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MAS – LECTURE NOTES ARMIN GLENN ARANETA,CPA

WORKING CAPITAL MANAGEMENT

WORKING CAPITAL

 For financial analysts, working capital equals current assets.

 For accountants, working capital equals current assets minus current liabilities.
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 with long-term liabilities.
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.
4. Balanced Policy – balances the trade-off between risk and profitability in a manner
consistent with its attitude toward bearing risk.
WAYS OF MINIMIZING WORKING CAPITAL REQUIREMENT
1. Managing cash and raw materials efficiently.
2. Having efficiency in making collections and in the manufacturing operations.
3. Implementing effective credit and collection policies.
4. Reducing the time lag between completion and delivery of finished goods.
5. Seeking favorable terms from suppliers and other creditors.

FORECASTING FINANCIAL STATEMENT VARIABLES

ASSUMPTIONS:
1. All variables are tied directly with sales.
2. The current levels of most balance sheet items are optimal for the current sales level.
STEPS:
1. Identify assets and liabilities that vary spontaneously with sales.
2. Estimate the amount of net income that will be retained.

3. Compute the amount of Additional Financing Needed (AFN) by subtracting the increase
in spontaneous liabilities and income retained from increase in total financing required
(increase in assets due to increase in sales).
AFN = Assets - Liabilities – Profit retained

MANAGEMENT OF CURRENT ASSETS

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.
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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 obligation.
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 Reserve – firms hold cash balances in order to handle unexpected
problems or contingencies due to the 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

FLOAT – difference between the bank’s balance for a firm’s account and the balance that the
firm shows on its own book.

TYPES OF FLOAT:
1. Mail Float – peso amount of customers’ payment that have been mailed by a customer
but not yet received by the seller.
2. Processing Float – peso amount of customers’ payment 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 – reduce negative (mail and processing) float
2. Control (slowdown) disbursement
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 the
finished goods. Its two components: average age of inventories and average collection period of
receivables. When the average age of accounts payable is subtracted from the operation cycle,
the result is called cash conversion cycle.
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.

ECQ = 2 x conversion cost x annual demand for cash

Opportunity cost

Conversion cost – the cost of converting marketable securities to cash

Opportunity cost – the cost of holding the cash rather than marketable securities (rate of interest
that can be earned on marketable securities).

MARKETABLE SECURITIES
 Short-term money market instruments that can easily be converted to cash.
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REASONS FOR HOLDING MARKETABLE SECURITIES:

1. MS serve as substitute for cash (transactions, precautionary, and speculative) 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.

RECEIVABLE MANAGEMENT

ACCOUNTS RECEIVABLE MANAGEMENT – formulation and administration of plans and

policies related to sales on account and ensuring the maintenance of receivables at a
predetermined level and their collectability as planned.

WAYS OF ACCELERATING COLLECTION OF RECEIVABLES

1. Shorten credit terms.
2. Offer special discount 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 or receivables to net credit sales.
2. Receivable turnover.
3. Average collection period
4. Aging of accounts.

INVENTORY MANAGEMENT

INVENTORY MANAGEMENT – formulation and administration of plans and policies to

efficiently and satisfactorily meet production and merchandising requirements and minimize
costs relative to inventories.

INVENTORY MODELS
A basic INVENTORY MODEL exists to assist in two inventory questions:
1. How many units should be ordered?
2. When should the units be ordered?

Economic Order Quantity – the quantity to be ordered, which minimizes the sum of the ordering
and carrying costs.
Where: a = cost of placing one order (ordering cost)
EOQ = 2aD D = annual demand in units
k k = annual costs of carrying one unit
in inventory for one year

Assumptions of 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 item ordered are constant; thus, there can be no quantity discounts.
5. There are no limitations on the size of inventory.

 When applied to manufacturing operations, the EOQ formula may be used to compute the
Economic Lot Size (ELS).

Where: a = set-up cost

EOQ = 2aD D = annual production requirement
k k = annual costs of carrying one unit
in inventory for one year
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 When the EOQ figure is available, the average inventory is computed as follows:
Average Inventory = EOQ
2
 When to Reorder:
When to reorder is a stock-out problem. i.e., the objective is to order at a point in
time so as not to run out of stock before receiving the inventory ordered but not so early that
an excessive quantity of safety stock is maintained.

