WORKING CAPITAL POLICY

AND
MANAGEMENT
(BASIC FINANCIAL LITERACY)
PRESENTED BY: ANDRE PAOLO B. LIM, P.I.E., ASEAN Engineer
 WHY STUDY COSTING?

Cost accounting
 is a process of recording, classifying, analyzing, summarizing,
allocating and evaluating various alternative courses of action for the
control of costs.
 Its goal is to advise the management on the most appropriate course
of action based on the cost efficiency and capability.
 Cost accounting provides the detailed cost information that
management needs to control current operations and plan for the
future.
 WHY STUDY COSTING?

Cost accounting
 Since managers are making decisions only for their own organization,
there is no need for the information to be comparable to similar
information from other organizations.

 Instead, information must be relevant for a particular environment.

 Cost accounting information is commonly used in financial accounting

information, but its primary function is for use by managers to facilitate
making decisions.
 WHY STUDY PRICING?

PRICING
 It is the only element in the marketing mix that brings in MONEY.
(recall the 4 P’s in the marketing Mix)
1. Place
2. Product
3. Promotion
4. Price
Introduction

Business Operations
Financial Activities and Management
of Assets

1. Investment
2. Financing
3. Monitoring
COURSE OBJECTIVES

1. Understand the basic

concepts of Finance in
Operations
2. To be able to relate the
concepts into your own
operation’s
3. To be able to make business
decisions based on clear
understanding of the concepts.
Introduction

Management Activities regarding Business Operations

1. Resolves Sales Issues and Decisions
2. Regulates Purchasing activities
3. Monitors Production
Introduction

Management’s direct Involvement to operations:

1. Builds up and finances the company’s Inventory

2. Supports Sales by providing credit to customers

3. Products are Purchased

4. Suppliers are paid
Introduction

All these factors compose what we term

as WORKING CAPITAL
Working Capital is a major investment in
the business that calls for competent
analysis and decisions
Efficiency in the management and
financing of Working Capital shall
make the difference on the financial
performance of a business
Introduction
Topics to Cover:
Working Capital Concepts
Defines working capital policy and
relating them to indicators of financial
position and performance
Working Capital Policies
Presents financial analysis techniques
that examine management’s trade-off
in its decision on current assets
investments and financing
A. WORKING CAPITAL CONCEPTS

Working Capital Includes

1. All of Current Assets
2. All of Current Liabilities

It represents a company’s capacity to

conduct business with its customers,
suppliers and employees
A. WORKING CAPITAL CONCEPTS
Current Assets
Inventories ensure the efficient operation
of the business and uninterrupted
sales.
Giving credit to customers expands a
company’s business opportunities. To
do so needs financing.
A. WORKING CAPITAL CONCEPTS

Current Liabilities
Liabilities and staff salaries need to be
paid on schedule. Payment of debts
requires a business to maintain cash
balances in a Bank.
The Financing of Current Assets
involves Banks, Suppliers and
Management.
Types of Current Assets

Temporary
If it is temporary, once converted to cash in the
normal business cycle, it can be held as
cash or used for other purposes without
impairing operations.
Seasonal build up of inventories
Inventories and Receivable arising from one-
time orders
Excess cash held during peak periods
Cash from profitable operations
Types of Current Assets

Permanent
It is permanent if it is necessary to support
operations
Safety stocks
Raw materials inventory to ensure
continuous operations
Accounts receivable from customers
Pre-payments for insurance, warehousing
and other services
LIQUIDITY

Is the capacity of a company to raise

cash when needed
It enables a business to pay its debts without
significant loss in value to assets.
A company can be liquid by managing the
amount and form of its current assets.
Amount: Keep high levels of current assets
compared to obligations
Form: Hold current assets that can be easily
converted to cash without significant loss in
value.
TURNOVER

Is the capacity of a company to use its

assets to support sales
The indicators of turnovers are the days’
collection period, days’ inventory and length
of operating cycle.
An operating cycle (cash conversion cycle) =
is the length of time between firm’s
purchase of inventory and the receipt of
cash from accounts receivable.
 TURNOVER
Sales
Current Asset Turnover = ------------------
Current Assets
Example: Sales = P530
Current assets = P476
Current Asset Turnover = 1.1 times
How to Increase your turnover rate:
• decreasing the inventory stock to the minimum level, which would allow the
continuous operational process;
• sales promotion and decreasing the finished goods stock;
• activation of the accounts receivable collection process, etc.
TURNOVER

360 days
Cash Conversion = --------------------------
Period Current Asset turnover
Example:
Current assets turnover = 1.1

Cash conversion period = 328 days

TURNOVER

We normally use the Cash conversion period as a reference in

calculating the Operating Cycle of a business.

