CHAPTER III

WORKING CAPITAL MANAGEMENT

LEARNING OUTCOMES
At the end of this discussion, the student must be able to:

1. Define and identify the composition of a working capital.

2. Understand the objectives and importance of working capital
management.
 WORKING CAPITAL MANAGEMENT

Working Capital Management refers to the administration and control of

the more liquid resources to make sure that they are sufficient to cover day-to-
day business operations including anticipated contingencies. It involves the
determination of the level, quality and maturity of each major current liability and
also involves the financing and management of the current assets of the firm.
The amount by which current assets exceed current liabilities is significant in the
financial management for two important reasons:

1. Working capital represents a margin of safety for short term creditors.

Current assets are likely to yield a higher percentage of their book value
on liquidation than do fixed assets. Hence, short term creditors look at the
current assets as a source of repayment of their claims.
2. The amount of working capital represents the extent to which current
assets are financed from long term sources. Although current assets are
turned over within relatively short periods, they always represent some
percentage of sales. In this sense, a portion of current assets must be
owned by the firm permanently.

Working capital management involves the relationship between a

firm’s short-term assets and its short-term liabilities. Its goal is to ensure that a
firm is able to continue its operations and that it has sufficient ability to satisfy
both maturing short-term debt and upcoming operational expenses. The
management of working capital involves managing cash, accounts
receivables, inventories and accounts payables.
Working capital is often defined as the difference between current
assets and current liabilities. Practically speaking, it is the cash required to run
the daily, weekly or monthly operations of a business. Therefore, it is the
process of managing the short-term assets and liabilities so that a firm has
sufficient liquidity to run its operations smoothly.
 Working capital is a vital part of a business and can provide the
following advantages:
a. Higher return on capital;
b. Improved credit profile;
c. Higher profitability;
d. Higher liquidity;
e. Increased business value;
f. Favourable financing conditions;
g. Uninterrupted production; and
h. Competitive advantage

CASH MANAGEMENT
Cash
It includes all currency and cash items on hand (such as cash for deposits
and cash in working funds) as well as peso or foreign currency deposits in banks
which are unrestricted and immediately available for use in the current operations
of a certain business. Cash is a “non-earning” asset in the sense that cash itself
or commercial checking account earns no interest or very little interest. It is
needed to pay for labor, raw materials, taxes, debts or dividends and to buy fixed
assets.

Objectives of Cash Management

Cash management refers to the most effective way of handling cash or its
equivalent, in a manner intended to result in its most efficient use. It involves the
maintenance of cash and marketable securities investment level which will
enable the company to meet its cash requirements and at the same time
optimize the income on idle funds. Enough amounts of cash should be
maintained to meet daily operating requirements, which is neither too high nor
too low. A financial officer has the following specific objectives in monitoring cash
balances:
1. To meet the cash disbursement needs (payment schedule);
 2. To minimize the funds committed to transactions and precautionary cash
balances; and
3. To avoid misappropriation and handling losses in the normal course of
business.

Reasons for holding Cash

Despite the fact that cash is generally considered a non-earning asset,
business firms have to hold cash for the following reasons:
1. Transaction motive. Cash is needed to facilitate the normal transactions
of the business that is, carrying out its purchases and sales activities.
2. Precautionary motive. Cash may be held beyond its normal operating
requirement level in order to provide for a buffer against contingencies
such as unexpected slowdown in accounts receivable collection, strike or
increase in cash needs beyond management's original projections.
3. Speculative motive. Cash is held ready for profit-making or investment
opportunities that may come up such as a block of raw materials inventory
offered at discounted prices or a merger proposal.
4. Contractual motive. A company may be required by a bank to maintain a
certain compensating balance in its demand deposit account as a
condition of a loan extended to it.

