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Financial Management Part 1

MODULE 6/7 WORKING CAPITAL MANAGEMENT, FINANCING CURRENT ASSETS CONTENT CAPSULE: Basic concepts and significance of working capital management Working capital policy Cash and marketable securities management Receivables management Inventory management Short-term credit for financing current assets


As a general rule the

most successful man in life is the man who has the best information.

Benjamin Disraeli (1804 - 1881)

Basic concepts and significance of working capital management Working Capital is the revolving fund for the day-to-day operations. Different professionals view working capital in various ways. (1) Current Assets Current Liabilities Accountant (2) Total Current Assets Economist, Business owners Other important terms you need to be familiar with before starting this module: 1. Permanent working capital (or permanent current assets) - The minimum current assets required conducting the business regardless of seasonal requirements. 2. Variable working capital (or seasonal working capital; temporary current assets) - The additional working capital needed by the enterprise during the more active business seasons of the year. 3. Permanent Assets- The minimum current assets required conducting the business regardless of seasonal requirements, plus fixed assets. Working capital policy Policies on working capital are mainly focused on how much is the reasonable amount of investment in current assets and how should it be financed. It addresses the answers to two important questions: 1. Determine the levels or amount of the investment on current assets (i.e. based on sales) 2. Determining the approach to be applied by the management in order to finance working capital Advantages of adequate working capital and disadvantages of inadequate or excessive working capital 1 The dangers of too LITTLE working capital are: The dangers of too MUCH working capital are: The risk of business failure is increased. Unjustified expansion may be stimulated. Hampering of business operations. Management may become complacent and inefficient May loose on speculative use of money. Inefficient use of investment The firms credit standing may be adversely The use of money for speculation may be encouraged. affected and material discounts may be passed out Alternative current asset investment and financing policies and Risk -return trade offs Working Capital Policy on Current Asset Maintenance Description Relaxed Current Asset Cash is usually tied with non-cash current assets. Large investment on current assets requires a larger amount of cash. A high carrying cost is assumed.

Moderate Current Asset Restricted Current Asset Very little cash is usually tied RISKY with non-cash current assets. Small investment on accounts receivable and inventory calls for a low cash requirement. Little or no carrying cost is assumed.


J.A. Casio


CRC-ACE: ACC08FMS01 Lectures 2013_HANDOUT 6page 2 Working Capital Policy on Financing Aggressive policy When a firm can use temporary (short-term) financing to cover a portion of its permanent assets (PCA + FA). As a result, permanent capital (LT&E) is less than permanent assets (PCA + FA).

Peak Seasonal Funding


Short Term Financing

Ave. Seasonal Funding Permanent Current

Permanent Financing
Short Term Financing

Assets Permanent Fixed Assets


Maturity matching policy When a firm uses permanent capital (LT&E) for permanent assets (PCA + FA), and then uses short-term financing to cover seasonal and/or cyclical temporary assets. Conservative policy When a firm uses permanent capital (LT&E) to meet some of the cyclical demand, and then hold the temporary surpluses as marketable securities at the trough of the cycle. Here, the amount of permanent financing exceeds permanent assets.

