WORKING CAPITAL MANAGEMENT

DEFINITION
Working capital management involves managing the firms current assets and liabilities
to achieve a balance between profitability and risk that contributes positively to the firms
value.

Working capital management is all about RISK AND RETURN

TRADE-OFF. Generally, the higher the risk, the higher the return.
Thus, the yield curve is upward sloping.

Current assets are the least profitable assets of the company.

Therefore, investment in working capital involves lower return. The
lower the return, the lower the risk, right? But why lower risk? It is
because investment in working capital more has given the
company a greater liquidity, thus a lower default risk.

Therefore, PROFITABILITY is INVERSELY related to LIQUIDITY.

(Net) Working Capital = Current Assets – current liabilities

Working capital is used to finance the normal and short-term

operating business cycle.

Types of Working Capital

• Permanent –minimum level of working capital
(aka fixed)
• Temporary – additional working capital needed
in times of busy season (aka seasonal, variable,
incremental)
Working Capital Policy
A. Conservative (relaxed) – uses more of long-term financing low current liabilities,
more liquid but less profitable (due to higher financing cost)
B. Aggressive (restricted) – uses more of short-term financing high current liabilities,
less liquid but more profitable (due to lower financing cost).
C. Moderate – not too conservative, not too aggressive
D. Matching - short-term for short-term, long-term for long-term (hedging)

SO-RYAN co. is currently in the process of preparing its financial plan for next year 2020. The
following estimations are related to the said financial plan: (all amounts in millions PHP)
Month CA Month CA Month CA
Jan 20.2 May 42.5 Sept 44.4
Feb 19.4 June 43.8 Oct 37.6
Mar 25.7 Jul 38.6 Nov 49.4
Apr 35.1 Aug 40.2 Dec 29.8

SO-RYAN’s fixed assets is expected to be constant over the year amounting to P80 million.
REQUIREMENTS:
(a) Determine the amount of temporary and permanent amount of assets of SO-RYAN.
(b) Determine the amount of short-term and long-term amount of financing assuming
(1) Working capital policy requires that 50% of temporary assets be financed with
permanent financing.

(2) Working capital policy requires that 50% of permanent current assets be
financed with temporary financing.
 CASH AND MARKETABLE SECURITIES MANAGEMENT

Four reasons to hold cash instead of investing it:

1. Transaction motive – for day-to-day expenditures
2. Pre-cautionary motive – for contingencies
3. Speculative motive – for possible future favorable opportunities (e.g. sudden price
drop)
4. Contractual motive – required by agreement (e.g. compensating balance)

Optimal Cash Balance (OCB) - also known as Economic Cash Quantity/Economic

Conversion Size under Baumol Model (named after American Economist William Baumol).

Total costs of cash balance = Holding costs + Transaction costs

• HOLDING COSTS = Average cash balance x opportunity cost
• TRANSACTION COSTS = Number of transactions x cost per transaction

NOTE: Number of transactions can be computed as (Annual cash requirement ÷ OCB) and
average cash balance can be computed as (OCB ÷ 2).

The Baumol model, like its pattern EOQ, assumes that the demand for cash is spread evenly
throughout the year.

MARIA inc. projects that cash outlays of P45 million will occur uniformly throughout the year.
MARIA plans to meet its cash requirements by periodically selling marketable securities from
its portfolio. The firm’s marketable securities are invested to earn 12 percent, and the cost per
transaction of converting securities to cash P30.
REQUIREMENTS:
(a) Compute the total annual cost based on optimal transaction size.
(b) Compute the total annual cost if the transaction size is P200,000.
(c) Compute the total annual cost if the transaction size is P100,000.

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 - length of time between paying for working capital and
collecting cash from sale of inventory.
CCC = OPERATING CYCLE – DAYS AP

OPERATING CYCLE - the length of time in which the firm purchase inventories, sell it and
receive cash from sale.
OPERATING CYCLE = average age of inventory + average of receivable

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.
NOTE: Cash conversion cycle is the basis for how much the company should invest in working capital.
See sample discussion below. The idea is to minimize cash conversion cycle.

BAX co., a leading producer of microchips, turns out 2,000 microchips a day at a cost of P300
per battery for prime cost. It takes the firm 30 days to convert raw materials into microchips.
BAX allows its customers 25 days in which to pay for the batteries, and then it pays suppliers
on a 20-day basis.
REQUIREMENTS:
(a) How long is BAX’s operating cycle and cash conversion cycle, respectively?
(b) At a steady state in which BAX produces 2,000 batteries a day, what amount of
working capital must it finance?
(c) If BAX can stretch its DAYS AP into 30 days, by what amount could BAX reduce its
working capital financing needs?
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 location, 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
budgets)
➢ 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 ACCOUNT (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.

