WORKING CAPITAL MANAGEMENT

Disclaimer: This lecture notes is just a summary to guide students in pinpointing topics in the text in
accordance with the syllabus. Students are still required to read the whole chapter and related other
books or research as supplementary as applicable and ideally to make their own notes. For a wholistic
understanding of the topic and to raise items not discussed during class if any. Questions during exam
may be taken especially on the main source book even if not cited in this lecture notes but in
accordance with syllabus. Thank you.

INTRODUCTION

The firm’s goal is to establish an optimal level of cash, marketable securities, accounts receivable and
inventory. Then financing the working capital at the least cost. Effective working capital management
can generate considerable amounts of cash.

BACKGROUND on WORKING CAPITAL

Working Capital Basic Definitions

1. Working capital = this refers to current assets, “turn over” during a year
2. Net working capital = current assets less current liabilities
3. Net operating working capital (NOWC) = working capital used for operating purposes

NOWC = operating current assets less operating current liabilities. If you remember this NOWC has
been a significant part in previous chapter discussions.

Wherein operating current assets = current assets less excess cash ( excess cash is taken out to maximize
return ) . On the other hand operating current liabilities = current liabilities less notes payable. Notes
payable is taken out of the picture since it is a source of financing rather than a part of the working
capital.

CURRENT ASSETs INVESTMENT POLICIEs

Current Assets Investment Policies

(1) Relaxed Invested Policy – limits of the current assets is not strictly imposed resulting to increase
sales ( vs. bad debts), no work stoppages ( vs. cost of inventory ), customer satisfaction ( vs.
obsolete inventory ), among others. Though this tends to lower ROE due to low turnover of the
of the assets.

Dupont Equation

ROE = profit margin x total assets turnover x equity multiplier

Net income/Sales Sales/Assets Assets/Equity

The optimal strategy or policy is the one that maximizes the firm’s long run earnings and the stock’s
intrinsic value.

(2) Moderate Investment Policy

This policy is between the restricted and the relaxed policy.

 (3) Restricted Investment Policy
Stringent limits are placed on current assets components to improve ROE ( faster total assets
turnover ) and lowers cost of capital ( lower asset level ). Though this may expose the company
to uncompetitive sales terms ( receivables), inventory stoppage which may result to opportunity
cost ( unusual increase demand of customer order) and unhappy customers ( delayed deliveries,
loyal company customers maybe seeking for alternative products or brands). Technology
nowadays is getting better ( aiding in improving company optimal policy ). Which computers can
now monitor levels of inventory on set up “ safety stocks “ and the computerized system will
automatically request for inventories once the “safety stocks” level is hit.

CURRENT ASSETs FINANCING POLICIEs

Investment in current assets source of financing maybe :

- (1) Bank loans; (2) Credit terms from suppliers ( accounts Payable); accrued liabilities
( delaying cash payments ) which both will represent spontaneous current liabilities; (3)
Long term debt and (4) Common equity

Working capital loans could be:

- Due to suppliers
- Bank loans

Some companies may have seasonal business cycle that there is a need for the company to adjust to this
cycle.

Current assets maybe

(1) Permanent current assets = the safe level of current assets given its slack period ( low sales, low
productivity)
(2) Temporary current assets = these are additional current assets on top of the permanent ones
when sales will be hitting its momentum; thus will need additional financing

Alternative Current assets financing policy = please see figure 16-2

(1) Moderate current assets financing policy or Maturity matching or “self liquidating” . Here,
assets and liabilities are matched with their maturity dates. Example machine will 5 years life
will be financed with a 5 year financing alternative. Constraints on this include uncertainty on
life of the assets, and matching with common equity which has no maturity. Fixed assets and
permanent level of current assets ( these are the total permanent assets) is financed by long
term debt and equity and spontaneous current liabilities while temporary current assets is
financed by short term, nonspontaneous debt financing.
 (2) Aggressive approach . Example is financing permanent assets with short term debt. This
approach is an extremely non conservative. In this approach, fixed assets and a portion of
permanent level of current assets is financed via long term debt and spontaneous current
liabilities. The other portion of permanent level of current assets and the company’s temporary
current assets are financed by short term, non spontaneous debt financing. Advantage would
be being a short term borrowing, a lower interest rate maybe incurred. A disadvantage maybe
that long term assets may not generate the cash flows for the loan payments, thus lender may
not renew the loan, exposing the firm to bankruptcy.