Temporary CA Permanent Current Assets Permanent Fixed Assets

Permanent Financing

Marketable Securities

Peak Seasonal Funding Ave. Seasonal Funding

Permanent Financing

Permanent Current Assets Permanent Fixed Assets

External financing needed (EFN) The application of EFN in working capital management is determining how much of external financing would still be necessary to support sales changes that made variable and permanent assets change. Current assets are usually spontaneous with sales. So, in case before changes in sales, current assets equal to P30,000. With a projected 10% increase in sales, current assets required to support the increase would mean an additional current asset of P3,000 (i.e. 10% of P30,000). Fixed Assets, unlike the current assets, change only when its capacity is fully utilized at current sales level. When there is idle capacity, fixed assets may or may not change. Let us say, the current sales is P50,000 while fixed assets equal to P400,000. If the present fixed assets has excess capacity of 20%, and the projected sales will be 20% higher than this years, will the fixed assets be increased to support the 20% increase in sales? Based on the data given, one can understand that only P320,000 (or 80% of the P400,000) fixed assets level is required for P50,000 sales level. If this relationship will continue, then, with a P60,000 sales (P50,000 plus 20%), about P384,000 fixed assets will be required (i.e. [320/50] x 60) . Current fixed assets of P400,000, therefore, need not be increased. In fact, the P400,000 is enough up to sales of P62,500 (i.e. 400[320/50]). However, if the present fixed assets is fully utilized, and the projected sales will be 20% higher than this years, will the fixed assets be increased to support the 20% increase in sales? The fixed assets of P400,000 is just enough for a sales activity of P50,000, thus for a P60,000 sales value, fixed assets will have to be P480,000. An additional P80,000 fixed assets would have to be invested. Cash and Marketable Securities Management Basic Principles of cash management Proper cash management should begin when a customer pays its account with the company and ends when the collected funds are used to pay out the companys liabilities. The following should be considered as basic tasks to be performed helping management get the best out its liquid resource. 1. Preparation of cash budget2 2. Establishing control over cash receipts, billing and payments 3. Placing excess, idle cash in temporary investment whenever possible 4. Determining cost of keeping low level of cash and benefit of reducing cash requirement Cash conversion cycle Cash Conversion Cycle is the length of time from the point cash is paid for purchases to the point of collection from customers. It is computed by: Cash Conversion Cycle = Inventory conversion Period + Receivables Conversion Period Payables Deferral Period Cash Conversion Cycle = (Ave Age of Inventory + Ave Age of Receivables) Ave Payment Period The cash conversion cycle also determines the number of times cash is turned over for a given period (i.e. 365 over CCC). Of course, the more times cash is turned over, the better.

Forecasting cash requirements based on corporate plan and determining all possible sources of cash and costs involved.

CRC-ACE: ACC08FMS01 Lectures 2013_HANDOUT 6page 3 The primary goal is to shorten the cash cycle. A company can improve its cash cycle by: 1. Reducing the inventory conversion period 2. Reducing the receivables conversion period 3. Stretching the payables More specific strategies in managing the current assets are discussed in greater detail in the rest of this module. Other Cash Management Techniques Specific cash management techniques include: 1. Cash flow synchronization3 2. Managing the float : reducing collection float; maximizing disbursement float 3. Accelerating collection of receivables a. Prompt billing b. Lockbox system4 c. Direct sends or deposits by customers through collection arrangements in banks and other business centers d. Accepting payments by Bank transfers e. Electronic data interchange5 f. Enforcing collection through Auto debit arrangements g. Concentration banking6 4. Decelerating of payments a. Using controlled disbursing b. Payment using checks c. Maintaining zero-balancing checking accounts Managing the Float Float, generally refers to funds that have been sent by payer but are not yet available for use by payee. Net float is disbursement float less collections (or availability) float.

Collection float is the period that a customer draws a check and delivers but no actual receipt of cash has been made. Disbursement Float is the period that the company has drawn a check but no actual disbursement has happened.
Payor Mails Payment


A Banks balance:
Payee Receives the Mail


Disbursement float


Fund is actually available for use by the payee CLEARING FLOAT

Books balance: P80,000

Payee deposits remittance

Collection float

B Banks balance:

Reasons for holding cash Cash is maintained by an entity for the various reasons: 1. Transactions Motive Cash is held for purposes of paying planned expenses 2. Precautionary or Safety Motive Excess cash is placed on highly liquid investments that may easily be converted into cash when the working capital need arises or other unexpected expenditures 3. Speculative Motive Cash is held to take advantage of investment opportunities 4. Compensating Balance Cash is held as a requirement by a creditor, usually a bank

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Net credit position = Accounts Receivable Accounts Payable In a lockbox system, customers mail checks to a post office box in a specified city. A local bank then collects the checks, deposits them, starts the clearing process and notifies the depositor that payment has been received. 5 EDI is the communication of electronic documents directly from one computer to another. Sample applications include EFT, debit cards, and e-commerce. 6 Cash is received in various locations. With a minimum-maximum-balance policy for each location, a system can be set-up for the prompt remittance of cash funds to a central point , like the main offices account.

CRC-ACE: ACC08FMS01 Lectures 2013_HANDOUT 6page 4 Reasons for holding marketable securities Earlier, in the study of financing policies, the conservative approach pointed out the importance of marketable securities. Temporary asset surpluses can be placed in marketable securities until such time that seasonal needs for working capital arises. By doing this, the company can still earn from returns on this short-term investments and enjoy the availability of cash when required. Factors influencing the choice of marketable securities 1. Default risk the risk that the borrower may not be able to repay the principal with interest 2. Marketability the ability to be readily convertible to cash 3. Changes in price level which affect interest rates 4. Adherence to investment policy statement of the company Converting Marketable Securities into Cash In deciding how much of marketable securities would be converted to cash, the company should consider minimizing conversion costs and opportunity costs associated with the short term investment. The Baumol Cash Management Model includes both relevant costs in the cheapest quantity. Economic Conversion Quantity (ECQ) = 2 x Conversion Cost x Annual Demand for Cash Opportunity Cost (in decimal form)

