Emmanuel D.

Lubis CPA, MBA, CFC

WORKING CAPITAL MANAGEMENT
Part 1
WORKING CAPITAL POLICIES AND
MANAGEMENT OF SHORT TERM
ASSETS AND LIABILITIES
INTRODUCTION
Working capital management is the management of the short-term investment
and financing of a company.
Goals:
- Adequate cash flow for operations
- Most productive use of resources
Internal and External Factors that Affect Working Capital Needs
Internal Factors External Factors
Company size and growth rates
Organizational structure
Sophistication of working capital
management
Borrowing and investing positions/
activities/capacities
Banking services
Interest rates
New technologies and new products
The economy
Competitors

Bottom line: There are many influences on a companys need for working capital.
MANAGING AND MEASURING LIQUIDITY
Liquidity is the ability of the company to satisfy its short-term obligations using
assets that are readily converted into cash.
Liquidity management is the ability of the company to generate cash when
and where needed.
Liquidity management requires addressing drags and pulls on liquidity.
- Drags on liquidity are forces that delay the collection of cash, such as slow
payments by customers and obsolete inventory.
- Pulls on liquidity are decisions that result in paying cash too soon, such as
paying trade credit early or a bank reducing a line of credit.
SOURCES OF LIQUIDITY
Primary sources of liquidity
- Ready cash balances (cash and cash equivalents)
- Short-term funds (short-term financing, such as trade credit and bank loans)
- Cash flow management (for example, getting customers payments deposited
quickly)
Secondary sources of liquidity
- Renegotiating debt contracts
- Selling assets
- Filing for bankruptcy protection and reorganizing.
MEASURE OF LIQUIDITY
LIQUIDITY RATIOS
Ability to satisfy current
liabilities using current
assets
Ability to satisfy current
liabilities using the most
liquid of current assets
RATIOS INDICATING MANAGEMENT OF CURRENT ASSETS
How many times accounts
receivable are created and
collected during the period
How many times inventory
is created and sold during
the period
OPERATING AND CASH CONVERSION CYCLES
The operating cycle is the length of time it takes a companys investment in
inventory to be collected in cash from customers.
The net operating cycle (or the cash conversion cycle) is the length of time it
takes for a companys investment in inventory to generate cash, considering
that some or all of the inventory is purchased using credit.
The length of the companys operating and cash conversion cycles is a factor
that determines how much liquidity a company needs.
- The longer the cycle, the greater the companys need for liquidity.
OPERATING AND CASH CONVERSION CYCLES
Acquire
Inventory
for Credit
Sell
Inventory
for Credit
Collect on
Accounts
Receivable
Pay
Suppliers
Acquire
Inventory
for Cash
Sell
Inventory
for Credit
Collect on
Accounts
Receivable
Operating Cycle Cash Conversion Cycle
Operating Cycle = Inventory Days
+ Receivable Days
Cash Conversion Cycle = Inventory Days
+ Receivable Days
- Payable Days
OPERATING AND CASH CONVERSION CYCLES:
FORMULAS
Average time it
takes to create
and sell
inventory
Average time it
takes to collect
on accounts
receivable
Average time it
takes to pay its
suppliers
EXAMPLE: LIQUIDITY AND OPERATING CYCLES
Compare the liquidity and liquidity needs for
Company A and Company B for FY2:
Company A Company B

