WORKING CAPITAL MANAGEMENT (WCM)
Working Capital (WC) - generally refers to current assets only. For purposes of WCM, discussion will cover
the between current assets and current liabilities (i.e., net working capital).
Working Capital Management (WCM) - involves managing the firm’s current assets and current liabilities in
order to achieve a balance between risks (liquidity) and returns (profitability).
How to Manage Working Capital:
I. Identify the WC Requirement of the Business (meaning how much working capital is need to start
and run the business and what is the type of working capital is needed.)
Types:
1. Permanent or Fixed WC – minimum working capital requirement regardless of the seasonal variations
in business operations. Normally financed by long-term debts.
2. Seasonal or Variable or Incremental WC – additional working capital needed during the more active
business season. There are 2 ways to finance this WC – a. Long-term Debt, b. Short-Term Debt
EXAMPLE:
ABC Company is a flower shop. Below are the estimated amounts of working capital needed to operate the
business in one year:
MONTH WORKING CAPITAL REQUIREMENT
January 50,000
February 100,000
March 50,000
April 100,000
May 75,000
June 50,000
July 50,000
August 50,000
September 50,000
October 50,000
November 100,000
December 50,000
How much is the permanent WC? – The Permanent WC is the lowest amount needed by the company to
operate all throughout the period. Based on the table above, the permanent WC is 50,000. Thus, in order for
the company to continue operating in the succeeding months, it must maintain a permanent working capital of
50,000.
How much is the Seasonal WC? – We can identify 4 months with additional working capital requirement –
February, April, May and November. The seasonal WC for these months are:
February – 50,000 (computed by deducting the 100,000 less the permanent WC of 50,000)
April – 50,000
May – 25,000
November – 50,000
WORKING CAPITAL FINANCING POLICIES:
1. Conservative (relaxed policy) - minimizes liquidity risk by maintaining a relatively high level of working
capital. This policy reduces liquidity risk but is considered less profitable due to more reliance on long-term
financing, which incurs relatively higher financing costs. In this policy:
- Both Permanent and Seasonal are financed by long term debt.
- Results to higher Current Asset (CA) and lower Current Liability (CL)
compared to Aggressive Policy.
2. Aggressive financing strategy a.k.a. restricted policy: operations are conducted with a minimum amount of
working capital. This policy enhances profitability by relying more on short-term debts rather than long-term
debts but is considered risky due to higher chances of short-term insolvency. In this policy:
- Permanent is financed by long-term loan and seasonal is financed by short-
term loan.
- Results to lower CA and higher CL compared to Conservative policy.
II. Implement a sound practice of WCM by:
✓ Managing cash and its temporary investment efficiently. (Cash & Marketable Securities Management)
✓ Drafting and implementing effective credit and collection policies. (Receivable Management)
✓ Seeking favorable terms from suppliers and other short-term creditors. (Short-Term Credit Financing)
✓ Ensuring efficient manufacturing operations and sound material procurement. (Inventory Management
1. CASH & MARKETABLE SECURITIES MANAGEMENT
Normally, it is not advised to hold cash on hand as it does not earn income by being left idle. “Why would a
firm hold cash when, being idle, it is a non-earning asset?” However, there are instances that company should
hold SOME cash:
Four (4) reasons for holding cash:
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 to
provide for buffer against contingencies, such as slow-down in collection and possibilities of strikes.
3) SPECULATIVE motive: cash is held to avail of profit-making opportunities (e.g., sudden price drop).
4) CONTRACTUAL motive: cash is held as required by contracts or covenants (e.g., compensating balance).
Situation 1: But what do we do with the excess cash that does not qualify the above reasons? Invest it
somewhere in order to earn passive income such as interest, dividends or royalties.
Situation 2: I invested my money somewhere (treasury notes, banks, etc.) but I will utilize the money
throughout the year? Should I withdraw all them immediately or should I withdraw them by installment? – Use
the Baumol Model to identify how much cash you should withdraw at a time.
Baumol Model computes the Optimal Cash Balance. The goal is to balance Transaction Cost and Opportunity
Cost.
Optimal Cash Balance is the amount of cash to be held on hand or withdrawn from investments.
Transaction Cost is cost of selling investments or withdrawing cash from investments.
Opportunity Cost in this topic is the passive income forgone for pulling out your money from the investment.