An Operating Cycle is the length of time it takes a business to

buy inventory, and convert it into sales and collect account
receivables.

Operating Cycle = Inventory period + Accounts Receivables

Period
Operating Cycle Sample Activity

1. Calculate your Operating Cycle budget to run your business

2. Determine how many cycles your business needs to keep in
order to have enough current assets to keep the business
running.
PROFITABILITY
Profitability is affected by a business’ working capital position

High liquidity position is detrimental to profitability. Earnings

from near-cash investments earn less than interest paid
to creditors

For example, suppose a company took a short-term loan

from a bank at an interest of 18%. The loan proceeds
were then invested in treasury bills. If the yield on the
treasury bill is 12%, a net financing loss of 6% in incurred.
 PROFITABILITY

Profitability is measured by Return on Equity and Return on Current Assets

Return on Equity = Net income

--------------------
Stockholder’s Equity
Return on Current assets = Net income
----------------------
Total Current Assets
Equity = It is calculated either as a firm's total assets minus its total liabilities or as share capital plus
retained earnings minus treasury shares
SOLVENCY

Solvency is the capital position of the business

A business is solvent if its assets exceed its

liabilities.
Creditors are assured that that the business
has sufficient assets to pay its obligations.

Losses erode Capital and may lead to

insolvency.
SOLVENCY
Basic Causes of Losses:
1. Unprofitable operations.
Operating losses use up Capital
2. Decline in Asset Value.
Assets depreciate due to economic changes or due to
forced liquidation of assets
Example: Fx loan used to support local sales
3. Technical Insolvency
Refers to financial position which is solvent but cannot pay
obligations.
It has sufficient assets but not in form of cash or other liquid
assets.
NET WORKING CAPITAL

Is the difference between current assets and

current liabilities

Types of Net Working Capital

a. Positive Net Working Capital

b. Negative Net Working Capital

NET WORKING CAPITAL
a. Positive Net Working Capital
It is positive if current assets exceed current liabilities.

CURRENT LIABILITIES
CURRENT
ASSETS

LONG-TERM DEBT OR CAPITAL

It means that long-term capital such as long-term equity or long-term

debt is partly financing fixed assets.

It gives less pressure on liquidity because long-term sources of funds

are repaid over a longer period of time. However, interest
expense is higher and dividends are incurred longer.
NET WORKING CAPITAL

a. Negative Net Working Capital

Implies that part of the current liabilities was used to finance fixed assets.

CURRENT
ASSETS
CURRENT
LIABILITIES
FIXED ASSETS

It means that current assets are not sufficient to pay all current creditors.
Untimely demand for payment will cause liquidity problems.
NET WORKING CAPITAL
Implications of the concepts:
1. The risk of insolvency depends on the level and type of current assets
and financing sources
2. Solvency risk is high if a company’s position shows any or a
combination of these conditions:
a.) A high proportion of current assets in less liquid forms.

b.) Negative net working capital

c.) Short-term sources of funds finance fixed assets

d.) Any liquidation of current and fixed assets forced by creditors that
result in losses.
B. WORKING CAPITAL POLICY
The Objectives:
1. To maintain an investment in current assets that:
a.) Ensures repayment of maturing obligations
b.) Supports profitable investment in fixed assets

2. To keep insolvency risk at an acceptable level

Therefore, Working Capital Policy is a guideline set by

Management to control risk of insolvency and
achieve profitability.
It can also be stated as the guidelines on trade-
offs between profits and liquidity.
B. WORKING CAPITAL POLICY

Within these guidelines, the following decisions

are involved:
a.) How to invest in current assets
b.) How to source financing for these assets

Common Questions asked on Investment of current assets:

1. What should be the desired level of current assets?

2. What types of current assets should be held?

3. Will there be current asset fluctuations in a year?

B. WORKING CAPITAL POLICY

Common Questions asked on the financing of

current assets:
1. What should be the mix of short-term and long-term financing of
current assets?

2. How much supplier credit rather than bank credit can be availed of?

3. Should new capital be raised?

4. Or, should a long-term loan be negotiated to finance current assets?
B. WORKING CAPITAL POLICY

Policies on Investment of Current Assets

A. Aggressive Investment Policy
1. Aims to achieve high profitability by minimizing investment in
current assets.

2. Management tightens liquidity in order to channel investment in

fixed assets.