Determining Cash needs

The optimal cash balance may be derived with the use of the following
basic approaches, namely:

1. Cash budget. The firm estimates its need for cash as a part of its general
budgeting or forecasting process. First, it forecasts sales. Next, it
forecasts the fixed assets and inventories that will be required to meet the
forecasted sales level. Assets purchases and the actual payment for them
are then put on a time scale, along with the actual timing of the sales and
the timing of collection from sales.
 Gibeon Manufacturing Company
Cash Budget
For the Budget Year Ending December 31, 202A
Cash Balance, January 1, 202A P140,000
Add: Estimated Receipts
Collections from Customers P5,175,000
Sale of Assets 30,000
Total P5,205,000
Total cash available P5,345,000
Less: Estimated disbursements
Payment for material purchases P1,160,000
Direct labor 900,000
Manufacturing Overhead 740,000
Manufacturing and Administrative Expenses 1,450,000
Payments for income tax 262,000
Dividends 150,000
Reduction in long-term debt 85,000
Acquisition of new assets 330,000
Total Disbursements P5,077,000
Cash balance, December 31, 202A P268,000

2. Cash break-even chart. This chart shows the relationship between the
company's cash needs and cash sources. It indicates the minimum
amount of cash that should be maintained to enable the company to meet
its obligations.
¿ Costs ¿
Cash Cash
BEP =
Contribution per unit
Following is the diagrammatic representation of cash break-even chart:
3. Optimal cash balance model. In most medium or large-sized
corporations, liquidity management has assumed a greater role over the
past decade. Since cash is needed for both transactions and
precautionary needs in all companies, it must be available in some form,
(cash, marketable securities, borrowing capacity) all of the time. The
liquidity managers must utilize some formal models or techniques to
maintain the optimal amount at each moment in time because too much
liquidity brings down the rate of return on total assets employed and too
little liquidity jeopardizes the very existence of the firm itself. In managing
the level of cash (currency plus demand deposits) for transaction
purposes versus near cash (marketable securities), the following costs
must be considered:
1. Fixed and variable brokerage fees, and
2. Opportunity costs such as interest foregone by holding cash instead
of near cash.
One of the models that can be used to help determine the optimal
cash balance is the “Baumol Model”. This model balances the
opportunity cost of holding cash against the transaction costs associated
with replenishing the cash account by selling off marketable securities or
by borrowing.
The optimal cash balance can be calculated by using the following
variables and equations:
1. The total costs of cash balances consists of a holding (or
 opportunity) cost plus a transaction cost:
Total Cost = Holding Costs + Transaction Costs
= (Average Cash Balance) (Opportunity Costs) +
(Number of Transactions) (Cost per
Transaction)
C T
= ( K )+ ( F )
2 C
Where:
C = amount of cash raised by selling marketable securities or
by borrowing
C = average cash balance
2

C* = optimal amount of cash to be raised by selling marketable

securities or by borrowing
C* = optimal average cash balance
2

F = fixed costs of making a securities trade or of obtaining a

loan
T = total amount of net new cash needed for transactions
during the period (usually a year)
k = opportunity cost of holding cash is equal to the rate of
return foregone on marketable securities or the cost of
borrowing to hold cash.
2. The minimum costs of cash balances are achieved when C is set
equal to C*, the optimal cash transfer. The formula to find C* is as
follows”

C ¿=
√ ( )(
2 Total amount of net ¿ costs of trading securities
new cash required ¿ cost of borrowing
Opportunity cost of holding cash
)
 C ¿=
√ 2 (T ) ( F )
K

Illustrative Case: Determination of Optimal Average Cash Balance

Consider a business with total payments of P10 million for one year, cost
per transaction of P200, and the interest rate on marketable securities is 10%.
The optimal cash balance is calculated as follows:

C ¿=
√ 2 (10 Million )( 200 )
10 %

= P200,000

Optimal Cash Balance = P158,114

2

= P 79,057

The firm may also want to hold a safety stock of cash to reduce the
probability of a cash shortage to some specified level. The Baumol Model is
simple in many respects. Other models have been developed to deal both with
uncertainty in the cash flows and with trends. All of these models, including the
Baumol Model, can provide a useful starting point for establishing a target cash
balance, but all of them have limitations and must be applied with judgment.

