CHAPTER 3

WORKING CAPITAL MANAGEMENT

 WORKING CAPITAL MANAGEMENT

 Working capital refers to current assets

 Net working capital:
 Current Assets – Current Liabilities
 Working Capital Management involves the managing of:
i) Current Assets
ii) Current liabilities
 Management of Current Asset
A) Inventory Management
 Depends on the size of its investment
 Financial manager prefer to keep inventory levels as
low as possible to prevent unwise investment in excess
resources

 Techniques of Inventory Management

 Economic Order Quantity (EOQ) Model
 ABC system
 Just-in-time system
 Materials requirement planning system
• Ordering costs – include administration cost of placing and
receiving orders which consists of writing the purchase order,
processing it and checking it with the invoice
• Order costs decrease as the size of order increase

ii) TOC = (S) x O

Q
iii) Number of orders = S
Q
TOC = Total Ordering Costs
O = order cost per order/Fixed Cost per order
S = usage in units per period / annual usage /sales /demand in
units
Q = quantity Ordered or EOQ
• Carrying Costs (Holding Costs) – the variable costs per unit
of holding an item of inventory for a specified period of
time. Include storage costs, insurance costs, costs of
deterioration and obsolescence.
• Holding cost increase with order size

iv) Total Carrying Cost (Total Holding Cost)=

Average Inventory x Carrying Cost Per unit

Average Inventory = Q + SS
2
TCC = Total Carrying Cost
Q = Quantity Ordered or EOQ
SS = Safety Stock
C/H = Carrying Cost / Holding Cost
TCC = [Q + SS] x C
2
v) Total Inventory Cost (TIC)

TIC = TCC + TOC or

TIC = [Q + SS] x C + [S] x O
2 Q
vi) Reorder Point

When an item inventory level falls to the reorder point, a

new order will be placed.

Re-Order Point = S x delivery time + safety stock

weeks @days per year

= usage rate x delivery time (DT) + safety stock (SS)

 SELF-TEST PROBLEM
The following information supplied by Adidas Sdn Bhd,
retailer of designer football gloves

S = annual sales (30,000 units)

C = RM5 per pair of gloves
O = ordering cost per order (RM100)
SS = 1,000 pairs of gloves
DT = 2 weeks (50 weeks per year)

Calculate:
a) The economic ordering quantity
b) Total carrying cost
c) Total ordering cost
d) Total inventory cost
e) Number of orders placed
f) Re-order point
B) Accounts Receivable Management
• The efficient management of account receivable would
be to collect from debtors as quickly as possible without
losing sales from efficient policy collection technique
• The process of Credit Selection – to determine the
customers creditworthiness
• The 5Cs of credit risk evaluation on customer who
purchase in large monetary amount

i) Character : reliability in payments

• Reputation of the customers to pay back the debt
• Honesty and professional integrity of the applicant

ii) Capital : the customer debt to equity ratio

• Material wealth owned by individual/business
• Financial strength of the debtor
iii) Capacity : the cash flow available for repayment
• The ability of the debtor to pay back the debt
• Borrower’s ability to repay is determined by his gross
and net income.

iv) Collateral : the assets available for securing to obtain

credit
• Security pledge for the repayment of a loan

v) Conditions : prevailing economic and industry conditions

• Financial situation of the industry that the customer
operates in
Factors Determining the size of Accounts Receivable
1. Nature of Business
• It will determine whether the business should be
selling on credit basis or cash basis

• E.g: Size of Account Receivable in retail industry is less

compare to the automobile industry.

• In retail industry, most of transactions are on cash basis

compare to automobile industry where most of sales
are in credit

2. Level of Sales
• The greater the sales, the greater the account
receivable
3) Credit and Collection policies
• It cover the firm’s terms of sale, quality of its customer
and its collection effort

• If a firm adopts a strict credit and collection policy, the

account receivable balances would be small
Factors that effect the Financial Manager Decision
i) Terms of Sale
• Identify the possible discount for early payment, the
discount period and total credit period
• Generally stated in the form of a/b net c
• It means the customer can deducted a% if the payment is
made within b days, otherwise full payment must be
made within c days
• Failure to take discount represent a cost to the customer
• E.g: 2/10 net 30 – 2% discount will be given to the
debtors (customer) if made payment within 10 days;
otherwise he must pay within 30 days

ii) Type of Customer

• Financial manager have to determine on type of customer
that qualify for trade credit
• Sources information on customers would be credit
bureau, bank references, etc
iii) Collection effort
• The number of days taken by creditors to collect their
account receivables
• The longer time to collect, the higher probability of
customers who fail to make payment on debt
C) Cash Management
• It mainly concerned with maintaining the liquidity of a
firm so as to minimize the risk of insolvency
• Insolvency – unable to make prompt payment on its
current debt obligation

