B is considered conservative? aggressive?

3. Optimal Cash Balance – Baumol Model

Suju Corporation is expecting to have total payments of P 1,800,000 for one year, cost per transaction
amounted to P 25, and the interest rate of marketable securities is 10%.
A) What is the company’s optimal initial cash balance that minimizes total costs?
B) What is the total number of transactions or cash conversions that will be required per year?
C) How frequent in days shall Suju Corporation do the transaction or cash conversion within the year?
D) What will be the average cash balances for the period?
E) How much is the total cost of maintaining cash balances?

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Week No. 14 : WORKING CAPITAL MANAGEMENT

4. Cash Conversion Cycle

Delight Company is concerned about managing cash efficiently. On the average, inventories have an age of
90 days, and accounts receivable are collected in 60 days. Accounts payable are paid approximately 30
days after they arise. Delight spends P 30 million on operating-cycle investments each year, at a constant
rate.
REQUIRED:
A) How long in days is the normal operating cycle?
B) How long in days is the cash conversion cycle?
C) What is the number of cash conversion cycles in one year (360 days)?
D) How much amount of resources is needed to support the cash conversion cycle?

5. Float & Lockbox System

Smirnoff Company has daily cash receipts of P 120,000. A recent analysis of its collection indicated that
customer’s payments were in the mailing system for an average of 3.5 days. Once received, the payments
are processed in 1.5 days. After payments are deposited, it takes an average of 4 days for these receipts
to clear the banking system. Smirnoff considers adopting a lockbox system that will reduce the collection
float time to 6 days . Rate of return is 10%
REQUIRED:
A) How much is the reduction in collection float associated with implementing the lockbox system?
B) If the lockbox system costs P 2,500 per month, should the system be implemented?
C) What maximum amount is Smirnoff Company willing to pay for the lockbox system for one year?

6. Average Investment in Accounts Receivable

Gin Corporation sells on terms of 2/10, n/30. 70% of customers normally avail of the discounts. Annual
sales are P 900,000, 80% of which is made on credit. Cost is approximately 75% of sales.
REQUIRED:
A) Average balance of accounts receivable B) Average investment in accounts receivable.

7. Collection Policy - Cash Discount

3AM Company presents the following information:
 Annual credit sales: P 30,000,000
 Collection period: 2 months
 Rate of return: 15%
3AM considers changing its credit term from n/30 to 3/10, n/30 to achieve the following results:
(1) 25% of its customers will take advantage of the discount while sales remain constant.
(2) Collection period is expected to decrease from two months to one month.

REQUIRED:
What is the net advantage (disadvantage) of implementing the proposed discount?

8. Credit Policy –Relaxation of Credit Standards & Extension of Credit Period

Red Wristband Corporation reports the following information:
A) Selling price per unit P 10
B) Variable cost per unit P8
C) Total fixed costs P 120,000
D) Annual credit sales 240,000 units
E) Collection period 3 months
F) Rate of return 25%
Red Wristband considers relaxing its credit standards and extending its credit period. The following results
are expected: (1) sales will increase by 25%; (2) collection costs will increase by P 40,000; (3) bad debt
losses are expected to be 5% on the incremental sales; and (4) collection period will increase to 4 months.
REQUIRED:
What is the net advantage (disadvantage) of implementing the relaxation of credit standards and
extension of credit period?

9. SHORT-TERM CREDIT FINANCING

I - COST of TRADE CREDIT
CPL Trading purchases merchandise for P 200,000, 2/10, n/30.
REQUIRED:
A) The annual cost of trade credit.
B) The annual cost of trade credit if term is changed to 1/15, n/20.
II - COST of BANK LOANS
CPL Trading was granted a 180-day P 200,000 bank loan with 12% stated interest.
REQUIRED: The effective annual rate, under the following cases:
A) CPL receives the entire amount of P 200,000.
B) CPL is granted a discounted loan.
C) CPL is required to maintain a compensating balance of P 10,000 under the non-discounted loan.
D) CPL is required to maintain a compensating balance of 10% under a discounted loan.

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Week No. 14 : WORKING CAPITAL MANAGEMENT

III - COST of COMMERCIAL PAPERS

CPL Company plans to sell a 180-day commercial paper amounting to P 100,000,000, which it expects to
pay adiscounted interest of 12% per annum. C PL expects to incur P 100,000 in dealer placement fees and
paper issue costs.
REQUIRED:
Determine the effective cost of CPL’s credit.
IV - COST of FACTORING RECEIVABLES
CPL Company has P 200,000 in receivable that carries 30-day credit term, 2% factor’s fee, 6% holdback
reserve and an interest of 12% per annum on advances.
REQUIRED:
A) How much is the cash proceeds from factoring the receivable?
B) What is effective annual rate of financing thru factoring the receivable?

WRAP-UP EXERCISES (MULTIPLE-CHOICE QUESTIONS)

1. Working capital management is concerned about the trade-off between

a. Return and financial risk
b. Default risk and conservatism
c. Current ratio and return on equity
d. Profitability and risk of technical short-term insolvency
2. Which of the following characteristics are generally associated with a CONSERVATIVE financial policy?
a. High current assets relative to sales and high current liabilities relative to total assets
b. High current assets relative to sales and low current liabilities relative to total assets
c. Low current assets relative to sales and high current liabilities relative to total assets
d. Low current assets relative to sales and low current liabilities relative to total assets
3. The PRECAUTIONARY motive for holding cash is for:
a. Daily operating requirements
b. Safety and emergency reasons
c. Compensating balance requirements
d. Buying goods before prices rise to higher levels
4. A working capital technique that increases the payable float and therefore delays the outflow of cash is
a. A draft c. Electronic fund transfer (EFT)
b. A lockbox system d. Electronic data interchange (EDI)
5. A firm has an average age in inventory of 90 days, an average collection period of 40 days, and an
average payment period of 30 days. What is the firm’s cash conversion cycle?
a. 70 days c. 130 days
b. 100 days d. 160 days
6. An increase in sales resulting from an increased cash discount for prompt payment would be expected
to cause a(n)
a. Increase in the operating cycle
b. Increase in the average collection period
c. Decrease in the cash conversion cycle
d. Decrease in purchase discounts taken
7. Changing a firm’s credit terms from 2/20, net/60 to 2/10, net/30 will generally
a. Increase the average collection period and increase sales
b. Increase the average collection period and reduce sales
c. Decrease the average collection period and increase sales
d. Decrease the average collection period and reduce sales
8. Which of the following forms of short-term borrowing is a secured credit?
a. Line of credit c. Commercial paper
b. Banker’s acceptances d. Chattel mortgage
9. Using a 360-day year, what is the opportunity cost to a buyer of not accepting terms 3/10, n/45?
a. 22.27% c. 55.67%
b. 31.81% d. 101.73%
10. Sydney Corp. is considering borrowing P 100,000 from a bank for one year at a stated interest rate of
9%. What is the effective interest rate to Sydney if this borrowing is in the form of a discount note?
a. 8.10% c. 9.81%
b. 9.00% d. 9.89%

SELF-TEST QUESTIONS – with suggested answers

(Sources: CMA/CIA/RPCPA/AICPA/Various test banks)

1. If current assets go up by P 120,000, current liabilities go down by P 50,000, then net working capita l
C a. Did not change c. Increased by P 170,000
b. Increased by P 70,000 d. Decreased by P 170,000
2. Which of the following is strictly not a use of working capital?
B a. Repurchase of common stock c. Purchase of equipment on account
b. Purchase of inventory on account d. Repayment of long-term debt

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