Baumol Model computes the Optimal Cash Balance (OCB) using the below equation:
EXAMPLE:
ANSWER:
A – 30,000 B – 60 times C – every 6 days D – 15,000 E – 3,000
Situation3: I used my cash in my operation but I the turnover is so slow that I think I’m losing profits.
-This is where the cash conversion cycle comes in.
How do we compute gaano kaiha it cash nakatied up ha iba na current assets?
Cash Conversion Cycle – a.k.a. cash flow cycle is the average time from the point cash is used to
pay for raw materials until cash is collected on the accounts receivable associated with the goods produced
with those raw materials. CCC must be distinguished from the NORMAL OPERATING CYCLE (NOC), which is
the length of time within which the firm purchases or produces inventory, sells it and receives cash.
CCC = AAI + ACP – APP
GOAL: Shorten the CCC without hurting operations.
How to Shorten:
1. Turn over inventory as quickly as possible. (discussed later.)
2. Collect AR asap. (discussed later.)
3. Manage mail, processing and clearing time.
4. Pay AP as slowly as possible without damaging firm’s credit rating. (discussed later.)
Aside from the Inventoy and AR, another thing that delays availability of Cash is FLOAT.
Concept of Float: Happens when funds were already sent by payor but not yet usable by the recipient.
Types:
1. Positive Float (Disbursement)
2. Negative Float (Collection) – Speed up collections. How: Lockbox system – check is sent to a post
office box instead of mailing it to company connected ha ira bank then bank empties na post office box
and process agad.
Components of Float:
1. Mail Float – time delay payment is mailed to when it is received
2. Processing Float – receipt of check to depositing it.
3. Clearing Float – time required by bank to clear checks.
How to deal with Float (specifically negative float) – Use Lockbox system. 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.
SAMPLE PROBLEM:
Belarus Company has daily cash receipts of P 120,000. A recent analysis of its collection indicated that
customer’s payments were in the mailing system for an average of 2.5 days. Once received, the payments
are processed in 1.5 days. After payments are deposited, it takes an average of 5 days for these receipts to
clear the banking system. Belarus considers adopting a lockbox system that will reduce the collection float
time to 7 days. Rate of return is 10%
REQUIRED:
A) How much is the reduction in collection float associated with implementing the lockbox system?
B) If the lockbox system costs P 2,500 per month, should the system be implemented?
C) What maximum amount is Belarus Company willing to pay for the lockbox system for one year?
2. ACCOUNTS RECEIVABLE
Goal: Collect ARs as quickly as possible without losing sales due to high-pressure techniques.
Techniques:
1. Credit Selection – C.I. – Standards:
a. Character – customer’s willingness to pay
b. Capacity – ability to generate cash flows
c. Capital – customer’s financial sources
d. Conditions – current general and industry-specific economic condition
e. Collateral – customer’s assets to secure debt.
2. Changing credit standards above
3. Changing the Credit Terms – (example: due date of 15 days instead of 30 days)
4. Cash Discount – (example: 2%/15, net 30.)
5. Credit monitoring – check which client pays on time, has overdue balance, etc.
SAMPLE PROBLEM:
Taiwan Corporation reports the following information:
A) Selling price per unit P 10
B) Variable cost per unit P 8
C) Total fixed costs P 120,000
D) Annual credit sales 240,000 units
E) Collection period 3 months
F) Rate of return 25%
Taiwan 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?
3. INVENTORY
Goal: Maintain levels of inventory to save costs without hurting profit.
-Hoarding too much inventory may result to oversupply and may cause the unsold products to be damaged or
put to waste.
-Keeping too little stocks may cause stockout resulting to lost profits.
Techniques:
1. Use Economic Order Quantity:
Wherein:
Ordering Cost is the cost per order of inventory
Holding Costs/Carrying Costs is the cost of carrying inventories.
NUMBER OF ORDERS = Annual Demand / EOQ
TOTAL CARRYING COST = (EOQ/2) x Carrying Cost
AVERAGE INVENTORY LEVEL = EOQ/2
TOTAL ORDERING COSTS = (Annual Demand / EOQ) x Cost per Order
WHEN SHOULD I PLACE THE NEXT ORDER?
Use the formula for reorder point. Reorder point is the LEVEL OF INVENTORY at which a new order
should be placed to replenish stock, preventing stockouts and ensuring timely order fulfillment.