Techniques for Lessening Cash Needs

Part of the cash management job is to see to it that the company
maintains the same level of activity and profitability without using as much cash
as compared before one started managing cash. This may be accomplished by:

I. Accelerating Cash Collections

 A method that accelerates collections to lessen the firm's need for cash.
This may be accomplished through:
1. Prompt billing.
2. Offering trade and cash discounts.
3. Mechanical procedures such as enclosure of self-addressed return
envelopes with the bill to make it easier for the customer to mail
payments.
4. Maintenance of regional collection office.
5. Customer making direct payment to the firm's depository banks which
reduces the time required for a firm to receive incoming checks, to
deposit them and to get them cleared through the banking system.
6. Payment by wire. Most large firms require payments of larger bills by
wire, or even by automatic debits. This is, of course, the ultimate in
speeded-up collection process, and computer technology in making
such a process increasingly feasible and efficient.

II. Slowing Disbursements

An action on the part of the finance officer which slows the disbursement of
funds to lessen the use for cash. This can be done by:
1. Centralized processing of payables
This permits the finance manager to evaluate the payments
becoming due for the entire firm and to schedule the availability of funds
to meet these needs on a company-wide basis. It also results to more
efficient monitoring of payables and float balances. Care however
should be taken so as not to create ill will among suppliers of goods and
services or raise the company's cost if bills are not paid on time.
2. Zero balance accounts (ZBA)
These are special disbursement accounts having a zero peso
balance on which checks are written. As checks are presented to a ZBA
for payment, funds are automatically transferred from the master
account.
 3. Delaying payment
If one is not going to take advantage of any offered trade discount
for early payment, pay on the last day of the credit period.
4. “Play the float”
This involves taking advantage of the time it takes for the
company's check to clear the banking system.
5. Less frequent payroll
Instead of paying the workers weekly, they may just be paid semi-
monthly.

III. Reducing the Transactions and Precautionary Idle Cash

Since the transaction and precautionary motives are the important
determinants of the cash requirement, factors influencing their combined
level in the firm must be analysed. There are techniques that are available
for reducing the need for precautionary balances:
1. More accurate cash budgeting
Most critical is the accuracy of the cash budget or forecast. The
closer the fit between cash inflows and outflows, the more certain the
forecasts and hence the less need for precautionary balances.
2. Lines of credit
This is a pre-arranged loan where the company can withdraw
anytime within the period agreed upon.
3. Temporary investments
Investments in highly liquid securities may be maintained instead of
holding idle precautionary cash balances.

Safeguarding cash against losses

Conservation of cash would require its economical use and the provision
of built-in safeguards to prevent cash losses arising from theft or negligence.
Prevention of cash losses is particularly important in businesses with a sizable
volume of daily cash receipts or cash withdrawals, such as banks, department
stores, grocery and sari-sari stores, daily newspaper publications, transportation
companies and others. Here are some strategies in preventing cash losses:
1. Periodic audit of accounting records. These serve the purpose of testing
the accuracy of the recording of accounts in order to avoid fraud.
2. Surprise cash counts of money in the custody of the cashier.
Manipulation of cash in vault could be effected which may later on result in
serious losses. The total amount of cash on hand should correspond to the
amount stipulated in the issued receipts.
3. Life Style Checking. A cashier's honesty and integrity are plus factors in
cash conservation. It is also customary to require cashiers to file surety
bonds.
4. Regular deposit of cash receipts. A bank reconciliation statement verifies
the accuracy of their monthly current account statement balance.
5. The provision of counterchecks. A monetary transaction is not permitted
to start and end with only one person involved. There is a series of
counterchecks, for example, in a department store to prevent inventory and
cash losses. For instance, collection starts with the sales girl,
counterchecked by the cashier as to the quantity and price of the goods.
The duplicate copies of official receipts go to the accounting department for
verification. And the official receipts attached to the wrapper of specific
design allow security guards to check the out-flow of inventories.

Cash Conversion Cycle

Another important consideration in current asset management is the cash
conversion cycle of the company. Cash conversion cycle is the average length of
time involved – from the payment of raw materials to the collection of accounts
receivable. This is determined using the following formula:

Inventory + Receivable - Payable = Cash

Conversion Collection Deferral Conversion
Period Period Period Cycle
Inventory conversion period is the average time required to convert
materials into finished goods and then to sell these goods. It is computed
as follows:

Inventory Conversion Period = Average Inventory

Costs of Sales per day*

*Costs of Sales per day is computed by dividing the Cost of Sales in a

given year by 360 days.

