Acc08fms01 Lectures 2013_handout 6

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ACC08/FMS01

LECTURESFinancial Management Part 1

MODULE6/7WORKINGCAPITALMANAGEMENT,

FINANCINGCURRENTASSETS

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

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 invarious ways.

(1) Current AssetsCurrent Liabilities Accountant(2) Total Current Assets Economist, Business ownersOther 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 thebusiness regardless of seasonal requirements.

2. Variable working capital(or seasonal working capital; temporary current assets) - The additional working capitalneeded 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,plusfixed assets.

Working capital policyPolicies 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 capitalAdvantages 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

affected and material discounts may be passed out The use of money for speculation may be encouraged.

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

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.

1J.A. Casio

RISKY

RETURNS

Gems

As a general rule themost successful man in

life is the man who has

the best information.

Benjamin Disraeli(1804 - 1881)
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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).

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.

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 capacityof 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 isfully 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 Pri nciples of cash management

Propercash 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 budget22. Establishing control over cash receipts, billing and payments3. Placing excess, idle cash in temporary investment whenever possible4. Determining cost of keeping low level of cash and benefit of reducing cash requirementCash conversion cycle

Cash Conversion Cycleis 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.

2Forecasting cash requirements based on corporate plan and determining all possible sources of cash and costs involved.

RISKY

Permanent

Financin

Short Term

Financing

Permanent Fixed Assets

Permanent Current

Ave. Seasonal Funding

Permanent

FinancingPermanent Fixed Assets

Short Term Financing

Permanent Current Assets

Temporary CA

RETURNS

Permanent

Financing

Marketable Securities

Permanent Fixed Assets

Permanent Current Assets

Peak Seasonal Funding

Ave. Seasonal Funding

Peak Seasonal Funding


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The primary goal is to shorten the cash cycle. A company can improve its cash cycle by:

1. Reducing the inventory conversion period2. Reducing the receivables conversion period3. Stretching the payablesMore 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 techniquesinclude:

1. Cash flow synchronization32. Managing the float : reducing collection float; maximizing disbursement float3. Accelerating collection of receivables

a. Prompt billingb. Lockbox system4c. Direct sends or deposits by customers through collection arrangements in banks and other business centersd. Accepting payments by Bank transferse. Electronic data interchange5f. Enforcing collection through Auto debit arrangementsg. Concentration banking6

4. Decelerating of paymentsa. Using controlled disbursingb. Payment using checksc. Maintaining zero-balancing checking accounts

Managing the F loat

Float, generally refers to funds that have been sent by payer but are not yet available for use by payee.

Net floatis disbursement float lesscollections (or availability) float.

Collection floatis the period that a customer draws a check and delivers but no actual receipt of cash has been made.

Disbursement Floatis the period that the company has drawn a check but no actual disbursement has happened.

Reasons for holding cash

Cash is maintained by an entity for the various reasons:

1. Transactions MotiveCash is held for purposes of paying planned expenses2. Precautionary or Safety MotiveExcess 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 MotiveCash is held to take advantage of investment opportunities4.

Compensating BalanceCash is held as a requirement by a creditor, usually a bank

3Net credit position = Accounts ReceivableAccounts Payable4In 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.5EDI is the communication of electronic documents directly from one computer to another. Sample applications include

EFT, debit cards, and e-commerce.6Cash 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.

PayeeReceives

the Mail

Payee

deposits

remittance

Fund is

actually

available

for use bythe payee

MAIL FLOAT

PROCESSING

FLOAT

CLEARING

FLOAT

FLOAT

PayorMails

Payment

ABanks balance:P100,000

Books balance:

P80,000

BBanks balance:P75 000

BCo

llection fl oat

ADisb

ursement f loat


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Reasons for holding marketable secur it ies

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 inf luencing the choice of marketable securi ties

1. Default riskthe risk that the borrower may not be able to repay the principal with interest2. Marketabilitythe ability to be readily convertible to cash3. Changes in price level which affect interest rates4. Adherence to investment policy statement of the companyConverti ng M arketable Securi ties 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 RequirementMaximum Inventory = ECQ + Minimum Balance Requirement

Wherein the:

1. The conversion costis the cost of converting marketable securities to cash. It includes:a. Fixed cost of placing an order for cash and marketable securitiesb. Paperwork costsc. Brokerage feesd. Cost of any follow-up action

2. The opportunity costis the cost of holding cash rather than marketable securities (i.e. the rate of interest that canbe earned on marketable securities)

Receivables management

Objectives, factor s in determi ning accounts receivable poli cy

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.

OR

Aging of receivablesrequires 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 receivabl e

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 Funds72. Cost of doubtful accounts = Planned Bad DebtsBad Debts under present planSummary of trade-off s in credit and collection poli cies with incremental analysis of credit poli ciesCredit Policy is a set of decisions that include the following elements: authorization of credit or credit standards 8, 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.