Lead time – period between the time the order is placed and received.
Normal time usage – Normal lead time x Average usage
Safety stock – (Maximum lead time – Normal lead time) x Average usage
Reorder point if there is NO safety stock required – Normal lead time usage
Reorder point if there is safety stock required – Safety stock + Normal lead time usage
Or
Maximum lead time x Average usage

SHORT TERM FINANCING

ACCOUNTS PAYABLE – the major source of unsecured short-term financing.

a. Credit terms: credit period, cash discount, cash discount period
b. Analysis of credit terms:
 Taking the cash discount – if cash discount is to be taken, a firm should pay on the last
day of the discount period.
 Giving up cash discount – if the firm has to give up the cash discount, it should pay on
the last day of the credit period.
 Cost of giving up cash discount = [CD/(100% - CD)] x (360/N)
Where: CD – cash discount percentage
N – number of days payment can be delayed by giving up cash discount

The above formula assumes that a firm gives up only one discount during the year. If a
firm continually gives up the discount during the year, the annualized cost is calculated as
follows:
Annualized cost of giving up cash discount = [1 + (CD/(100% - CD)]306/N – 1

c. 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.

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.
Effective interest rate = Interest
Principal amount – Discounted Interest
If the term is less than a year, the interest rate is annualized.

c. Compensating Balance – an arrangement whereby a borrower is required to maintain a

certain percentage of amounts borrowed as compensating balance in the current account
of the borrower.

CONCEPT OF LEVERAGE

LEVERAGE – refers to that portion of the fixed costs which represents a risk to the firm.
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a. OPERATING LEVERAGE – (a measure of operating risk) refers to the fixed operating

costs found in the firm’s income statement.
 The higher the firm’s operating leverage, the higher its business risk, and the
lower its optimal debt ratio.

Degree of Operating Leverage (DOL) = CM

EBIT
b. FINANCIAL LEVERAGE – (a measure of financial risk) refers to financing a portion
of the firm’s assets, bearing financing charges in hopes of increasing the return to the
common stockholders.
 The higher the financial leverage, the higher the financial risk, and the higher the
cost of capital.

Degree of Financial Leverage (DFL) = EBIT

EBIT – Interest
c. TOTAL LEVERAGE – the measure of total risk.
 A decrease in operating leverage would cause an increase in optimal amount of
financial leverage.
 A decrease in operating leverage would result into a decrease in the optimal
amount of debt.

Degree of Total Leverage = CM

EBIT – Interest

Practice Problems:
1. FORECASTING. Tataynor Corporation’s sales are expected to increase by 20% in 2014
from 3 million in 2013. Its financial records show the following information as of the end
of 2013:
Total assets P1, 800, 000
Current liabilities 675, 000

The corporation is at full capacity, so its assets must grow in proportion to projected
sales. Its current liabilities include Notes Payable amounting to P375, 000. The projected
after tax profit margin is 12% and the forecasted profit retention ratio is 30%.

Required:
a. How much is Tataynor Corporation’s additional funds (AFN) needed for the coming
year? What was the capital intensity ratio in 2013?
b. What would the additional funds needed be if the corporation’s year-end 2013 assets
had been P1, 350, 000? Assume that all other numbers are the same. What is the
corporation’s new capital intensity ratio?

2. FINANCING STRATEGY. Bosh Inc.’s total assets are composed of the following:
Current assets:
Permanent P1, 800, 000
Temporary 1, 200, 000 P3, 000, 000
Fixed assets 4, 500, 000
Total P7, 500, 000

The company’s earnings before interest and taxes (EBIT) is P900, 000. Bosh pays the
prevailing corporate income tax rate. Compute Bosh’s earnings after tax under each of
the following financing plans:

a. Finance all fixed assets and half of the permanent current assets with long term
financing costing 12%. Short term financing currently cists 7%.
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b. Finance all fixed assets and permanent current assets plus half of its temporary
current assets with long term financing costing 12%. Short term financing currently
costs 7%.

