WORKING CAPITAL MANAGEMENT

WORKING CAPITAL MANAGENENT involves managing the firm's current assets and liabilities
to achieve a balance between profitability and risk that
contributes positively to the firm's value.

EXERCISE: WORKING CAPITAL

Given the partial balance sheet information of Ana Company:

Cash 12,000 Accounts Payable 10,000

Accounts Receivable 18,000 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:

1. What is the net working capital? 50k-20k=30k

2. What is the present current ratio? 50k/20k=2.50
3. If only the quick assets are considered, then what is the quick or acid-test ratio? 30k/20k=1.50
4. Assuming the entire accounts payable are paid in cash, what is the new current ratio?
(50-10)/ (20-10)=4.0
5. Assuming a short-term loan of P 10,000 is obtained from a bank, what is the new current ratio?
(50+10)/(20+10)=2.0

FACTORS TO CONSIDER IN MANAGING WORKING CAPITAL

APPROPRIATE LEVEL This refers to adequacy of working capital

Consider: Nature of business and length of operating cycle

STRUCTURAL HEALTH This refers to composition of working capital

Consider: Need for cash and stock of inventory units

LIQUIDITY This refers to the relative transformation (and its rate) of current
assets into more liquid current assets (e.g., cash and marketable
securities).

WORKING CAPITAL RISK and RETURNS

The management of working capital requires consideration for the trade-off between risk and
returns. The primary objective is to achieve a balance between risk and profitability (return). More
current assets lead to greater flexibility and reduced liquidity risk. However, the rate of return will be
less than with current assets than with long-term assets. Long-term assets typically earn a greater return
than current assets. Long-term financing has less liquidity risk than short-term debt, but it carries a
higher explicit cost (hence, lower return).

Working Capital Policy

Conservative Aggresive
Relaxed Restricted
Description High Low
Level of Current Assets High Low
Reliance on Long term financing Low High
Profitability and Returns Low High

Conservative Aggresive
Current Assets Current Liabilities Current Assets Current Liabilities

Sound working capital policy requires:

1. Managing cash and its temporary investment efficiently. (Cash/Marketable Securities Management)
2. Ensuring efficient manufacturing operations and sound material procurement. (Inventory
Management)
3. Drafting and implementing effective credit and collection policies. (Receivable Management)
4. Seeking favorable terms from suppliers and other temporary creditors. (Short-Term Credit
Financing)

CASH & MARKETABLE SECURITIES (MS) MANAGEMENT

CASH MANAGEMENT involves the maintenance of the appropriate level of cash to meet
the firm's cash requirements and to maximize income on idle
funds.

MS MANAGEMENT involves the process of planning and controlling investment in

marketable securities to meet the firm's cash requirements and to
maximize income on idle funds.

OBJECTIVE: To minimize the amount of cash on hand while retaining sufficient liquidity to
satisfy business requirements (e.g., take advantage of cash discounts, maintain
credit rating, meet unexpected needs).

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 level to provide for buffer against
contingencies, such as slow-down in accounts receivable collection and possibilities of strikes.
3. SPECULATIVE motive
Cash is held to avail of business incentives (e.g., discounts) and investment opportunities.
4. CONTRACTUAL motive (Compensating Balance Requirements)
Cash is held as required by provisions of a contract (e.g., company is sometimes required to
maintain a minimum balance in its bank account as a condition of a loan granted by the bank.

OPTIMAL CASH BALANCE: BAUMOL MODEL

OPTIMAL CASH BALANCE = square root of 2 (annual cash requirement) (Cost per transaction)
(OCB) Opportunity Cost of holding cash

Total cost of cash balance= holding costs + Transaction cost

HOLDING costs = average cash balance* x opportunity cost
TRANSACTION costs = number of transactions** x cost per transaction

* Average cash balance = OCB/ 2

**Number of transactions per year = annual cash requirement / OCB

CASH CONVERSION CYCLE - is the average length of time a peso is tied up in current
assets from the date a company makes payment of raw
materials to the date company receives cash inflows thru
collection of accounts receivable. It is also known as the
cash flow cycle.