It usually takes AMUMU INC. 15 calendar days to receive and deposit customer
remittances. The system is expected to reduce mailing time by 3 days, reduce processing
time by 2.5 days, and reduce check clearing time by 0.5 day. The average daily cash
receipts are P800,000. The expected rate of return is 8%.
REQUIREMENTS:
(a) How much cash would the lock-box system free up for the company?
(b) What is the maximum amount that AMUMU would be willing to pay for the lock-box
system?
(c) If the lock-box system could be arranged at an annual cost of P300,000, what
would be the annual net gain from instituting the system?

THE CONCEPT OF FLOAT

FLOAT is defined as the difference between balance per book and balance per bank.

Types of float
(a) Positive float or disbursement float – bank balance > book balance
(b) Negative float or collection float – bank balance < book balance
1. MAIL Float – amount 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 be maximized while negative
float be minimized.

(For theories only)

MARKETABLE SECURITIES - short-term money market instruments that can easily be
converted to cash
Examples:
(1) Government Securities
• Treasury bills - debt instruments representing obligations of the National
Government issued by the Central Bank and sold at a discount through competitive
bidding.
• CB Bills or Central Bank Certificates of Indebtedness (CBCIs) - represent
indebtedness by the Central Bank
(2) Commercial Papers (CPs) - short-term, unsecured promissory notes issued by
corporations with very high credit standing.
(3) Certificate of deposits – savings deposits at financial institutions (e.g. time deposit)
(4) Money market funds – shares in a fund that purchases higher-yielding bank
certificate of deposits, commercial paper and other large-denomination, higher
yielding securities.
NOTE: Government issued securities are considered to be the safest securities (lower
return) and commercial papers are considered to be the securities with highest return.
FACTORS TO CONSIDER IN CHOOSING MARKETABLE SECURITIES
(1) Risk
a. Default Risk - refers to the chances that the issuer may not be able to pay the
interest or principal on time or not at all.
b. Interest Rate Risk - refers to fluctuations in securities' price caused by changes
in market interest rates.
c. Inflation Risk - refers to the 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 a
significant price concession
(3) Term to 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.

RECEIVABLE MANAGEMENT

Objective: to have both the optimal amount of receivables outstanding and the optimal
amount of bad debts. This balance requires the trade-off between the benefit of more
credit sales, and the costs of accounts receivable such as collection, interest, and bad
debts cost.
CREDIT POLICY
This is a set of guidelines for extending credit to customers. The company may choose
between a conservative or aggressive policy.

POLICY SALES COLLECTION PERIOD AR BALANCE BAD DEBTS

AGGRESSIVE ↓ ↓ ↓ ↓
CONSERVATIVE ↑ ↑ ↑ ↑

TERMINOLOGIES USED
• Credit cap – also known as credit limit. It refers to the maximum or ceiling amount of
credit given to customers.
• Credit block – refers to action of credit department where a customer is not granted
line of credit.
• Credit class – pertains to the group of customers.
NOTE: The treasurer is generally responsible for the credit and collection function.

COMPONENTS OF CREDIT POLICY

(1) Credit standards – the criteria that determine which customers will be granted
credit and what is the limit. The following are the factors to consider in establishing
credit standards. (The 5 C’s of Credit)
(a) Character – customers’ willingness to pay
(b) Capacity – customers’ ability to generate cash flows
(c) Capital – customers’ financial sources
(d) Conditions – current economic or business conditions
(e) Collateral – customers’ assets pledged to secure debt.
(2) Credit terms – this defines the credit period and discount offered for customers’
prompt payment.
(3) Collection policy – refers to the procedures the firm follows to collect accounts
including past accounts.
FREQUENTLY ASKED QUESTIONS ON AR MANAGEMENT
(1) Days Sales Outstanding (DSO) or Average Collection Period
If the problem is silent, DSO is the credit term. Otherwise, DSO is computed as the
average days of collection by the company.

US Corporation sells on terms of 2/10, n/30. 70% of customers normally avail of the discounts. Annual
sales are P 9,000,000, 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.
(2) Net advantage or disadvantage of change in policy
Benefit (increase in contribution margin) xx
Costs:
Incremental bad debts expense (xx)
Incremental carrying cost on accounts receivable(a) (xx)
Net benefit (loss) xx

NOTES:
(a) The incremental carrying cost on accounts receivable is computed by multiplying the
incremental investment on accounts receivable to the opportunity cost rate.
(b) The net benefit (loss) should be after-tax.