Receivable collection period is the average length of time required to

convert the firm's receivables into cash, that is, to collect cash following a
sale. This is also called the days sales outstanding (DSO), and it is
computed as follows:

Receivable Collection Period = Average Receivables

Credit Sales / 360 days

Payables deferral period is the average length of time between the

purchase of materials and labor and the payment of cash for them. It is
computed as follows:

Payables Deferral Period = Average Payables

Purchases per day

or

Average Payables
Cost of Sales per year
Illustrative Case I: Cash Conversion Cycle

CBEA Inc. generated this year a total sales of P2,000,000 all of which are on
credit and with a gross profit rate of 40% of total sales. They have an average net
trade receivable of P875,000, an average inventory of P675,000 and an average
payable of P715,000. Compute for the cash conversion cycle.

1. Inventory Conversion = Average Inventory

Period Cost of Sales per day

= P675,000
P1,200,000/360 days

= P675,000
3333.33

= 202.50 days

This means that CBEA Inc. takes an average of 202.50 days to convert its
raw materials into finished goods and to sell it.

2. Receivable Collection = Average Receivables

Period Credit Sales / 360 days

= P875,000
P2,000,000 / 360 days

= P875,000
5555.55

= 157.50 days

This means that CBEA Inc., takes an average of 157.50 days to collect its
outstanding receivables.
 3. Payables Deferral Period = Average Payables
Cost of Sales / 360 days

= P715,000
P1,200,000 / 360 days

= P715,000
3333.33

= 214.50 days

This means that CBEA Inc. takes an average of 214.50 days before it can
pay its purchases that are used in production.

4. Cash Conversion Cycle

This nets out the three periods defined and which therefore equals the
length of time between the firm's actual cash expenditures to pay for
productive resources (materials and labor) and its cash receipts from the
sale of products (that is, the length of time between paying for labor and
materials and collecting of receivables). The cash conversion cycle thus
equals the average length of time a peso is tied up in current assets.

Inventory + Receivable - Payable = Cash

Conversion Collection Deferral Conversion
Period Period Period Cycle

202.50 days + 157.50 days - 214.50 days = 145.50 days

Illustrative Case II: Acceleration of Cash Receipts

Abubot Fashion Designs is evaluating a special processing system as a
cash receipts acceleration device. In a typical year, this firm receives remittances
totaling P7 million by check. The firm will record and process 4,000 checks over
the same time period. First National Bank has informed the management of
Abubot Fashion Designs' that it will process checks and associated documents
through the special processing system for a unit costs of P0.25 per check.
Abubot Fashion Designs' financial manager has projected that cash freed by
adoption of the system can be invested in a portfolio of near-cash assets that will
yield an annual before-tax return of 8%. Abubot Fashion Designs' financial
analysts use a 365-day year in their procedures.

Required:
a) What reduction in check collection is necessary for Abubot Fashion
Designs to be neither better nor worse off for having adopted the
proposed system?
b) How would your solution to (a) be affected if Abubot Fashion Designs
could invest the freed balances only at an expected annual return of
5.5%?
c) What is the logical explanation for the differences in your answers to (a)
and (b) above?
Solution:
a) Initially, it is necessary to calculate Abubot Fashion Designs' average
remittance check amount and the daily opportunity cost of carrying
cash.The average check size is:
P7,000,000 = P1,750 per check
4,000

The daily opportunity cost of carrying cash is

0.08 = 0.0002192 per day

365

Next, the days saved in the collection process can be evaluated according
to the general format of
added costs = added benefits
or
 P = (D) (S) (I)

P0.25 = (D) (P1,750) (0.0002192)

0.6517 days = D
Abubot Fashion Designs therefore will experience a financial gain if it
implements the special processing system and by doing so will speed up its
collection by more than 0.6517 days.