3. It tries to squeeze profits from operating assets like inventory

4. An aggressive policy allocates more funds in fixed assets.

B. WORKING CAPITAL POLICY

Policies on Investment of Current Assets

B. Conservative Investment Policy
1. Avoids technical insolvency by investing in more current assets

2. Lower returns are accepted for the assurance of good access to credit.

3. A conservative policy allocates more funds in current assets.

B. WORKING CAPITAL POLICY
Policies on Investment of Current Assets
Conservative Investment Policy Aggressive Investment Policy

CURRENT ASSETS

CURRENT ASSETS

FIXED ASSETS
FIXED ASSETS

An aggressive investment policy positions a business to achieve its full

production and revenue potential.
A conservative investment policy does not achieve such revenue
potential, but then its liquidity position is stronger.
B. WORKING CAPITAL POLICY

Policies on Financing of Current Assets

Again, the principle of trade-off in profitability and risk is used.

Short-term financing strategies and trade-offs

1. Profitability is higher because interest rates are lower
2. The business can limit its short-term loans to match the amount
needed and its maturity needs
3. However, short-term loans are a threat to a business’ liquidity. If
business deteriorates, maturing short-term loans might not be paid.
B. WORKING CAPITAL POLICY

Policies on Financing of Current Assets

Long-term financing strategies and trade-offs
1. Higher interest costs or dividends are paid even these
funds are idle.
2. However, these loans are repaid over a longer
period of time.
3. If business deteriorates, the excess cash can be used
to support the business.
B. WORKING CAPITAL POLICY

Policies on Financing of Current Assets

Aggressive Financing Policy Conservative Financing Policy
CURRENT CURRENT CURRENT CURRENT
ASSETS LIABILITIES ASSETS LIABILITIES
FIXED FIXED
ASSETS LT DEBT ASSETS LT DEBT
CAPITAL CAPITAL

An aggressive financing policy uses more short-term funding

sources because it aims for higher profits while accepting a
higher liquidity risk.
A conservative financing policy uses more long-term sources of
financing. It incurs higher cost of financing and lower profitability
but has lower liquidity risk.
B. WORKING CAPITAL POLICY
Range of Possible working Capital Policies
1. Profit-oriented
Aggressive investment and financing
Aggressive working capital position
Suited for growth businesses
2. Balanced Profit-oriented
Aggressive investment but conservative financing
Mixed working capital position
Profit targets are high
B. WORKING CAPITAL POLICY
Range of Possible working Capital Policies
3. Excess Liquidity
Conservative investment but aggressive financing
Current assets are beyond requirements
Balanced but Liquidity-oriented
For businesses that face sudden surges in demand

4. Liquidity-oriented
Conservative investment and financing policy
Avoiding risk of insolvency
Liquidity risk avoiding policy
Profit targets are low
B. WORKING CAPITAL POLICY
SUMMARY
1. The objectives of working capital investment policy are
to support revenue operations and to meet maturing
obligations.

2. Working capital includes all current assets and

current liabilities. Net working capital is the
difference between current assets and current
liabilities.

3. A sound policy therefore could help a business

achieve profitability goals while controlling
insolvency risk.
B. WORKING CAPITAL POLICY
SUMMARY
4. Management can choose to be aggressive or conservative in
investing in current assets using profitability and liquidity
indicators.

5. Management can also choose to be aggressive or conservative in

financing current assets also using profitability and liquidity as
indicators

6. Working capital policies are implemented using financial ratios

as indicators and management should be prepared to diagnose
and respond to liquidity problems revealed by such indicators.
Sample Exercise

1. The Balance sheets of two companies North Company and

South company are presented below:
North Co. South Co.
Current assets 90 40
Fixed assets 65 86
Current Liabilities 55 40
Long-term liabilities 60 16
Stockholder’s equity 40 70
Question:
1. Compare the two companies according to liquidity and
solvency.
2. Which company has more potential for profits?
 Sample Exercise #2

2. Performance Norms Depend on the Nature of the Industry

Information taken form recent annual reports of two retailers appears below. One of
these retailers is like Gaisano, a value store chain, and the other is like H&M, a
specialty store of women’s clothes.
Co A Co B
Sales P6,149 P43,887
Interest Expense 257 266
Net income 403 1,608
Average total assets 3,145 13,416

• Using only ratios, which is Gaisano and which is H&M? Explain your answer.
Sample Exercise #3

3. Industry Norms and Returns on Equity

Recent annual reports for three companies:
Co A Co B Co C
Revenues $6,373 $6,562 $12,223
Income b4 Interest n tax 932 735 934
Net income 699 705 782
Total assets 13,493 4,352 9,136
Shareholder’s Equity 5,192 1,760 3,887

• Compute the rate of return on assets for each company.