(3) Conservative approach. Here fixed assets, permanent level of current assets and a portion of
temporary current assets are financed via long term debt plus equity plus spontaneous current
liabilities. The other portion of temporary current assets is financed by short term financing, any
excess cash will be parked in marketable securities, we call this “storing liquidity”. Typically as
the business going concern moves over the year , its fixed assets will increase moderately,
permanent assets will increase heavily while the temporary assets stays with the same
magnitude to the permanent assets.

Why short term debt is riskier?

- Volatility of interest rate on short term vs long term which tends to be higher with short
term
- Mandatory payment in short term which the company might still be struggling with growth
and cash; and during recession which the company maybe affected yet will be obliged for
the mandatory short term maturities payments ; both exposes the company to bankruptcy

Advantages of short term debt:

- Easier to negotiate with lender

- Flexibility = the firm may decrease loans if interest rates will go higher; no prepayment
penalties as compared with long term; more covenants with long term as well.

Which approach to choose then?

This really depends on the firm’s specific conditions, and the firm’s manager’s optimistic
(aggressiveness) vs. conservatism.
The CASH CONVERSION CYCLE ( CCC )

The Cash conversion cycle is the total number of days , its operations is rolled over from inventories to
sales receivables less trade payable deferrals. This CCC number of days needs financing.

Formula:

CCC = Inventory conversion period + average collection period less payable deferral period

Inventory conversion period = number of days inventory is converted from raw materials to finished
goods; or merchandise inventory staying as an inventory. Formula is Inventory/Cost of goods per day

Average collection period = or days sales outstanding ( DSO ) ; this is the number of days sales stays as
receivables then collected as cash. Formula is Receivables/Daily sales

Payable deferral period = the number of days trade payables are outstanding plus labor payment
outstanding as well if material. Formula is Payables/Cost of goods sold per day

The shorter the CCC , i.e., sells goods faster, collects receivables faster plus defer payables , without
hurting sales or increasing operating costs, CCC may decrease . This will result to reduced interest
expense and improved profits and stock price.

Multiple cash conversion cycle might exist causing more working capital volatility in the firm.

The CASH BUDGET

No rule , here, depends on the company’s operating policies.

Example on table 16-1
We take the column July as our reviewed month, and how the figures are calculated:
Collections for the month of July :
May sales x 10% = $200 x 10% = $ 20
June sales x 70% = $250 x 70% = 175
July sales x 20% x 98% = $300 x 20% x 98% = 59
=============
Total collection $254

=========

Purchases during July:

70% of next months sales ($400 x70%) $ 280
Payments of last months’ sales 210

Plus inputs on wages, lease, other expenses, taxes ( Sept and Dec ) plant construction Oct

Net cash flow = collection of $ 254 less $ 265 payment equals ($11), this will be forwarded to next
month . Target cash level of the company is $ 10. Thus financing needed during end of July would be
the $11 deficit and the target cash level of $ 10 equals $ 21.
Target cash balance is the desired cash balance that a firm plans to maintain in order to conduct
business.

In summary the maximum required loan is during Sept at $ 115. While the maximum month in which
the company experienced excess cash and invested in marketable securities is during December at $77.

During the negotiation of the financing with funds provider , considerations would be on how accurate
the projections would be and the impact if ever there will be departures.

Most firms would do monthly cash budget for annual planning, while daily cash budget give more
precise picture on timing of cash flows.

Questions on the cash budget:

How accurate is the forecast likely it to be?

What would be the effects of significant errors if ever?

On the timing of cashflow, the possibility on difference of cashflow in and out on a daily basis. In which
the cash outflow will occur first before the cash inflow which cannot be tracked in the monthly
calculation. This should be considered if ever.

CASH and MARKETABLE SECURITIEs

Cash and marketable securities include:

- Currency
- Demand deposits
- Marketable securities

These is also termed as cash equivalents which is characterized as safe, highly liquid marketable
securities which can be sold/converted to cash quickly given predictable market prices.