NEZMEEN CORP. sells on terms of 2/15, n/30. Total sales for the years are P864,000. 60% of
the customers pay on the 15th day and take discounts. The remainder pay, on average, 40
days after their purchases. Assume 360 days per year.
REQUIREMENTS:
(a) What is the days sales outstanding?
(b) What is the average amount of receivables?

BASHIF INC. currently has sales of P2.5 million. Its credit period and days sales outstanding
(DSO) are both 30 days, and 1 percent of its sales end up as bad debts. The credit manager
estimates that, if the firm extends its credit period to 45 days so that its days sales
outstanding increases to 45 days, sales will increase by P250,000, but its bad debt losses on
the incremental sales would be 2.5 percent. Variable costs are 60 percent, and the cost of
carrying receivables (opportunity cost), k, is 12.5 percent. Assume a tax rate of 40 percent
and 360 days per year.
REQUIREMENTS:
(a) Compute the incremental investment required to finance the increase in receivables
if the change is effected.
(b) What would be the incremental cost of carrying receivables?
(c) What would be the effect of those changes in net income?

CAROL Company presents the following information:

• Annual credit sales: P 36,000,000
• Collection period: 2 months
• Rate of return: 15%
CAROL considers changing its credit term from ‘n/30’ to ‘4/10, n/30’ with the following
expected results:
(1) 30% 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 ?

DANIEL 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%

DANIEL 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?
 INVENTORY MANAGEMENT
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.

INVENTORY MANAGEMENT TECHNIQUES

(1) INVENTORY PLANNING – involves 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) ECONOMIC ORDER QUANTITY - the quantity to be ordered, which minimizes the
sum of the ordering and carrying costs. The total inventory cost function includes:
• Carrying Costs (which increase with order size)
(1) Storage costs (3) Spoilage
(2) Interest costs (4) Insurance

• Ordering Costs (which decrease with order size)

(1) Transportation (delivery costs)
(2) Administrative cost of purchasing and costs of receiving and inspecting
goods

Total costs of inventories = Ordering costs + Carrying costs

• CARRYING COSTS = (Average inventory + Safety stock) x carrying cost per
unit
• ORDERING COSTS = Number of times the company will order x ordering costs

NOTES:
(1) Number of times the company will order can be computed as (Annual demand
in units ÷ EOQ) and average inventory can be computed as (EOQ ÷ 2)
(2) When applied to manufacturing operations, the EOQ formula may be used to
compute the Economic Lot Size (ELS)

(b) SAFETY STOCK AND REORDER POINT

REORDER POINT is a stock-out problem, the objective is to order at a point in
time so as not to run out of stock before receiving the inventory ordered but not
so early that an excessive quantity of safety stock is maintained.

The computation of reorder point depends if lead time (period between the time
the order is placed and received) is constant or fluctuating.

If lead time is constant:

REORDER POINT = AVE. USAGE x NORMAL LEAD TIME

If lead time is fluctuating:

REORDER POINT = (AVE. USAGE x NORMAL LEAD TIME) + SAFETY STOCK
or AVE. USAGE X MAXIMUM LEAD TIME)
(Extra notes)
(2) INVENTORY CONTROL - regulation of inventory within pre-determined 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 is 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- 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
 (e) 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.
(f) 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.

The Dell COMPANY purchases 20,000 units of a major component part each year. The firm's
order costs are P200 per order and the carrying cost per unit is P2 per year.
REQUIREMENTS:
(a) Compute the total inventory costs associated with placing orders of 20,000, 10,000,
5,000, 1,000.
(b) Determine the EOQ for the component parts.

A company annually consumes 50,000 units of Part X. The carrying cost of this part is P3.00
per year and the ordering costs are P200. The company uses an order quantity of 5,000 units.
REQUIREMENTS:
Based on the information, compute:
(a) Average number of inventory units.
(b) Number of orders per year.
(c) Using 360 days a year, the frequency of making an order.
(d) The annual inventory costs, broken down into ordering and carrying costs.
(e) The economic order quantity. Compute the amount of annual inventory costs if the
company uses the economic order quantity.

The following information is available for Gerwin CORP.’s Material ABC.