Motives for Holding Cash

1) The transaction motive
• Purpose of meeting cash needs in doing business
• Cash outflow such as payment of wages, utilities

2) The precautionary motive

• to hold some cash reserve or marketable securities that
can be liquidated quickly for emergencies needs
3) The speculative motive
• cash balance or excess cash held may enable the company
to take advantage of trade discounts or short-term
investment
• Purchasing raw material in bulk in anticipation of a fall in
price reduces the cost of good sold and increase profit
D) Marketable Securities Management
• short-term security investments the firm can quickly
convert into cash
• treasury bills, commercial paper, and negotiable
certificates of deposit

Rationale for holding Marketable Securities

i) As a substitute for cash
• when the firm cash outflow is greater than cash inflow,
the firm will sell the marketable securities to obtain cash

ii) As a temporary investment

• When inventories and receivable are low due to
seasonality in sales
• To meet financial requirement such as preceding
quarterly corporate tax payment dates and financing of
major assets or acquisition
Characteristics of Selecting Marketable Securities
1. Financial risk / Default risk
• The risk of the borrower (security issuer) not being
able to pay interest/principal on a loan to the security
owner

2. Interest rate risk

• The risk to which investors are exposed due to rising
interest rate
• Firms tend to choose security investment that mature
in a short period of time to avoid the price fluctuation
caused by interest rate
• Financial instruments with longer terms to maturity are
more sensitive to changes in interest rate , therefore
have higher interest rate risk
3) Inflation Risk
• Inflation will reduce purchasing power
• Financial instruments whose returns increase will lower
inflation risk
4) Marketable/ liquidity Risk
• Financial instruments can be sold immediately at a price
close to market price are more marketable or liquid
• If can sell on short notice, it considered highly
marketable
5) Yields/ rates of return / return on securities
• The return on marketable securities are dependent on
the four factors above. The higher the risk, the higher the
return
• Higher risk can also be zero return in times of economic
recession
 Management of Current Liabilities
• Short term sources of funds for a firm include:
a) Accruals
b) Account Payable
c) Notes Payable
d) Short term loans

• Some of the sources are secured and unsecured

• Secured sources – require the borrower to pledge
specific assets as collateral if any default payment
• Unsecured sources – the ability of borrower to repay the
funds when due
A) Accounts Payable Management

Spontaneous Short-Term Financing (Secured)

• Trade Credit
 The most flexible sources of short-term financing
 A firm may obtain credit when it places an order with a
supplier
 The firm obtained trade credit from its supplier when it
buys goods on credit. No loan agreement or negotiation
incurred
 The supplier would offer cash discount for early payment
or firm may pay full amount without taking discount
Calculation the interest rate of not taking cash discount
i = a x 360
(1 – a) (c – b)

i = annual interest cost of not taking a discount

a = percentage discount
b = cash discount period
c = credit period

Fitness Bhd is considering accepting a cash discount of

2/10 net 30 from one of its supplier. Other sources of
short-term financing charge 10%

Should Fitness Bhd take the cash discount or use the

maximum of 30 days credit from supplier?
Answer
i = 0.02 x 360
(1-0.02) (30-10)
= 0.367 = 36.7%
• Therefore the annualized rate charged by the supplier to a
borrower for not taking the cash discount is 36.7%, whereas
other sources charge only 10%. Fitness Berhad should take
the cash discount and obtain the needed funds from the
other sources available.
Non-Spontaneous Sources of Financing (unsecured)
• Bank Credit
 Commercial banks are a major source of unsecured
short-term credit
 The three principal types are:
– Line of Credit/overdraft
– Revolving Credit Agreement
– Transaction Loan
 Line of Credit

• It’s an informal arrangement between a bank and its

customer specifying the maximum amount of unsecured
credit the bank will permit to owe at any one time
• The bank will charge interest under loan agreement
• The loan rate charged to a specific customer will depend
on the customer’s creditworthiness, relationship with the
bank and other factors
• Interest loan can be paid :-
a. Cost of a Bank Loan: Simple Interest
• Interest is charged on the basis of the amount borrowed
and its paid when the loan ends
• Interest paid at maturity

• Formula
= Interest Rate x Principal x Days in Year
Principal Days loan is outstanding

• Sara wishes to borrow RM20,000 for 1 year. The bank

offers a simple interest loan at 14% per annum.
Calculate the effective annual interest cost of the loan
Cost of a Bank Loan : Discount Interest
• Interest calculated on the amount borrowed but is paid
when the loan begin. The interest is deducted in the
beginning, resulting in the borrower receiving less than
the face value of the loan

Formula
Step 1
Loan Amount = RMKKK
Less: Interest (% x KKK) = RMYYY
Usable Funds RMAAA

Step 2
Effective Interest Rate = Interest Paid x 360
Usable Funds t
• Sara wishes to borrow RM20,000 from a local
bank. The bank charged her 14% discount interest.
Determine the effective annual interest cost.