Highly profitable firms held more securities to:

- Pay dividends
- Repurchase stocks
- Retire debts
- Acquire other firms
- Finance major expansions

Lately the emergence of credit cards, debit cards, online transfers, digital transfers and other payment
mechanisms lessen the need for currency levels.

Demand deposits = these are bank accounts with check issuance ( checking account ) as a feature on the
account. The firm will issue a check for the company’s various payments.
Some techniques in optimizing demand deposit holdings:
1. Hold marketable securities rather than demand deposits to provide liquidity ( also higher
returns)
2. Borrow on short term notice = consider though the cost of commitment fees
3. Improve Forecast payments and receipts
4. Speed up payments = in advance countries and widely geographical set up, banks offer the
lockbox services , cost benefit analysis though should be conducted before applying the lockbox
alternative. This is usually availed by large corporations having a high volume of check
payments on a widely geographical set up.
5. Use credit cards, debit cards, wire transfers and direct deposits. Technology advances like
electronic transfers, online banking, among others.
6. Synchronize cash flows = avail of bank’s cash management services, consider bank costs though

There are two categories of marketable securities

1. Operating short term securities = securities held primarily to provide liquidity and are bought
and sold as needed to provide funds for operations
2. Other short term securities = these are holdings in excess of the amount needed to support
normal operations

Marketable securities are managed with close coordination with cash . Should be highly liquid to be
converted to cash as needed. Their market/maturity value is ensured to earn a return even on a short
term. Examples are treasury bills, commercial papers, cds, money market funds, among others

INVENTORIES

These could include: for manufacturing cos = supplies, raw materials, work in process and finished
goods. For merchandising, = goods or those via retail supermarkets

Inventory levels depend on sales, so sales forecast is crucial for optimal inventory level. If inventory is
too high, there is the excessive carrying cost attached to the inventories plus the risk of obsolescence ;
Too low a level of inventory means the risk of losing sales. However these functions is more under the
care of production managers and marketing people.

Role of finance managers in inventory management:

1. Determining of inventory levels, it’s not automatic that a sophisticated computer system will be
installed to assist in inventory movement and procurement . The cost has to evaluated first via
capital budgeting.
2. Determining of capital needed for inventory financing.
3. Applying financial ratios and benchmark against industry.
ACCOUNTS RECEIVABLE

Credit policy is a set of rules governing a company’s credit sales or sales for collection via receivables.
Variables affecting credit policy of a company:

1. Credit period = increasing the period will mean higher sales while the risk involved would be
exposure to possible default and finally bad debts which means losses to the company rather
than profits. The two will always be balanced in determining credit period.
2. Discounts = the advantage would be increasing sales without increasing receivables. However
since the sales price will be reduced to a certain level, a higher volume coming from a customer
given discounts will highly be favorable. Still a balancing act would be necessary between
profitability due to increase in sales by offering discounts vs sales price lost due to the discount.
3. Credit standards = financial strength of acceptable credit customer should be established. For
considerations would be financial ratios applied to a customer’s level of debt and its servicing of
interest. Another would be looking on the customer’s credit history. For individuals a credit
score will be a good tool for decision making. In advance countries mostly all individuals and
businesses have a credit score basing on his/its previous historical financial transactions. Too
low a credit standard means an exposure to bad debts while too high a credit standard would
mean lost sales resulting to lost profits. These two needs to be balanced for an optimal credit
standard.
4. Collection policy = this refers to the procedure in collecting receivables especially bad debts or
past due. Usually a company may start with a customer sensitive collection advise then
progresses to a rigid one. The toughness or laxity of a collection policy again needs to be
balanced. Also, delinquent accounts maybe turnover to a collection agency.

It’s notable that the company should charge receivables outstanding. Example a 1.5% per month or
18% p.a. EAR on this will be EAR ( Effective annual return ) = (1.015)^12-1 = 18%

Setting and Implementing the Credit Policy

The importance of credit policy:

- Its major effect on sales
- Its influence on the amount of funds tied up in receivables
- Its effect on bad debt losses

Robinson Patman Act = A US legislation which put into legality , the fair granting of credits amongst
various customers except when there is a default risk tendency given some validating supports. Such as
past history, financials, among others or what we call cost justified.