Annual usage 12,600 units
Working days per year 360 days
Normal lead time 20 days
The units of Material ABC are required evenly throughout the year.
REQUIREMENTS:
A. What is the reorder point?
B. Assuming that occasionally, the company experiences delay in the delivery of
Material ABC, such that the lead time reaches a maximum of 30 days, how many
units of safety stock should the company maintain and what is the reorder point?

Each stockout of a product sold by Bus-man CORP. costs P1,750 per occurrence. The carrying
cost per unit of inventory is P5 per year, and the company orders 1,500 units of product 24
times a year at a cost of P100 per order. The probability of a stockout at various levels of
safety stocks is.
Units of safety stock Probability of stockout
0 .50
100 .30
200 .14
300 .05
400 .01
REQUIREMENT: The optimal safety level for the company is

SHORT-TERM FINANCING
1. Accounts Payable
* Credit terms: credit period, cash discount, cash discount period
discount rate 360
* Cost of giving up cash discount = x
100%−discount rate credit period−discount period

Credit period – discount period is number of days payment can be delayed by giving up cash discount.

2. Bank loans
* Single-payment notes: if the interest is payable upon maturity, the effective
interest rate is equal to the nominal rate.
* Discounted Note – the effective interest rate is higher than the nominal rate.
net interest 360
Cost = x
net proceeds loan term
 - Where net proceeds is equal to face value if non-discounted, or face value net
of interest if discounted (interest deducted in advance).
- Also if there is a compensating balance, it will be deducted from face amount.
- If transaction cost was also paid, it will be deducted from it.
- Net interest =
interest paid + transaction cost (if any) – income from compensating balance

3. Cost of commercial papers

interest + issue cost 360
Cost = x
face value−interest−issue cost 𝑝𝑎𝑝𝑒𝑟 𝑡𝑒𝑟𝑚

4. Cost of Factoring Receivables

interest + factor′ s fee 360
cost = x
face value−interest−factor′ sfee−holdback remaining maturity period

TRADE CREDIT: The following information is related to the trade credit for each supplier of
BLITZCRANK INC.:
SUPPLIER CREDIT TERM DATE OF PAYMENT
A 3/15 net 40 On the 30th day
B 2/10 net 30 On the 35th day
C 1/5 net 20 On the 30th day
REQUIREMENTS:
(a) What is the nominal cost and effective cost of giving up the cash discount from
each supplier?
(b) Assuming that the firm needs short-term financing, recommend whether it would
be better to give up the cash discount or take the discount and borrow from a bank
at 20% annual interest.

SHORT-TERM BANK LOAN: MILO COMPANY is negotiating with NEDO BANK for a P1M, 1-
year loan. NEDO BANK has offered MILO COMPANY the following alternatives. Calculate the
effective annual interest rate for each alternative. Redo requirement (A) to (F) assuming the
loan is for four (4) months.
(A) A 12.5 percent annual rate on a simple interest loan, with no compensating balance
required and interest due at the end of the year.
(B) A 9.25 percent annual rate on a simple interest loan, with a 20 percent compensating
balance required and interest again due at the end of the year.
(C) A 8.75 percent annual rate on a discount loan, with a 20 percent compensating balance.
(D) A 8.75 percent annual rate on a discount loan, with a 20 percent compensating balance
and an existing cash balance of P150,000
(E) A 8.75 percent annual rate on a discount loan, with a 20 percent compensating balance
which earns 5% interest income.
(F) A 8.75 percent annual rate on a discount loan, with a 20 percent compensating balance
and an existing cash balance of P150,000. The bank balance earns 5% interest income.

RANIA CORP. can issue a four-month commercial paper with a face value of P1,000,000 for
P985,000. Transaction costs would be P2,400. REQUIREMENT: What is the annualized cost of
the commercial paper?

CAMILLE CORP. enters into an agreement with a firm that will buy CAMILLE’s accounts
receivable and assume the risk of collection.
Details about the agreement are as follows:
Average amount of receivable to be factored each month P300,000
Average collection period 30 days
Amount to be advanced by the factor 75% of the face amount of the receivables
Interest rate, deductible in advance 12% p.a.
Factor’s fee, deductible in advance 3%
Annual savings of CAMILLE CORP in collection expenses: P40,000
REQUIREMENTS:
(a) How much is the monthly net proceeds from factoring the receivables?
(b) What is the annual net cost of factoring?
(c) What is the effective annual cost rate of financing?
(d) If the interest charge and factor’s fee is not deducted in advance, the effective
annual cost rate is