b) The daily opportunity cost of carrying cash is

0.055 = 0.0001507 per day

365

For Abubot Fashion Designs to break-even, should it choose to install the

special processing system, cash collections must be accelerated by
0.9480 days, as follows:

P0.25 = (D) (P1,750) (0.0001507)

D = 0.9480 days
c) The break-even cash-acceleration period of 0.9480 days is greater than
the 0.6517 days found in (a). This is due to the lower yield available on
near-cash assets of 5.5% annually, versus 8.0%. Since the alternative rate
of return on the freed-up balances is lower in the second situation, more
funds must be invested to cover up the cost of operating the special
processing system. The greater cash-acceleration period generates the
increased level or required funds.
Illustrative Case III: Valuing Float Reduction
Next year, Miguel Motors expects it gross revenues from sales to be P80
million. The firm's treasurer has projected that its marketable securities portfolio
will earn 6.50% over the coming budget year. What is the value of one day's float
reduction to the company? Miguel Motors uses a 365-day year in all of its
financial analysis procedures.

Solution:
Value of one day's float = P80 million x 6.5%
reduction 365

= P14,247

The company will earn P14, 247 per year if it is able to invest its one day
sales at 6.5%.
 EXERCISE 2.1

Problem 1
Pink Company presented selected data as follows:

P4,680,00
Net Credit Sales 0
Cost of Sales 2,808,000
Net Credit Purchases 3,240,000
Average Receivables 455,000
Average Accounts
Payables 72,000
Assume 360-day year.
Average Inventory 226,200
Compute for the average number
of days in the company’s:
1. Inventory conversion period________
2. Receivable Collection Period________
3. Payable Deferral period________
4. Cash Conversion Cycle________

Problem 2
Marivic Corporation has an inventory conversion period of 75 days, an average
collection period of 38 days, and a payables deferral period of 30 days.
a. What is the length of the cash conversion cycle?
b. If Marivic’s annual sales are P3,421,875 and all sales are on credit, what
is the investment in accounts receivable?
Problem 3
ABC Trading Company’s actual furniture sales and purchases for May are shown
here along with forecasted sales and purchases for June through October:

Purchase
Sales s
P300,00 P150,00
May( Actual) 0 0
June ( forecast) 200,000 120,000
July ( forecast) 250,000 110,000
August ( forecast) 300,000 150,000
September
(forecast) 250,000 130,000
October( Forecast 500,000 200,000
 )

All sales and purchases are made on credit. 20% of the credit sales are collected
within the month of sale, 50% of the credit sales are collected the month
following the sale and 30% are collected two months after the month of sale.

ABC pays for 30% of its purchases in the month following the purchase and 70%
in the second month following the purchase.

Monthly labor expense are estimated to be 10% of the current month’s sales.
Overhead expenses equals 10,000 per month. Interest payments of P20,000 are
due in August and October. Tax payments of P30,000 are due in June and
September. There is a scheduled capital outlay of P50,000 in October.

ABC’s ending cash balance in June is P50,000.

Required: Prepare a schedule of monthly cash receipts, monthly cash payments,

and a complete monthly cash budget for July through October.

Problem 4
A company uses the “baumol” formula in determining its optimal level of cash.
Assume that the fixed cost of selling marketable securities is P20 per transaction
and the interest rate on marketable securities is 6% per year. The company
estimates that it will make cash payments of P100,000 over one year period.
What is the optimal cash balance?

Problem 5

Ben Corporation uses the Baumol Cash Management Model to determine its
optimal cash balance. For the coming year, the expected cash disbursements
total P432,000. The interest rate for marketable securities is 5% per annum. The
fixed cost of selling marketable securities is P8 per transaction.

Using the Baumol Cash Management Model, the company's optimal cash
balance is ______
Using the Baumol Cash Management Model, the average cash balance is
______________

Problem 6
Data Company’s average annual cash payments amounts to P15,600,000. Each
transaction costs P50 and the interest rate on marketable securities is 6%.
Compute for the optimal cash balance.
Problem 7
Lucky Company expects it gross revenues from sales to be P105 million. The
firm's treasurer has projected that its marketable securities portfolio will earn
8.50% over the coming budget year. What is the value of one day's float
reduction to the company? Lucky Company uses a 365-day year in all of its
financial analysis procedures.