7Required Rate of Return on Investment; cost of money8Aided by credit scoring; Five Cs of credit: character, capacity, capital, collateral, conditions

Average Collection = Number of Days for the PeriodPeriod Net Sales Average Receivables

DSO = Receivables BalanceAverage Daily Credit Sales


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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 Benefit Costs

Stricter credit standards Encourage cash transactions ; Reduce

bad debts, increasing income by the

decrease in bad debts net of tax

Put off large volume sales, reducing

income by as much as its contribution

margin

Relaxed credit standards Increase sales activity, increase incomeby as much as its contribution margin

Increase bad debts, reducing income byas much as the additional bad debts

expense

Shorten credit period Hasten cash receipts ; Reduce cost of

carrying accounts receivable,

decreasing carrying cost of working

capital by the cost of cash released

from receivables investment

Depress sales activity, reducing

income by as much as its contribution

margin

Lengthen credit period Permit slow remittance rate Encourage credit activity ; increase

carrying cost of working capital by the

cost of additional cash tied in

receivables

Offering discounts Hasten cash receipts; Reduce cost of

carrying accounts receivable,decreasing carrying cost of working

capital by the cost of cash released

from receivables investment

Reduce expected revenues by the

amount of discounts taken bycustomers

Accommodation of major credit card

transactions

Increase sales activity, increase income

by as much as its contribution margin

Incur bank charges as a result of

processing charge tickets

Inventory management

Objectives, reasons for managing inventor ies

The primary objective for managing inventories is to free cash from investment in inventory as soon as possible without

losing sales from stock outs.

I nventory management techniques1. ABC Systemwhere 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 Modelwhere 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 usageAverage Usage) x Lead Time

Average Inventory = EOQ/2 + Safety Stock

Maximum Inventory = EOQ + Safety Stock

3. Just-in-Time Systemwhere the investment in inventory is minimized by keeping a significantly low level ofinventory.

4. Materials requirement planning systemwhere EOQ concepts are coupled with computer software to calculate theproduction requirements and the availability of the inventory to satisfy its needs

Cost of I nventory

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 :1.

placing of ordering costs2. receiving of order

3. handling and courier costs.b. Carrying Cost. This is composed of :

1. storage costs9Some companies may apply the red-line method or the 2-bin method.10Safety stock can also be determined by computing the safety stock level which results to cheapeststock 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)}.

Total Carrying Costs = AverageInventory level x Annualcarrying costs per unit

Total Ordering Costs = Number of orders x Cost per order


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2. insurance, security3. opportunity costs while letting money sleep on inventory4. property taxes on warehouse5. depreciation or rent of facilities6. obsolescence7. 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 thedemands of customers. This cost is relevant in determining the appropriate safety stock level. This include costs ofdissatisfied 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 financing2. Terms: compensating balance, loan size, maturity, security3. Flexibility or ease in obtainingSources of short- term funds

Source of short-term credit Major Features Cost

1. Accounts payable (TradeCredit)

Spontaneous; free credit (for Accounts

payable accumulated, within discount period);

costly credit (for Accounts payable

accumulated, beyond discount period up to

payment date) *where N is the number of days payment can be delayed by giving upthe cash discount

2. Accruals Spontaneous; free3. Bank loans 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.

4. Commercial paper Unsecured; cheaper than bank loans; issued bylarge companies with credit standing

Effective interest on the loan

5. Factoring of AccountsReceivable

A factor purchases accounts receivable and

assumes risk of collection

Peso Cost of Factoring:

{FACTORS +INTEREST CHARGED FORFEE CREDIT PERIOD}

The interest charge is usually on the

amount advanced. Factors fee is

normally charged on the entireamount

of receivables factored.

The cost of factoring is then compared

to cost of other borrowing

arrangements or cost of operating acollection department

6. Pledging of AccountsReceivable

Obtaining short-term loan using accounts

receivable as collateral

Stated interest on the loan plus service

charge for administrative costs of

collection

7. Warehouse InventoryFinancing

This uses inventory as security. A third party

holds the inventory as agent and releases

inventory as they are sold.

Interest on the secured loan

8. Inventory Trust Receipts The creditor purchases and holds title toinventory; 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.

Any risk of loss on unsold goods

Addi tional notes on Costs of short-term funds

1. Nominal (stated) annual rate = Annual percentage rate (consumer loans) = Periodic rate x number of periods2. Effective (true) annual rate = Annual percentage yield (savings and business loans) = (1+periodic rate) n-13. 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)

/jrm

Total Inventory Costs = Total Carrying Costs + Total Ordering Costs

Approximate Cost of = Discount Rate x 360Foregoing discount (1- Discount Rate) N

Effective CFD (continuously) = {(1+ CFD)360/N

} - 1

APR = Net Interest Expense + Other charges x 360

PrincipalDiscountAdditional N

Compensating

Balance

Add-on = Add-on Interest

Rate (Amount Received/2)

APY* ={(1+Net Interest Expense + Other charges )360/N

} -1

PrincipalDiscountAdditional

Compensating

Balance

Acc08fms01 Lectures 2013_handout 6

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