FY2 FY1 FY2 FY1
Cash and cash equivalents !200 !110 !200 !300
Inventory !500 !450 !900 !900
Receivables !600 !625 !1,000 !1,100
Accounts payable !400 !350 !600 !825
Revenues !3,000 !950 !6,000 !6,000
Cost of goods sold !2,500 !750 !5,200 !5,050
EXAMPLE: LIQUIDITY AND OPERATING CYCLES
Company A Company B
FY2 FY2
Current ratio 3.3 times 3.5 times
Quick ratio 2.0 times 2.0 times
Number of days of inventory 73.0 days 63.2 days
Number of days of receivables 73.0 days 60.8 days
Number of days of payables 57.3 days 42.1 days
Operating cycle 146.0 days 124.0 days
Cash conversion cycle 88.7 days 81.9 days
1. How do these companies compare in terms of liquidity?
2. How do these companies compare in terms of their need for
liquidity, based on their operating cycles?
HOW CAN OPERATING CYCLE BE REDUCED
1. Production Management - Under Inventory Management
2. Purchasing Management - Under Inventory Management
3. Marketing Management - meaning sale and production should be synchronised
4. Credit an Collection Policy - Under Cash Management and Receivables
Management
5. External Environment - fluctuation in demand analysis; entrants of new
competitors, government and fiscal policies, price fluctuations, etc.
ALTERNATIVE POLICIES IN WORKING
CAPITAL MANAGEMENT
ALTERNATIVE POLICIES REGARDING THE TOTAL
AMOUNT OF CURRENT ASSETS CARRIED
1.Relaxed Current Asset Investment Policy - a relaxed
current asset investment strategy leads to a company
maintaining a higher level of current assets relative to
sales. Using this strategy, the company will keep a higher
level of A/R and inventory.
2.Restrictive Current Asset Investment Strategy - When
using a restrictive current asset investment strategy a
company will maintain a low level of current assets relative
to sales. Accounts Receivables (A/R) are kept low and
inventory is managed as tightly as possible.
COST RELEVANT TO INVESTMENT IN CURRENT
ASSETS
Carrying costs - are the cost associated with having current assets
Opportunity Costs - costs of having a capital tied up in the current asset rather
than in a more productive fixed asset.
Explicit costs - costs necessary to maintain the value of the current assets.
(e.g. storage costs)
Shortage costs - are the costs associated with not having the current asset
Opportunity Costs - costs of not having the sale due to not having enough
inventory
Explicit transaction fees - costs paid up to replenish the particular inventory.
(e.g. extra shipping cows, interest expense for money borrowed)
ALTERNATIVE STRATEGIES IN FINANCING
WORKING CAPITAL
1.Long Term / Permanent Assets - These consist of
property, plant and equipment, long term investment, and
the portion of the assets that remain unchanged over the
year.
2.Fluctuating or Seasonal Assets - These are current
assets that vary over the year due to seasonal or cyclical
needs.
ASPECTS TO TAKE INTO CONSIDERATION IN
CHOOSING FINANCING POLICY
The Financing Policies to be chosen should take into the
consideration.
Maturity Hedging
Cash Reserves
Relative Interest Rates
Availability and Costs of Alternative Financing
Impact on Future Sales
END OF PART 1
Part 2
CASH AND MARKETABLE SECURITIES
MANAGEMENT
CASH MANAGEMENT
REASONS FOR HOLDING CASH BALANCES
Transactions Motive - to meet payments arising in the ordinary
course of business
Precautionary Motive - to maintain a cushion or buffer to meet
unexpected cash needs
Speculative Motive - to take advantage of temporary
opportunities (Investment Opportunities)
Compliance with Creditors Covenant - Firms using bank debt
are required to maintain a compensating balance with the bank
from which they have borrowed the money
Compensating balance: when a bank makes a loan to a firm,
the bank requires this minimum balance in a non-interest-
earning checking account equal to a specified percentage of
the amount borrowed
DETERMINING THE TARGET CASH BALANCE
1. Cash Budget - is the tool used to present the expected cash inflows and
outflows of the company
2. Cash Break-even Chart
Fixed Monthly Mayments / Contribution Margin
3. Optimal Cash Balance Approach
The Baumol Model
Balances the opportunity costs of holding cash against the transactions
associated with replenishing the cash account.
The Miller-Orr Model
It assumes that the distribution of daily net cash flow is normally
distributed.
THE BAUMOL MODEL
Total Costs = Holding Costs + Transaction Costs
=
(
Average
Cash
Balance ) (
Opportunity
Cost
)
+
(
No. of
Transactions
) (
Cost of
Transactions
)
=
C
( K ) +
T
( F )
2 C
Where:
C = Amount of Cash Raised C* = Optimal Cash to be Raised
C/2 = Ave. cash balance C*/2 = Optimal ave. cash balance
T = Total Amount of net new cash needed F = Fixed costs in obtaining cash
k = opportunity cost of holding cash
THE BAUMOL MODEL
C* = 2 (T) (F)
K
Where:
C = Amount of Cash Raised C* = Optimal Cash to be Raised
C/2 = Ave. cash balance C*/2 = Optimal ave. cash balance
T = Total Amount of net new cash needed F = Fixed costs
k = opportunity cash of holding cash