3. OPTIMAL TRANSACTIONS SIZE. Assume that the fixed cost of selling marketable
securities is P10 per transaction and the interest rate on marketable securities is 6% per
year. The company estimates that it will make cash payment of P144, 000 over a oe-year
period.

Required: Compute the (a) optimal level of cash balance or optimal transaction size, (b)
the average cash balance, (c) the total cost of converting marketable securities to cash,
and (d) the total carrying cost of cash.

4. OPERATING AND CASH CONVERSION CYCLES. Consider the following data for
Gatas Corporation:

Sales (all on account) P13, 500, 000

Cost of goods sold 6, 480, 000
Credit purchases 14, 400, 000
Average accounts receivable 1, 500, 000
Average inventory 450, 000
Average accounts payable 480, 000

The firm spends P19, 440, 000 on operating cycle investments each year, at a constant
rate. Assume a 360-day year.
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.

5. The RIPD Company purchases 48, 600 units of bleaching soap per year. The average
purchase lead time is 3 working days. Maximum lead-time is 7 working days. The
company works 360 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 3 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?

6. FOREGOING DISCOUNTS ON PURCHASES. Sakana Bayad Company purchases

raw materials on terms of 3/10, net 60. A review of the company’s records by the owner,
Mr. Sakana, revealed that payments are usually made 40 days after purchased are
received. When asked why the firm did not take advantage of its discounts, the
bookkeeper, Mr. Tinidor be Libro replied that it costs only 3% for these funds, whereas
the bank loan would cost the firm 12%.

Required:
a. What is the real cost of not taking advantage of the discount?
b. What mistake is de Libro making?
c. If the firm could not borrow from the bank and was forced to resort to the use of trade
credit funds, what suggestions might be made to de Libro that would reduce the
annual interest costs?
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7. STRETCHING PAYABLES. Kuletz Corporation’s suppliers sell merchandise to Kuletz

on terms of 60 days. Despite this fact, the corporation pays its accounts, on the average,
in 50 days, so that its accounts payables average P500, 000.

The corporation is now considering payment of its payable to the end of the term in order
to decrease it cash requirements.

Required: How much is the expected increase in accounts payable if payments are
delayed to the 60th day?

8. COST OF BANK LOANS. Domino Arms Company is negotiating with Embank for a
P2 million, one-year loan. Embank has offered Domino Arms the following alternatives.
Calculate the effective annual interest rate for each alternative. Which alternative is the
most attractive?
a. A 10% annual rate on a simple interest loan, with no compensating balance required
and interest due at the end of the year.
b. An 8% annual rate on a simple interest loan, with 25% compensating balance
required and interest due at the end of the year.
c. A 10% annual rate on a discounted loan, with a 20% compensating balance.
d. An 8% add-on annual interest, payable in equal monthly installments.

9. WORKING CAPITAL INVESTMENST – The Abangers Corporation is a leading

manufacturer of robots popularly known as “ Boltron”. The Corporation turns out 1, 500
robots a day at a cost of P6 per robot for materials and labor. It takes the firm 22 days to
convert raw materials into a robot. Abangers allows its customers 40 days in which to pay
for the robots, and the firm generally pays its suppliers in 30 days.

Required :

a. What is the length of Abangers’ cash conversion cycle?

b. At a steady state in which Abangers produces 1, 5000 robots a day, what amount of
working capital must it finance?

c. By what amount could Abangers reduce its working capital financing needs if it was able
to stretch its payables deferral period to 35 days?

d. Abangers’ management is trying to analyze the effect of a proposed new production

process on the working capital investment. The new production process would allow
Abangers to decrease its inventory conversion period to 20 days and to increase its daily
production to 1, 800 robots. However, the new process would cause the cost of materials
and labor to increase to P7. Assuming the change does no affect the receivables
collection period (40 days) or the payables deferral period (30 days), what will be the
length of the cash conversion cycle and the working capital financing requirement if the
new production process is implemented?

“A half truth is a whole lie.”

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