• Suppose you borrow RM10,000 for one year at 11%

interest. If the loan is on a discount basis, then the
effective interest rate will be:
Compensating Balance
• Many banks require a borrower to maintain a minimum
balance hold from 10% to 20% on deposit in the
borrower’s account throughout the period of loan
Formula
Step 1
Loan = RMsss
Less: Compensating Amount = RM ggg
[% compensating x sss(loan)]
Usable Funds RMbbb

Step 2
Effective Interest Rate = Interest x 360
(effective cost rate) Usable Fund t
• Suppose you borrow RM20,000 at 14% interest rate per-
annum paid at maturity and the compensating balance
requirement is 10%.What will the effective cost of the
loan be?

• Sara wishes to borrow RM20,000 for 1 year. The bank

offers simple interest loan at 14% per annum, and
requires Sara to maintain compensating balance of 20%
of the loan amount. What is the cost to Sara of taking up
such a loan?
Revolving Credit Agreement
• It is similar to a line of credit except the bank makes a
formal and legally commitment to give credit to the
borrower up to the stated amount agreed

• In return, the borrower pays interest on its loan plus a

commitment fee on the unused portion of the credit
line
Formula
Step 1
Loan Amount = RMccc
Less: Compensating Amount = RMddd
[% compensating x ccc(loan)]
Usable Amount = RMkkk
Step 2
Interest = % x ccc (loan)
= RMggg

Commitment Fee = Unused portion x Fee

= RMbbb
Step 3
Effective cost = Interest + Commitment Fee x 360
of Borrowing Usable Fund 360
• Suppose Binariang Corporation has a revolving
agreement with a bank. It can borrow up to RM
2,000,000 at 12% interest but is required to maintain a
10% compensating balance on any funds borrowed
under the agreement. In addition, it must pay a 0.5
percent commitment fee on the unused portion of the
formal line. What is the effective cost of taking such a
loan, if the firm utilizes RM800,000 for an entire year
Commercial Paper
• Commercial paper is an unsecured, short-term debt
instrument issued by a corporation, typically for the
financing of accounts receivable, inventories and meeting
short-term liabilities
• An alternative to raise fund. It’s a short term unsecured
promissory note that is generally sold by large
corporations on discount basis to institutional investors
and to other corporations
• It can be issued either thru dealer or the firm directly sale
• Maturity period varies from 30 to 270 days
• The interest charge is lower, 0.5% to 4% as compared
with that of commercials bank
• Commercial papers can be sold directly by the issuing
company to the investors or else issuers can sell to the dealer
who in turn will sell it into the market
• Purchasers of Commercial Paper can be:
i) Corporations with excess funds to invest
ii) Banks
iii) Insurance companies
iv) Other types of financial institution
• Advantages of Commercial paper:
1) Lower interest rate
 interest rate charged is lower compared to bank loans
and other sources of short-term financing.
2) No compensating balance requirement
 The issuing firms do not require any compensating
balance on their outstanding amount
 Convenient to borrower and less costly
3) Offer large amount of credit
 Offers large amount of short-term fund to firm with
large credit requirements
4) Prestige
 It’s widely recognized and usually issued by
creditworthy firms
Formula

Step 1
Value of Commercial Paper = RMkkk
Less: Interest Amount = RMbbb
[ RMkkk (C/P) x % x days/360]
Fees = RMjjj
Usable Funds RM fff

Step 2
Effective Cost = Interest + Fees x 360
of Commercial Paper Usable Fund t
= www%
 On May 2009, Motorola Corporation plans a
commercial paper issue of RM30million. The firm has
never used commercial paper before but has decided
to go through a dealer to handle the process. The
commercial paper will carry a 270 days maturity and
require interest based upon a rate of 11% per annum.
In addition, the firm will have to pay fees totaling
RM200,000 for going through the dealer. What is the
effective cost of the commercial paper issue to
Motorola Corporation