Therefore minimum cash balance required:
THE BAUMOL MODEL (EXAMPLE)
Problem 4:
Jaypee Inc. has 2 dates when it receives its cash inflows (Feb 15 and Aug 15).
On each dates, it expects to receive P 30 million. Cash expenditures are
expected to be set through out the subsequent 6 month period. Presently, the ROI
in marketable securities is 8% per annum and the cost of transfer from securities
to cash is P 125 each time a transfer occurs.

Required:
A. What is the optimal transfer size using the Baumol model? What is the
average cash balance?
B. What would be the answer to (a) if the ROI were 12% per annum and the
transfer cost were P75? Why do they differ from those in (a)?
THE BAUMOL MODEL (EXAMPLE)
C* = 2 (30M) (125) C*/2 = 153,093.11
8%
C* = 306,186.22
Given: A
T = P 30,000,000
F = P 125
k = 8%

Problem 4:
THE BAUMOL MODEL (EXAMPLE)
C* = 2 (30M) (75) C*/2 = 96,824.58
12%
C* = 193,649.17
Given: B
T = P 30,000,000
F = P 75
k = 12%

Problem 4:
THE MILLER-ORR MODEL
Z* = 3 3 F
+ L
4 i
Where:
L = Lower control Limit " = standard deviation
iday = daily interest rate F = Trading Cost
Z* = Optimal Cash Return point
H* = Upper Control limit for cash balances

Miller-Orr Model Formula
H* = 3Z* - 2L
THE MILLER-ORR MODEL (EXAMPLE)
Problem 10:
Hot Foot Entreprises would like to maintain their cash account at a minimum level
of P25,000, but expect the standard deviation in net daily cash flows to be
P2,000. The effective annual rate on marketable securities to be 6.5% per year,
and the trading cost per sale or purchase of marketable securities to be P200 per
transaction. What will be the optimal upper cash limit
THE MILLER-ORR MODEL
Z* = 3 3 (200) 2K
+ 25K
4 (6.5%/365)
Where:
L = P25,000 " = P2,000
iday = 6.5% / 365 F = P200

Miller-Orr Model Formula
Z* = P39,991.45
therefore:
H* = 3Z* - 2L
= 3(39,991.45) - 2(25,000)
= 69,974.34
OTHER FACTORS INFLUENCING THE TARGET
CASH BALANCE
Option to incur short-term borrowing to meet unexpected
demands.

Transaction Cost and Time Element

Maintenance of minimum balance in the companys deposit
CASH MANAGEMENT TECHNIQUES
Synchronizing Cash Flows - is a situation in which inflows
coincide with the outflows of the firm therefore reducing
transaction balances.
Using Floats - is the difference between the balance in the
books and the balance in the banks.
Accelerating Cash Collections
Slowing Disbursements
Reducing the need for Precautionary Balance
THE USE OF FLOATS
Disbursement Floats - represents the value the checks the
firm has written but which are still processes
Collection Floats - represents the amount of the checks that
have been received but not yet credited to the firms bank
account
Mail Floats, Deposit Float (Processing and Availability)
Net Float - is the difference between the positive disbursement
float vs. its negative collection float
In Financial Accounting this is more commonly noted as the
bank reconciling items other than book and bank errors.
FLOAT REDUCTION VALUATION
If Miguel Motors expects its gross revenue from sales to be P80
million. The firms treasurer has projected its marketable
securities portfolio will earn 6.50% over the coming budget year.
What is the value of one days float reduction to the company.
(Use 365 days working year as basis for the assumption)