Sample information needed in assessing credit terms to a customer:

1. Balance sheet and income statement
2. Financial ratios
3. Its supplier credit/payment history
4. The firm’s operations
5. Character of key owners and officers
6. Credit ratings
Monitoring Accounts Receivable

2 variables influencing receivables = sales per day x collection period; any changes of these two will
affect level of receivable

Formulas:

To determine receivables then = average daily sales ( ADS ) x days sales outstanding ( DSO )
DSO( Days sales outstanding) =
(Receivables/average sales per day) x (Receivables/Annual sales divided by 365)

ACCOUNTS PAYABLE ( or TRADE CREDIT )

Trade credit is a debt arising from credit sales and recorded as an accounts receivable by the seller and
an accounts payable by the buyer

Accounts payable = or trade credit, is the largest category of short debt comprising of around 40% of the
company’s current liabilities. This is a spontaneous source of financing. This is influenced by two
variables, i.e., the expanding sales and the lengthening of the credit period. This may be free or costly;
the days with the discount is the free portion of the accounts payable , e.i., the 10 days on the 2/10;n/30
credit while the 20 days ( 30 – 10 ) is the one with the cost.

For example, 2/10,n/30, for a selling price of $ 100 this means that the true price is $98, the $2
represents the discount. List price = $ 98 true price plus $2 finance charges.

On a monthly basis:

30 days = 30 days x 20 units x $98 = $ 58,800

10 days = 10 days x 20 units x $98 = 19,600

-----------

Payables stretched on the 20 days $ 39,200 the trade credit with a cost . for the $ 39,200 financed
by the spontaneous stretching of the trade credit , would it be possible to finance this instead with
another alternative and the company instead availed of the discount?

To compute:

Yearly
At true price 20 units ( $ 98 ) ( 365 ) = $ 715,.400
At total price 20 units ( $100 ) ( 365 ) = 730,000
------------
Yearly discount $14,600
========

Cost of trade credit then = $ 14,600/$ 39,200 = 37.24%

So if we can find an alternative source of capital lower than 37.24% , then the company should avail of
the discount, and vice versa.
Formula:
Nominal cost of trade credit = discount % 365
---------------- x -----------------------
100 - discount days credit is o/s less discount period
= 2/98 x 365/20
= 2.04% x 18.25
= approximately 37.24%

The 2.04% represents the cost per period per trade credit. While the 18.25 is the number of times in a
year this 2.04% cost is repeated/turn over.

Types of trade credit, using our sample 2/10, 2/30

Free trade credit = days of the term within the discount period 10 days
Costly trade credit = the days of the term which there’s no discount anymore 20 days
----------
30 days
==========

BANK LOANS

Promissory Note = a bank/lending institution legal document in which all the terms and conditions of
the lending relationship is contained

Features of a promissory note

1. Amount – in words and figures and a specific currency or a mention of an equivalent to another
currency
2. Maturity – most are short term or on demand ( anytime collectible )
3. Interest rate – fixed or floating. Benchmark would be either t-bills, bank’s prime rate ( special
rate vs the regular rate), LIBOR which lately is in the process to be replaced; based on a 360 or
365 days more often 360 days since it tends to increase the actual amount of interest
4. Interest only vs amortized = commercial loans is usually interest only though lenders will take
no payment on principal even partial as a red flag, amortized is usually on consumer loans such
as car loans, housing loans, salary loans, personal loans, among others
5. Frequency of interest payments = this is calculated daily and collected monthly
6. Discount interest = more often the interest is collected in advance of the term rather than at the
end; usually done monthly; the amortized version though with consumer loans is an installment
collection of interest and principal combined and via an amortization schedule of equal
payments during the term
7. Add on loans = applicable to consumer loans via equal amortization of principal and interest
combined
8. Collateral
9. Restrictive covenants
10. Loan guarantees = for corporate borrowers, a guarantee is required for principal people in the
corporation in which their personal belongings can be ran after by the lender in case the
corporation has lacking funds/assets if ever it goes into bankruptcy; we call this surety
Line of credit – a credit facility made available to the borrower like 30 day, 60 days, 1 year, among
others; which sets the amount limit and period availability, any time to be utilized by borrower but
subject to certain conditions like sound business going concern, no deterioration with collateral, etc.