Total Cost of Cash = (Cost per conversion x Number of conversion) + (Opportunity Cost % x Ave Cash Balance) Average Cash Balance = ECQ/2 + Minimum Balance Requirement Maximum Inventory = ECQ + Minimum Balance Requirement Wherein the: 1. The conversion cost is the cost of converting marketable securities to cash. It includes: a. Fixed cost of placing an order for cash and marketable securities b. Paperwork costs c. Brokerage fees d. Cost of any follow-up action 2. The opportunity cost is the cost of holding cash rather than marketable securities (i.e. the rate of interest that can be earned on marketable securities) Receivables management Objectives, factors in determining accounts receivable policy Receivables management refers to the formulation and preparation of plans and policies related to credit sales and maintenance of receivables at reasonable level, and its collection. In order to establish appropriate credit policies, a study of the days sales outstanding (DSO) and the a ging of receivables must be conducted to determine areas of possible improvement. Days sales outstanding (DSO) is also sometimes called the average collection period (ACP). The DSO measures the average length of time it takes a firm's customers to pay off their credit purchases. The DSO is compared to benchmark credit period to know whether collection policies are enforced. DSO = Receivables Balance Average Daily Credit Sales OR Average Collection = Period Number of Days for the Period Net Sales Average Receivables

Aging of receivables requires the preparation of a schedule showing percentages of receivables as outstanding for a specific period of time. This reflects the behavior of its customers in making payments. The effectiveness of the credit collection may be evaluated using the data from the aging schedule. Costs associated with accounts receivable The following are costs associated with accounts receivable: 1. Cost of carrying receivables = (DSO x Average Daily Sales x Variable cost ratio) x Cost of Funds7 2. Cost of doubtful accounts = Planned Bad Debts Bad Debts under present plan Summary of trade-offs in credit and collection policies with incremental analysis of credit policies Credit Policy is a set of decisions that include the following elements: authorization of credit or credit standards8, firms credit period, collection procedures, and discounts offered to customers. As much as, most of these are dictated by the industry, where the entity belongs, the entitys management has to decide whether their credit and collection policies would be more relaxed or tighter than that of its competitors.

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Required Rate of Return on Investment; cost of money Aided by credit scoring; Five Cs of credit: character, capacity, capital, collateral, conditions

CRC-ACE: ACC08FMS01 Lectures 2013_HANDOUT 6page 5 Stringiness in any of these can of course result to increased availability of cash however, sales may dwindle. Relaxation of the credit policy may encourage sales but will result to additional investment in accounts receivable. Some specific changes in policies are found in the table below, together with their possible consequences to the entitys income. Changes in Credit Policies Stricter credit standards Benefit Encourage cash transactions ; Reduce bad debts, increasing income by the decrease in bad debts net of tax Increase sales activity, increase income by as much as its contribution margin Hasten cash receipts ; Reduce cost of carrying accounts receivable, decreasing carrying cost of working capital by the cost of cash released from receivables investment Permit slow remittance rate Costs Put off large volume sales, reducing income by as much as its contribution margin Increase bad debts, reducing income by as much as the additional bad debts expense Depress sales activity, reducing income by as much as its contribution margin

Relaxed credit standards

Shorten credit period

Lengthen credit period

Offering discounts

Accommodation of major credit card transactions Inventory management

Hasten cash receipts; Reduce cost of carrying accounts receivable, decreasing carrying cost of working capital by the cost of cash released from receivables investment Increase sales activity, increase income by as much as its contribution margin

Encourage credit activity ; increase carrying cost of working capital by the cost of additional cash tied in receivables Reduce expected revenues by the amount of discounts taken by customers

Incur bank charges as a result of processing charge tickets

Objectives, reasons for managing inventories The primary objective for managing inventories is to free cash from investment in inventory as soon as possible without losing sales from stock outs. Inventory management techniques 1. ABC System where Group A inventory consists of the highest peso investment but smallest number of inventory; Group C consists of the smallest peso investment but where the largest percentage in number of inventory lies. Group B is right in between A and C. 2. EOQ Model where the optimal size of order is determined in order to minimize carrying costs and ordering costs. Relevant Formula for EOQ determination is listed below: EOQ = 2 x Annual Demand (in units) x Cost of placing an order Annual Carrying cost (per unit of stock)