Problem 8
A firm purchased raw materials on account and paid for them within 30 days.
The raw materials were used in manufacturing a finished good sold on account
100 days after the raw materials were purchased. The customer paid for the
finished good 60 days later. The firm's cash conversion cycle is ______ days.

Problem 9
Bully Corporation purchases raw materials on July 1. It converts the raw
materials into inventory by September 30. However, Bully pays for the materials
on July 20. On October 31, it sells the finished goods inventory. Then, the firm
collects cash from the sale 1 month later on November 30. If this sequence
accurately represents the average working capital cycle, what is the firm's cash
conversion cycle in days?

Problem 10

For the Cook County Company, the average age of accounts receivable is 60
days, the average age of accounts payable is 45 days, and the average age of
inventory is 72 days. Assuming a 360-day year, what is the length of the firm’s
cash conversion cycle?
RECEIVABLE MANAGEMENT

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.
Credit and Collection policies refer to the sets of operating procedures that
are designed to facilitate the effective administration of a company’s credit and
collection transactions. These policies are dependent on two major points, which
are:
1. The fact that economic and competitive conditions can substantially
influence the company’s decisions on such policies; and,
2. That the company’s credit and collection policies consist of a resolution of
trade-offs across many operating decision variables, such as:
 Credit standards
 Credit terms or period
 Discounts
 Collection policy
Any decision with regard to changes in the policy of a company should
involve a comparison of possible gains and costs which will vary from time to
time until the company achieves an optimal solution, or the best combination of
credit standard, credit period, cash discount policy and the level of collection
expenditures. Credit and collection policies are interrelated with the pricing of a
similar product or service and must be viewed as part of the overall competitive
process, since it is accounted for in the specification of the demand function as
well as the opportunity cost associated with taking on additional receivables.
In measuring the effects of a credit policy on the other current fund
considerations, one should be aware of the increase in inventories and cash
requirement to support the higher levels of sales resulting from a more liberal
credit policy. Therefore, the relationships between and among increased
demand, average collection period, quality of accounts receivables, credit rating
and other variables associated with credit policy should be accounted for since
these affect the ability of the firm to secure its own short term financing.

Factors in Determining Accounts Receivable Policy

1. Credit Standards
Credit standards consist of set qualifications, which a company must apply
in order to enable management to determine the customers to whom regular
credit terms should be extended and the amount of credit it should extend to
every customer. A company must develop a system of credit standards in
order to evaluate the credit worthiness of its present and potential customers.
However, this does not guarantee that poor credit risks will be totally
eliminated, but it will definitely enhance the probability that its credit personnel
will be guided accordingly in making the correct decision, which should be
based on the assumption that the system is used fairly and consistently.
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. Evaluating the past credit history like customer’s
payment habits and attitudes and its willingness to pay.
2. Capacity. Evaluating the customer’s ability to pay as reflected in his
personal cash flows.
 3. Conditions. Evaluating the factors that are exogenous and beyond
the control of the company.
4. Capital. Evaluating the assets and earning capacity of the customer
5. Collateral. Determining any asset in which the customer has
available and is willing to put on pledge as against the debt.
Credit policy can have a significant influence upon sales. If credit
policy is relaxed, while sales may increase, the quality of accounts receivable
may suffer. This may result into longer average collection period. On the other
hand, if credit policy is tight, it reduces the problem of tying up funds in
receivable and bad debts but it will prevent the company from optimizing its
sales potential. An optimal credit policy would involve extending trade credit
more liberally until the marginal profitability on additional sales equals the
required return on the additional investment in receivables. Or it is a trade-off
between the profits on sales that give rise to receivables plus bad-debt losses
on the other.
Incremental approach is used in evaluating alternative credit and
collection policies. The decision to whether to relax or tighten a credit policy
will depend on whether the benefits expected on the increase in sales exceed
the costs, which consists of the sum of the incremental processing costs and
additional bad debts resulting from the incremental sales, and the opportunity
cost of higher investment in receivables due to the increase in sales. In order
for the company to determine whether to relax or tighten its credit standards,
it should identify:
1. Profitability of additional sales;
2. Added demand for products due to relaxed credit standards;
3. Increased slowness of the average collection period; and
4. The required return on investment.
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 the 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.
The credit period is a flexible factor which management can use in
influencing product demand. Its extension will probably increase sales and
profits so long as it compensates for the opportunity costs on the expected
returns in investment in accounts receivable. On the other hand, giving out
discounts to customers on credit is an attempt to speed up collection
however, will reduce gross margins and at the same time will have an effect
on the demand and bad debt losses.
3. Collection Program
Collection program is a set procedures that a company follows to collect
accounts receivable. 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.
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 that provides the greatest marginal
benefit.
Costs Associated with 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:
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 > Incremental Cost ;then accept the change in
credit contribution policy