Safety stock is extra inventory held to protect against unexpected increases in demand or delays in
supply.
Safety Stock = (maximum lead time – average lead time) x daily usage or daily sales
SAMPLE PROBLEM:
What is the economic order quantity for the following inventory policy: A firm sells 32,000 bags of
premium sugar per year. The cost per order is P200 and the firm experiences a carrying cost of P0.80
per bag.
2. Just in time – Raw Materials received are put to production immediately. Finished goods are sold
outright. Normally only “Work in Process” account is left in the entity’s balance sheet.
4. ACCOUNTS PAYABLE
1. Analyze Credit Terms – Remember that giving-up trade credit or cash discounts may not cause actual
costs but will generate opportunity cost.
SAMPLE PROBLEM:
China Trading purchases merchandise for P 200,000, 2/10, n/30.
REQUIRED:
A) The annual cost of trade credit.
B) The annual cost of trade credit if term is changed to 1/15, n/20.
2. For Short-term Bank Loans – Compute effective interest.
IF THE BANK LOAN IS MORE THAN 1 YEAR:
Effective Interest Rate = Interest / Usable Loan Amount*
*Usable Loan Amount = Loan amount – Discount interest – Compensating Balance
IF THE BANK LOAN IS 1 YEAR OR LESS:
Net proceeds is the same as usable loan amount.
SAMPLE PROBLEM:
North Korea Trading was granted a 180-day P 200,000 bank loan with 12% stated interest.
REQUIRED: The effective annual rate, under the following cases:
A) North Korea receives the entire amount of P 200,000.
B) North Korea is granted a discounted loan.
C) North Korea is required to maintain a compensating balance of P 10,000.
D) North Korea is required to maintain a compensating balance of 10% under a discounted loan.
3. For Commercial papers such as promissory note – Compute effective interest.
SAMPLE PROBLEM:
South Korea Company plans to sell a 180-day commercial paper amounting to P 100,000,000, which it expects
to pay a discounted interest of 12% per annum. South Korea expects to incur P 100,000 in dealer placement
fees and paper issue costs.
REQUIRED:
Determine the effective cost of South Korea’s credit.
EXERCISES:
A. Russia Company has P 1,000,000 in current assets, 40% of which are considered permanent current
assets. In addition, the firm has P 600,000 invested in fixed assets.
1. What was Russia’s permanent funding requirement?
2. What was Russia’s seasonal funding requirement?
Assume that interest rates are as follows:
✓ Short-term financing: 5%
✓ Long-term financing: 10%
1. What is the total interest expense under conservative policy?
2. What is the total interest expense under aggressive policy?
3. If Russia’s income before interest expense is 200,000, how much is the income after interest under
conservative policy?
4. If Russia’s income before interest expense is 200,000, how much is the income after interest under
aggressive policy?
B. Simile Inc. has a total annual cash requirement of P9,075,000 which are to be paid uniformly. Simile
has the opportunity to invest the money at 24% per annum. The company spends, on the average, P40 for
every cash conversion to marketable securities. What is the optimal cash conversion size?
C. What are the expected annual savings from a lock-box system that collects 150 checks per day
averaging P500 each, and reduces mailing and processing times by 2.5 and 1.5 days respectively, if
the annual interest rate is 7%?
D. The Camp Company has an inventory conversion period of 60 days, a receivable conversion period
of 30 days, and a payable payment period of 45 days. The Camp’s variable cost ratio is 60 percent
and annual fixed costs of P600,000. The current cost of capital for Camp is 12%.
If Camp’s annual sales are P3,375,000 and all sales are on credit, what is the firm’s carrying cost on
accounts receivable, using 360 days year?
E. Marsman Co. has determined the following for a given year:
Economic order quantity (standard order size) ? units
Cost to place one purchase order P 100
Cost to carry one unit for one year P4
Annual Usage 2,000,000 units
Compute the EOQ.
F. If a firm is given a trade credit terms of 2/10, net 30, then the cost to the firm failing to take the
discount is?
G. You plan to borrow P10,000 from your bank, which offers to lend you the money at a 10 percent
nominal, or stated, rate on a one-year loan. What is the effective interest rate if the loan is a discounted
loan?
H. Brazil Co. can issue 3-month commercial paper with a face value of P 1,000,000 for P 980,000. The
transaction costs would be P 1,200. What would be the annualized percentage cost of financing?