Reorder Point9 = (Lead time x Average Usage) + Safety Stock Safety Stock 10= (Maximum usage Average Usage) x Lead Time Average Inventory = EOQ/2 + Safety Stock Maximum Inventory = EOQ + Safety Stock 3. 4. Just-in-Time System where the investment in inventory is minimized by keeping a significantly low level of inventory. Materials requirement planning system where EOQ concepts are coupled with computer software to calculate the production requirements and the availability of the inventory to satisfy its needs

Cost of Inventory There are various costs associated with inventories that are needed to be kept at a practical minimum. These relevant costs are the following: a. Ordering cost. This includes : Total Ordering Costs = Number of orders x Cost per order 1. placing of ordering costs 2. receiving of order 3. handling and courier costs. Total Carrying Costs = Average Inventory level x Annual b. Carrying Cost. This is composed of : carrying costs per unit 1. storage costs

Some companies may apply the red -line method or the 2-bin method. Safety stock can also be determined by computing the safety stock level which results to cheapest stock out costs combined with carrying costs. Stock out costs is equal to {(stock-out cost per unit x number of shortage (units) x number of orders x probability x per unit/time)}.

CRC-ACE: ACC08FMS01 Lectures 2013_HANDOUT 6page 6 2. insurance, security 3. opportunity costs while letting money sleep on inventory 4. property taxes on warehouse Total Inventory Costs = Total Carrying Costs + Total Ordering Costs 5. depreciation or rent of facilities 6. obsolescence 7. opportunity costs for keeping inventory instead of having free cash c. Stock-out cost. Costs that a company will suffer from if it does not keep adequate level of inventory to respond to the demands of customers. This cost is relevant in determining the appropriate safety stock level. This include costs of dissatisfied customers, possible trade discounts passed out, hampering of production runs, incurrence of rush delivery charges, among others.

Financing Current Assets Factors in selecting source of short- term funds 1. Costs of financing 2. Terms: compensating balance, loan size, maturity, security 3. Flexibility or ease in obtaining Sources of short-term funds Source of short-term credit 1. Accounts payable (Trade Credit)

2. Accruals 3. Bank loans

Major Features Spontaneous; free credit (for Accounts payable accumulated, within discount period); costly credit (for Accounts payable accumulated, beyond discount period up to payment date) Spontaneous; free May require compensating balances; may include a formal line of credit or revolving line of credit which charges a commitment fee; for less than a year loan, interest charged or advanced is computed for the specific loan period.

Approximate Cost of = Discount Rate Foregoing discount (1- Discount Rate) Effective CFD (continuously) = {(1+ CFD) x 360 N 360/N }-1
*where N is the number of days payment can be delayed by giving up the cash discount


Net Interest Expense + Other charges x 360 Principal Discount Additional N Compensating Balance 360/N APY* ={(1+Net Interest Expense + Other charges ) } -1 Principal Discount Additional Compensating Balance Add-on = Add-on Interest Rate (Amount Received/2)

4. Commercial paper 5. Factoring of Accounts Receivable

Unsecured; cheaper than bank loans; issued by large companies with credit standing A factor purchases accounts receivable and assumes risk of collection

Effective interest on the loan Peso Cost of Factoring: {FACTORS + INTEREST CHARGED FOR

The interest charge is usually on the amount advanced. Factors fee is normally charged on the entire amount of receivables factored. The cost of factoring is then compared to cost of other borrowing arrangements or cost of operating a collection department 6. Pledging of Accounts Receivable 7. Warehouse Inventory Financing 8. Inventory Trust Receipts Obtaining short-term loan using accounts receivable as collateral This uses inventory as security. A third party holds the inventory as agent and releases inventory as they are sold. The creditor purchases and holds title to inventory; the debtor is considered trustee of selling inventory. When the inventory is sold, the trust receipt is canceled and the funds go into the lender's account. Stated interest on the loan plus service charge for administrative costs of collection Interest on the secured loan

Any risk of loss on unsold goods

Additional notes on Costs of short-term funds 1. Nominal (stated) annual rate = Annual percentage rate (consumer loans) = Periodic rate x number of periods 2. Effective (true) annual rate = Annual percentage yield (savings and business loans) = (1+periodic rate)n -1 3. Installment loans, with compensating balances a. = (2 x Annual number of payments x Interest) {(Number of Payments +1) x Amount Received} b. = __(Interest)________ (Amount Received/2)