WORKING CAPITAL MANAGEMENT

Working Capital Management – refers to the administration and control of current assets and current
liabilities to maximize the firm’s value by achieving a balance between profitability and risk.

Working Capital Financing Policies

1. Matching Policy (also called self-liquidating policy or hedging policy) – matching the maturity of
a financing source with an asset’s useful life
- Short-term assets are financed with short-term liabilities.
- Long-term assets are funded by long-term financing sources.
2. Conservative (Relaxed) Policy – operations are conducted with too much working capital;
involves financing almost all asset investment with long-term capital.
3. Aggressive (Restricted) Policy – operations are conducted on a minimum amount of working
capital; uses short-term liabilities to finance, not only temporary, but also part or all of the
permanent current asset requirement.

Cash Management – involves the maintenance of the appropriate level of cash and investment in
marketable securities to meet the firm’s cash requirements and to maximize income on idle funds.

Reasons for Holding Cash

1. Transaction Purposes – firms maintain cash balances that they can use to conduct the ordinary
business transactions; cash balances are needed to meet cash outflow requirements for
operational or financial obligations.
2. Compensating Balance Requirements – a certain amount of cash that a firm must leave in its
checking account at all times as part of a loan agreement. These balances give banks additional
compensation because they can be relent or used to satisfy reserve requirements.
3. Precautionary Reserves – firms hold cash balance in order to handle unexpected problems or
contingencies due to uncertain pattern of cash inflows and outflows
4. Potential Investment Opportunities – excess cash reserved are allowed to build up in anticipation
of a future investment opportunity such as a major capital expenditure project.
5. Speculation – firms delay purchases and store up cash for use later to take advantage of
possible changes in prices of materials, equipment and securities, as well as changes in
currency exchange rates.

The Concept of Float in Cash Management

Types of Floats:
1. Mail Float – peso amount of customers’ payments that have been mailed by a customer but not
yet received by the seller.
2. Processing Float – peso amount of customers’ payments that have been received by the seller
but not yet deposited.
3. Clearing Float – peso amount of customers’ checks that have been deposited but not yet cleared.
Cash Management Strategies
1. Accelerate cash collections
2. Control disbursements
3. Reduce the need for precautionary cash balance

OPERATING CYCLE – the amount of time that elapses from the point when the firm inputs materials
and labor into the production process to the point when cash is collected from the sale of finished
goods.

ECONOMIC CONVERSION QUANTITY (Optimal Transaction Size) – the amount of marketable

securities that must be converted to cash (or vice versa), considering the conversion costs and
opportunity costs involved.

Marketable Securities – short-term money market instruments that can easily be converted to cash.

Reasons for holding Marketable Securities

1. MS serve as substitute for cash balances
2. MS serve as a temporary investment that yields return while funds are idle
3. Cash is invested in MS to meet known financial obligations such as tax payments and loan
amortizations

Accounts Receivable Management – formulation and administration of plans and policies related to
sales on account and ensuring the maintenance of receivables at a pre-determined level and their
collectability as planned.

Ways of Accelerating Collection of Receivables

1. Shorten credit terms
2. Offer special discounts to customers who pay their accounts within a specified period
3. Speed up the mailing time of payments from customers to the firm
4. Minimize float, that is, reduce the time during which payments received by the firm remain
uncollected funds

Aids in Analyzing Receivables

1. Ratio of receivables to net credit sales
2. Receivable turnover
3. Average collection period
4. Aging of accounts
INVENTORY MANAGEMENT - Formulation and administration of plans and policies to efficiently and
satisfactorily meet production and merchandising requirements and minimize costs relative to
inventories.

Economic Order Quantity – the quantity to be ordered, which minimizes the sum of ordering and
carrying costs.

2 𝑥 𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 𝑥 𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑚𝑎𝑛𝑑

𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐶𝑜𝑠𝑡

Assumptions of the EOQ Model:

1. Demand occurs at a constant rate throughout the year.
2. Lead time on the receipt of the orders is constant.
3. The entire quantity ordered is received at one time
4. The unit costs of the items ordered are constant.
5. There are no limitations on the size of the inventory.