Revolving credit agreement = a formal commitment of line credit this time, granted by the lender/bank
for similar flexible utilization by a certain borrower/business, for a term, ex. A P 5M line from Jan 1, 2022
to Dec 31, 2022. The borrower can draw any amount on this P5M for a certain period during the year
subject to current market rates. In advance countries though, the lender/bank charges additional
commitment fees on amount of the agreement not utilized/borrowed by the borrower/corporation

Revolving credit agreement differs from the line of credit in which the revolving credit has the legal
obligation to honor the commitment and there is the commitment fee charged if ever there’s no availing
or utilization of the agreement

Cost of bank loans = usually higher interest rates on risky borrowers and smaller loans due to processing
costs. Though there is a limitation on how high the interest rate would be as mandated by central
banks. Anti usurious laws.

Prime rates = are special rates given to certain special accounts below the regular rates which is based
on current market rates. Ex are account has lots of transactions with the bank aside from the
borrowing, large amount of the borrowing, among others.

Behavior of loan rates. If economy is weak, demand for loans decreased, inflation will decrease and the
Fed or central banks will be dovish ( conversative ) and will pump money into the company and lower
rates to ignite business. Vice versa, hawkish ( aggressive )

Computation of interest

Simple interest per day computation = nominal rate/360 days

Interest = principal x rate per day x no of days or
Interest = principal x nominal rate x no of days/360

The more frequently interest is paid, the higher the effective rate

If interest is paid once a year, the nominal rate would be the effective rate

Example:

Principal $10,000, rate at 4.25%, 30 days

Computation of interest:

$10,000 x 4.25% x 30/360 = $ 35.42 or

4.25%/360 = .000118056 x $ 10,000 x 30 days = $35.42
Add on interest

Ex. $10,000 principal; 3% nominal rate; 1 year; consumer loan

Approximate annual rate = interest paid

-------------------
Amount received/2 = divided by two considering this is a consumer loans
and principal is amortized as well during the life of the loan, since this is a one year term; half of the
principal is perceived to be already paid in half of the year.

Example:

Interest Paid
-----------------------------------
Amount Received/2

$300
-----------------
$10,000/2

= 6%

COMMERCIAL PAPER

= a money market instrument in which a promissory note is issued by large strong firms and usually
bought by financial institutions. This is unsecured ( no collateral ) or we call as clean yet “asset backed
paper” like the “mortgage backed securities (MBS)” which cause the sub prime crises in 1988.

ACCRUALS ( ACCRUED LIABILITIES )

This is a spontaneous source of funds. This has no cost yet as a source of financing is beyond the
control of the firm.

USE of SECURITY in SHORT TERM FINANCING

Security refers to collateral. An asset by the firm offered as a security in case of bankruptcy. This
includes assets such as stocks, bonds, buildings, land, equipment, receivables, inventories, among
others. The latest form of collateral used in advance countries is intangibles. For clean or unsecured
borrowings, an additional rate is added to the loan rate given its risk. Secured loans on the other hand
entails additional processing cost on the documentation of these securities.
Additional per syllabus

EOQ under Inventory Management

EOQ = Economic Order Quantity

It helps to find a production volume or order that the company add to minimize the holding cost and
order cost. Holding cost is the cost of holding inventory in storage. ( eg. Insurance, security guard).
Ordering is the cost of placing an order to supplier for inventory.

EOQ formula = square root ( sorry guys can’t find symbol hi hi) of 2SD/H

Where S is the ordering cost

D = annual volume of inventory

H = holding cost

Example:

A pen manufacturing company where the company’s annual quality is 400, the holding cost is $2, and
the ordering cost is $1. EOQ?

EOQ = square root of 2SD/H = square root of (2($1)(400))/$2 = square root of $800/$2 = square root of
$400, EOQ = 20 units.

Thank you 😊
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