• Compute return on equity.
Note: for 1&2 disaggregate into profit margins, asset turnovers, and leverage ratios
3. The three companies are Ayala Malls, Nestle Phils., and Davao Light. Which is
which and explain the clues you got in deriving your answer.
ACTIVITY-BASED COSTING
AND MANAGEMENT

PRESENTED BY: ANDRE PAOLO B. LIM, P.I.E., ASEAN Engineer

What is ABC?
 It is a method of tracking specific methods
of production or service for the purpose of
capturing cost as it occurs as an activity.
What is ABM?
 A Method of Improving Operations
a. Activity Analysis
b. Improving Process Performance
c. ABC / Feature Costing
d. Implement ABM

ABM is Continuous Improvement or…

KAIZEN
What drives ABC / ABM?

 Stakeholders are forcing organizations to change

in order to get…
A. Lower Cost

B. Higher Quality

C. Quicker Response
What drives ABC / ABM?

GLOBALIZATION
Organizations have to be
competitive especially during bad
times.

“If you have to be good, you have

to do it all the time.”
Customer Expectations

They expect to be offered a product / service that…

A. Has the features / functionality desired
(Quality)
B. At a competitive price
(Cost)
C. With a desired level of service
(Delivery)
 Company Expectations

Naturally, to make profitable returns (exceeding

cost of capital) while…
A. Providing employees an equitable level
of compensation. (Financial Satisfaction)
B. Providing a safe working environment
(Work Satisfaction)
C. Providing a fulfilling work environment
(Work Satisfaction)
Stakeholder Expectations

Providing stakeholders with

above-industry stock
appreciation dividends and
returns.
External Expectations

1. Governments expect payment of taxes

2. People expect to be employed

3. Communities expect environmental safety

Supplier Expectations

1. Provide fair price for products and services

2. Ensure quality consistency

3. Receive payment promptly and as agreed

The Sum of Expectations

Organizations must continuously create value in

order to be ahead.

“ Do things right, better than competitors.”

VALUE CREATION
What keeps us from maximizing value?
1. Complex work environment
- Too much Data
- Too little information

View and use Data intelligently

 What keeps us from maximizing value?

2. Firefighter Management

UNHAPPY CUSTOMERS PROFITS VS. SALES

WORK SLOWDOWN

Reactionary Crisis Management

Driven by EVENTS instead of by STRATEGY

 What keeps us from maximizing value?
3. Poorly Structured Processes
Activity Value Loss
Sales Contract Unprofitable / Disruptive Business
Check Credit Credit Problems / Cost Business
Enter Order Entry Errors
Check Inventory Incorrect Data
Issue Inventory Incorrect Inventory Issued
Ship Product Incorrect Shipment / High Ship Costs

Failure – bound processes costs companies more than

failure to sell.
 What keeps us from maximizing value?

4. Uncoordinated Improvement Efforts

TQM
BPR
ABC TIME REDUCTION

ISO 9000 TEAMS

- Each addresses only a piece of the problem

- Often treats only symptoms rather than root causes
- Efforts can absorb vast resources
- Efforts can will an organization into thinking it is addressing its needs.
What keeps us from maximizing value?

4. And assumes magic will happen

 What Should We Do?

1. Take out non-essential costs

2. Invest intelligently
3. Improve current costs
4. Maximize Resources
5. Least Possible Cost and Greatest Possible Profit
6. Cope with Competitors
7. Pricing – Value Analysis
 Traditional Functional Organizations

President

VP - Mfg VP - Fin VP - Sales VP - HR

Prodn Purch Matls Facilities

 Method of Data (Cost) Capture
Actual Cost = Expenditure by type of cost during the time period
Account Actual Budget Variance
Salaries / Wages 137,400 125,350 (12,050)
Depreciation 7,500 7,500 0
Information Sys 6,000 8,000 2,000
Travel Expense 7,200 1,900 ( 5,300)
Training and Edu 15,000 5,000 (10,000)
------------ ------------ ------------
173,100 147,750 (25,350)
 Static Cost Analysis

 View cost in time segments

 Compare Actual vs. Budget
 To Understand variances, dissect cost by major factors