Reorder Point – when to reorder is a stock-out problem. The objective is to order at a point in time so
as not to run out of stocks before receiving the inventory ordered but not so early that an excessive
quantity of safety stock is maintained.

SHORT-TERM FINANCING
1. Accounts Payable – the major source of unsecured short-term financing.

 Stretching accounts payable – a firm should pay the bills as late as possible without
damaging its credit rating. When a firm can stretch the payment of accounts payable, the
cost of foregoing the discount is reduced.

2. Bank Loans
a. Single-payment notes – if the interest is payable upon maturity, the effective interest rate is
equal to the nominal rate.
b. Discounted note – the effective interest rate is higher than the nominal rate.
c. Compensating balance – an arrangement whereby a borrower is required to maintain a
certain percentage of amount borrowed as compensating balance in the current account of
the borrower.
 Working Capital Management - Trainer Part 1

Problem 1: Magnus Company is a wholesaler. It purchases 800,000 units of Product X each year for sale to
retailers. The cost of placing an order is P 40. The cost of holding one unit of inventory for one year is P 4.

Required:
1. Compute the EOQ.
2. How many orders would Magnus place under the EOQ policy?
3. Compute the annual carrying cost for the EOQ.
4. Compute the annual ordering cost for the EOQ.

Problem 2: The Hikaru Company purchases 45,000 units of bleaching soap per year. The average purchase
lead time is 20 working days. Maximum lead-time is 26 working days. The company works 300 days per year.

Required:
a. Units of safety stock that the Company should carry?
b. The reorder point for bleaching soap.
c. Assume that the lead time is always 20 days and no delay in delivery has been experienced by the
company. What is the reorder point? How many units of safety stock must be kept by the company in
this case?

Problem 3: Wesley Company estimates its total cash outlays at P160 million during the coming year. The
company normally spends P30 to transfer cash from marketable securities to cash in bank and vice versa.
The marketable securities portfolio currently earns a 4% annual rate of return.

Requirements:
1. Optimal transaction size.
2. Average cash balance.
3. Total annual cost of cash if the company adopts the optimal transaction size.
4. Minimum and maximum cash balances.
5. Assume that the company has to keep P100,000 balance in the bank as safety cash. Repeat
your solution for the first four requirements.

Problem 4: Consider the following date for Ding Corporation:

Cash Sales 3,200,000

Credit Sales 28,800,000
Cost of goods sold 4,374,000
Purchases (80% on account) 17,280,000
Accounts receivable, beginning 820,000
Accounts receivable, ending 1,100,000
Averaged finished goods inventory 364,500
Raw materials used 3,060,000
Average raw materials inventory 170,000
Average accounts payable 384,000

The firm spends 25,200,000 in operating cycle investments each year, at a constant rate. Assume a 360-day
year.
Required:
a. Calculate the firm’s operating cycle.
b. Calculate the firm’s cash conversion cycle.
c. Calculate the amount of resources needed to support the firm’s cash conversion cycle.

Problem 5: Compute the approximate and the effective annual cost of foregoing the cash discount
for each of the following scenarios of Anish Company:

Supplier A : 3/10 net 50

Supplier B : 2/10 net 60

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. Evaluate each
supplier separately.

Problem 6: Fabi Company is negotiating with the Oslo Bank Company for a 1-year P2 million loan. The
bank has offered the company the following alternatives. Calculate the effective annual interest rate for
each of the following.

1. A 9 percent annual rate on a simple interest loan, with no compensating balance required and
interest due at the end of the year.

2. An 8.5 percent annual rate on a simple interest loan, with a 15 percent compensating balance
required and interest again due at the end of the year.
3. An 8 percent annual rate on a discounted loan, with a 20 percent compensating balance.
4. A 7.5 percent add-on loan, payable in twelve equal installments.

Problem 7: Nepo company obtained a short-term bank loan of P 2 million at an annual interest rate of 10%. As
a condition of the loan, the company is required to maintain a 20% compensating balance in its checking account.
The checking account earns interest of 5% per annum. Before the loan was granted, the company maintained a
balance of P 100,000 in its checking account. Compute the effective interest for this loan.