2. Incremental profit < Incremental Cost ;then reject the change in

credit contribution policy

3. Incremental profit = Incremental Cost ;then be indifferent to the

contribution change in credit policy

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

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

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.
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
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.
 EXERCISE 2.2

1. For the Flesher Company, the average age of accounts receivable is 48 days,
the average age of accounts payable is 32 days, and the average age of
inventory is 59 days. Assume a 360-day year. If McIntyre's annual sales are
P2,050,200, what is the firm's investment in accounts receivable?

2. A company plans to tighten its credit policy. The new policy will decrease the
average number of days for collection from 75 to 50 days and will reduce the
ratio of credit sales to total revenue from 70% to 60%. The company
estimates that projected sales will be 5% less if the proposed new credit
policy is implemented. If projected sales for the coming year are P50 million,
calculate the dollar amount of accounts receivable of this proposed change in
credit policy. Assume a 360-day year.

3. Real Company’s budgeted sales for the coming year are P50,000,000 of
which 75% are expected to be credit sales at terms of n/30. Real estimates
that a proposed relaxation of credit standards will increase credit sales by
20% and increase the average collection period from 30 days to 40 days.
Based on a 360-day year, the proposed relaxation of credit standards will
increase average accounts receivable balance by what amount?

4. A firm sells on terms of 2/10 net 60. It sells 1,000 units per day at a unit price
of P10. On 60% of sales, customers take the cash discount. On the remaining
40% of sales, customers pay, on average, in 70 days. What would be the
decrease on the balance of accounts receivable if the firm initiates a more
aggressive collection policy and is able to reduce the average payment period
to 60 days for those customers not taking the cash discount? (Assume sales
levels are unaffected by the change in policy.)
5. Hat Co. is considering a proposal to relax its credit standards. If the proposal
is accepted, total credit sales will increase by 10% which represents sales to
new customers. New customers will be given 60 days to settle their account.
With the present policy, sales per year amounts to P5 million, 15% of which is
credit sales. Variable cost ratio is 60%. Cost of capital is 10%. Assume 360-
day in a year. If the proposal is implemented, and if the payment behavior of
the existing customers will not change, what will be the Increase or decrease
in contribution margin ___________
INVENTORY MANAGEMENT

Inventory management refers to the development and administration of

inventory policies, systems, and procedures necessary to efficiently and
satisfactorily meet inventory requirements at the minimum cost possible. It
requires the coordination of both purchasing and financing functions to effectively
manage inventory. Turnover formulas can be used not only to test the efficiency
of inventory utilization but also to measure the efficiency in purchasing, stock
management and selling activities.

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.
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) Model and Reorder point.

Economic Order Quantity is the order size or the appropriate number of

units 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:

1. prices are stable.

2. supply of goods is stable.
3. demand or use in a given period is uniform.
EOQ is computed as follows:

EOQ=
√ 2 ( Annual Demand ) (Ordering Costs )
CarryingCosts

Annual Demand (AD) refers to the total estimated demand for the given
product.