Solution:

Value of One days Float = P80M 365 x 6.5%
= P14,246.57
CASH COLLECTION ACCELERATION
Prompt Billing and Periodic Statements
Incentives such as trade and Cash discounts
Prompt deposit
Direct Deposit to firms bank account
Electronic depository transfer
Maintenance of regional collection office
CASH COLLECTION ACCELERATION (EXAMPLE)
ABC Co. is evaluating a new bank facility which
expects to accelerate its cash collection. In a typical
year the firm usually receives Php 5M by check
where the company record and process 2,500
checks in the same time period. Bank A has advised
the firm that the new facility will cost an extra P0.50
per check. The firm projected that the firm can invest
the freed cash to a marketable security with an eight
percent yield per annum. Calculate the minimum
days freed by the process in order to accept the bank
facility. (Use 365 days working year for the analysis)
CASH COLLECTION ACCELERATION (EXAMPLE)
Solution:
Ave. check value = Php 5M / 2,500
= Php 2,000 per check
Opportunity cost per day = 0.08/365 = 0.02192%
where:
added cost = added benefits
P0.25/check = (N)(P2,000/check)(0.02192%)
N = 1.7534 days
OTHER METHODS IN ACCELERATING CASH
COLLECTION
Lockbox System - customers are instructed to mail their
remittance to a lockbox location.
Advantage - Reduces the mailing and processing float
Disadvantage - Cost of creating such a system ( Not
advantageous to small remittances)
Concentration Banking - the process of having lockbox
accounts or field bank accounts to a central cash pool residing
in a concentration bank.
Depository Transfer Check - Funds are not immediately
available upon receipt of the DTC.
Automated Clearinghouse (ACH) Electronic Transfer
Wire Transfer
SLOWING DISBURSEMENTS
Centralized Processing of Payables - this permits the finance
manager to evaluate the payments for the whole firm.
Zero Balance Accounts - a function in concetration banking
sometimes called in-house banking where a master account is
used to control all of the firms accounts.
Delaying payment
Playing the Float
Less Frequent payroll
REDUCING THE NEED FOR PRECAUTIONARY
BALANCE
More accurate cash budgeting
Lines of Credit
Temporary Investments
CASH RECEIPT ACCELERATION AND FLOAT
VALUATION CALCULATIONS
Uses the concept of cost - benefit comparisons
The usage of break-even analysis
Usually compared to opportunity costs
MARKETABLE SECURITIES
MANAGEMENT
REASONS FOR HOLDING MARKETABLE
SECURITIES
They serve as a substitute for cash balances
They are held as temporary investments
They are built up to meet known financial requirements
FACTORS INFLUENCING THE CHOICE OF
MARKETABLE SECURITIES
Risks
Default Risk - the risk that it cannot be paid on the due dates
Interest rate risks - the risk in the decline in market values
Inflation risk
Marketability (liquidity) risk - risk that security cannot be sold at quoted price
Event Risk - the probability that an event will happen and increase the firms
default risk.
Maturity - is that if security can be sold when the cash is required
Yield or return on securities - the higher the risk, the higher the yield or return.
TYPES OF MARKETABLE SECURITIES
Money Market Securities
Discount Paper - sells less than its par or face value
Interest bearing securities
Treasury Bills (Government Security with one year or less maturity)
Other Short-term Commercial Papers - typically unsecured with maturity of less
than 270 days. Usually discounted but can be interest bearing.
Negotiable Certificate of Deposits
Repurchase Agreements (REPOS) - securities with an agreement to
repurchase.
Bankers Acceptance - a time draft drawn on and accepted by a bank usually
used as a source of financing in international trade
Money Market Mutual Fund - open ended mutual fund that invests in money
market instruments. Highly liquid because they can be sold back to the fund any
time.
END OF PART 2