Inventory conversion period = Inventory / CGS* per day

+ Receivable collection period = Receivables / Sales per day
-Payable deferral period = Payables / purchases per day
CASH CONVERSION CYCLE

Alternatively, sales per day may be also used to compute inventory conversion period. The intention is
to use an amount in proportion to unit sales.

The firm's goal should be to shorten its cash conversion cycle without hurting operations. The longer
the cash conversion cycle, the greater the need for external financing (hence, the more cost of
financing).

CASH MANAGEMENT STRATEGIES

1. Accelerating collections (e.g., prompt billing, cash discount offers, online banking, lockbox system)
2. Slowing disbursements (e.g., stretching payable payment, playing the float)
3. Reducing precautionary idle cash (e.g., zero-balance accounts)

THE CONCEPT OF FLOAT

 FLOAT - generally defined as the difference between the cash balance per BANK and the
cash balance per BOOK as of a particular period, primarily due to outstanding
checks and other similar reasons.

Types of Float:

1. POSITIVE (Disbursement) Float: bank balance > book balance

EXAMPLE: Outstanding checks issued by the firm that have not cleared yet.

2. NEGATIVE (Collection) Float: book balance > bank balance

EXAMPLES:
A. MAIL Float - Amount of customers' payments that have been mailed by
customers but not yet received by the seller-company.

B. PROCESSING Float — Amount of customers' payments that have been received by the
seller but not yet deposited.

C. CLEARING Float — Amount of custorners' checks that have been deposited but have
not cleared yet.

Good cash management suggests that positive float should be maximized while negative float be
minimized or, if possible, eliminated.

MARKETABLE SECURITIES — short-term money market instruments that can easily be

converted to cash

CERTIFICATES of DEPOSITS (CD) — savings deposits at financial institutions (e.g. time

deposit)
MONEY MARKET FUNDS — shares in a fund that purchases higher-yieding bank
CDs, commercial paper, and other large-
denomination, higher-yielding securities.
GOVERNMENT SECURITIES
Treasury bills — debt instruments representing obligations of
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 promissory notes issued by
corporations with very high credit standing

FACTORS CONSIDERED IN CHOOSING MARKETABLE SECURITIES (MS)

1. RISK
Default Risk — refers to the chances that the issuer may not be able to pay the interest or
principal on time or at all.

Interest Rate Risk or —refers to fluctuations in MS prices caused by changes in market interest
rates.
 Inflation Risk -- refers to the risk that inflation will reduce the relevant value of the investment.

2. RETURNS
The higher the MS’s risk involved, the higher its required return. While MS must consist of highly
liquid short term investments. The company should not sacrifice safety for higher rates of return

3. MATURITY Maturity dates of MS held should coincide, whenever possible, with the date at
which the firm needs cash , or when the firm will no longer have cash to invest.

4. MARKETABILITY refers to how quickly a security can be sold before maturity date without a
significant price concession.

ACCOUNT RECEIVABLE (AR) MANAGEMENT

AR Management involves the determination of the amount and terms of credit to extend to
customers and monitoring receivables from credit customers.

OBJECTIVE: To collect AR as quickly as possible without losing sales from high-pressure collection
techniques. Accomplishing this goal encompasses three aspects of AR: (i) credit standards, (2) credit
terms, and (3) collection and monitoring program

Consider this trade-off:

Offering liberal and relaxed credit terms attracts more customers while it would entail more costs of
AR such as collection, bad debts and interests (opportunity costs).

FACTORS CONSIDERED IN MAKING AR POLICIES

1. CREDIT STANDARD
consider the following questions: Who (customers) will be granted credit? How much is the
credit limit?

Factors to consider in establishing credit standards — the Five 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 — customers' assets pledged to secure debt.

2. CREDIT TERMS

This defines the credit period and discount offered for customer's prompt payment. The following costs
associated with the credit terms must be considered: cash discounts, credit analysis and collections
costs, bad debt losses and financing costs.

3. COLLECTION PROGRAM
Shortening the average collection period may preclude too much investment in receivable (low
opportunity costs) and too much loss due to delinquency and defaults. The same could also result to
loss of customers if harshly implernented.