Ordering Costs (OC) refers to cost 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) refers to costs incurred in holding or carrying an
inventory. It includes:

 Storage space costs (i.e. warehouse rental or depreciation and

security costs);
 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:

Annual Demand ∈units

Total Ordering Costs= x Ordering Costs per order
EOQ

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

 EOQ
Average Inventory=
2

Another use of the EOQ model is to help the management in deciding

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

ℜ−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 ∈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 per year while
ordering costs are estimated at P25.

a. Determine the economic order quantity for the sets of wine glasses.
Answer:

EOQ =
√ 2 ( Annual Demand ) ( Ordering Cost per order )
Carrying cost per unit

EOQ =
√ 2 ( 800 )( 25 )
1

= 200 units per order

b. Determine the annual inventory costs for the firm if it orders in this
quantity.
Answer:

Total inventory costs=Total Ordering Costs+Total CarryingCosts

= [ AD
EOQ
x OC +
][
EOQ
2
x CC
]
= [ 800 units
200 units ][
x P 25.00 +
200 units
2
x P1
]
= [ P100 ] + [ P 100 ]

= P200
Illustrative Case II:

Given the following inventory information and relationships for the Baguio
Corporation:

IV. Orders can be placed only in multiples of 100 units.

V. Annual unit usage is 300,000. (Assume a 50-week year in your
calculations.)
VI. The carrying cost is 30 percent of the purchase price of the goods.
VII. The purchase price is P10 per unit.
VIII. The ordering cost is P50 per order.
IX. The desired safety stock is 1,000 units. (This does not include delivery-
time stock.)
X. 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?

Solution:

3. EOQ =
√ 2 ( Annual Demand ) ( Ordering Cost per order )
Carrying cost per unit
= 3,162 units

but since orders must be placed in multiples of 100 units , the effective
EOQ becomes 3,200.
 Annual Demand
4. Number of Orders =
EOQ
= 94.87 orders per year

5. Reorder Point = Lead Time Usage + Safety Stock

=

[ Annual Demand
Est .no . of weeks∈a year ]
x Lead Time + Safety Stock

= [ 300,000 units
50 weeks ]
x 2 +1,000 units

= 13,000 units

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

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.
 EXERCISE 2.3

Problem 1

Yellow Corp. trades plain shirts. Average annual demand for the five previous
years is 40,000 units. Yellow expects the same trend of demand for 2018. Every
order from its supplier would cost P57.60. Annual warehousing costs for each
unit amounts to P5.

1. What is the optimal inventory quantity?

2. What is the average inventory for 2018?

3. How many orders are expected to be made during 2018?

4. How much is the total carrying costs?

5. How much is the total ordering costs?

Problem 2

Solve Inc. buys and sells quality pillows for an annual demand of 1,000,000. It
determined the inventory level of 3,600 to be incurring the least amount of
inventory-related costs and orders this amount for every order from its supplier.
To ascertain availability of inventory stock during periods of high demand, it also
holds a buffer stock of 400 units. Every order made is received within three days.
Annual carrying costs for every unit is P2.50.

1. How much is the average daily usage?

2. How much is the lead time usage?

3. Determine the reorder point.

4. How much is the total carrying costs?

5. How much is the total inventory-related costs?

Problem 3

Shane Traders, Inc. sells cellphone cases which it buys from a local
manufacturer. Emil Traders sells 24,000 cases evenly throughout the year. The
cost of carrying one unit in inventory for one year is P11.52 and the order cost
per order is P38.40.

1. What is the economic order quantity? _________________________

2. If Emil would buy in economic order quantities, the total order costs is
______________
3. If Emil Traders would buy in economic order quantities, the total inventory
carrying costs per year is __________________
4. If the annual demand increases by 44%, the EOQ will increase (decrease) by
(state in %) _________________

Problem 4

A. Given the following inventory information and relationships for the Galaxy,
Inc.:
I. Annual unit usage is 500,000. (Assume a 50-week year)
II. The carrying cost is 60% of the purchase price.
III. The purchase price is P25 per unit.
IV. The ordering cost is P60 per order.
V. The desired safety stock is 5,000 units
VI. Lead time is 2 weeks.

Required:

1. Determine the Economic Order Quantity_______

2. How many times orders are placed annually? __________
3. At what inventory level should reorder be made (Re-order point)?
__________