 Explain major events that caused the variance

DID NOT DO SOMETHING ABOUT THE CAUSE OF THE

VARIANCE
 Traditional Accounting
 Accounting for Cost Control Steps:
a. Plan (Budget)
b. Monitor (Report)
c. Control Costs (by type of cost)
Example:
Utilities Account
a. Water
b. Gas
c. Electricity
 Traditional Accounting
 Compare actual Performance with budget to find
overspending
Account Actual Budget Variance
Water 1,050 1,200 (150)

Management is happy/unhappy but is not any more

knowledgeable as to why the figures are this way.
ACTIVITY-BASED COSTING
AND MANAGEMENT

PRESENTED BY: ANDRE PAOLO B. LIM, P.I.E., ASEAN Engineer

Traditional Accounting
 Current Finance processes do not support advanced management
- too late for corrective action - Historical
- too aggregate data; it conceals waste instead of highlighting it.

- does not adjust performance for non-controllable performance

- Budget reporting are by function and department;

not by value stream
- Finance is reported as separate, and often adversarial function
from Operations
So, How will Value Stream Management Reports look like?

Actual Cost = Process Cost

+ Feature Variations
+ Process Variations
+ Excess Capacity
Dynamic Cost Analysis
- events-based
- Processes Determines Resources
- Minimize Process Variations - 6σ
- Minimize Workload Variation
- Compare actual used to validate processes
 Activity-Based Management
Changes the way you look at cost

From: To:
Procurement Dept. Procurement Dept.
Salaries - 460,000 ID Alternatives - 40,000
Depreciation - 50,000 Development - 70,000
Space - 50,000 Prepare RFQ - 50,000
Supplies - 30,000 Evaluate/Select - 200,000
Others - 10,000 Inspect WIP - 100,000
-------------- Audit Deliverables 100,000
600,000 Make Payment - 40,000
--------------
600,000
 Activity-Based Management

Value Stream Management identifies what is wasteful and why!!!

Cost per A/P Invoice 8.57
6.00
Time - A/P Invoice cycle time 1.50 0.25
- What performance measures are directly
influenced by departments
- What is the impact of activities on the
performance measures
- To show how activities add cost to other
departments’ costs.
Activity-Based Management

Value Stream Accounting

Engineering Changes

Schedule variances – demand but can’t make

Total Cost Schedule variances – demand but can’t make

Inventory variances – no demand ; pure waste

Process variances – Required (setup, move, inspect) and not

required (repair, rework, retry, etc.)

Lost Time – leaves, training, etc.

Make – units produced per demand

Activity-Based Costing
Typical Items to be Costed
Products (Current And New)
- Product Family
- Product Brand
Services
Customers
Allows you to do:
a. Target Costing
b. New product Cost Estimation
 Activity-Based Costing

Cost practices have evolved!

Conventional Cost Activity – Based Costing
Systems
-Products consume cost -Activities consume resources

-Products consume Activities

 Activity-Based Costing

ABC improves the traceability of Costs.

Customer Service Coordination
Maintenance
Production and Inventory Management
Physical Inventory
Raw materials Receiving, etc.
Activity-Based Costing
Steps in applying ABC
1. Validate Activity Data

2. Create Bill of Activities

Trace Activities
Trace Processes
3. Allocate non-value added activities
4. Add Raw Materials cost
Activity-Based Costing
Sample Calculation Activity
1. Use a product in your company to be used as
an example
2. Go through the motions of applying the 4 ABC
steps
3. Present your output and explain the results
END
 Activity-Based Costing
Step 1 – Validate Activity Analysis
Schedule Production 184,000 500 orders 368 / order
Support Employees 350,000 460 employees 761 / employee
Procure Materials 310,000 20,000 receipts 15.50 / receipt
Store and Issue parts 400,000 180,000 issues 2.22 / issue
Material Handling 240,000 100,000 moves 2.40 / move
Inspect Product 510,000 15,000 inspections 34 / inspection
Pay employees 110,000 460 employees 239 / employee
General Accounting 140,000 460 employees 305 / employee
Management/supvrs 380,000 460 employees 826 / employee
Provide Facilities 280,000 460 employees 609 / employee
 Activity-Based Costing

Step 2 – Create a Bill of Activities

A listing of all activities, business processes and
direct costs related to a product, service, customer
or other item where a cause and effect relationship
can be cost effectively established.
Activity-Based Costing

Step 2 – Create a Bill of Activities

Identify Unit-Treaceable Activities