CHAPTER 5: WORKING CAPITAL MANAGEMENT

I. LEARNING OUTCOMES
Upon finishing this session, the learner is expected to:
1. Critically evaluate a business case problem using quantitative tools and
techniques
2. Critically make proper decision to address a business case problem

II. LEARNING CONTENTS / PROPER

Working Capital Management Definition

Working capital refers to short term funds to meet operating expenses. It
refers to the funds which a company must possess to finance its day to day
operations. It is concerned with the management of the firms’ current assets
and current liabilities.
Current assets consist of inventories (raw materials, work - in process,
finished goods), trade debtors, loans and advances, investments, cash and
bank balances.
Current liabilities consist of sundry creditors, trade advances, short term
borrowings, etc.
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Working Capital Management Concept

Working capital management involves the financing and controlling of
the current assets of the firm. These current assets include cash, marketable
securities, accounts receivable, and inventory. A firm’s ability to properly
manage current assets and the associated liability obligations may determine
how well it is able to survive in the short run.
Because a firm with continuous operations will always maintain
minimum levels of current assets, management must be able to distinguish
between those current assets that are permanent and those that are temporary
or cyclical. In order to determine the permanent or cyclical nature of current
assets, the financial manager must give careful attention to the growth in sales
and the relationship of the production process to sales. Level production in a
seasonal sales environment increases operating efficiency, but it also calls for
more careful financial planning.
In general, we advocate tying the maturity of the financial plan to the
maturity of the current assets. That is, finance short-term cyclical current
assets with short-term liabilities and permanent current assets with long-term
sources of funds. In order to carry out the company’s financing plan with
minimum cost, the financial manager must keep an eye on the general cost of
borrowing, the term structure of interest rates, the relative volatility of short-
term and long-term rates, and predict, if possible, any change in the direction
of interest rate movements.
Because the yield curve is usually upward sloping, long-term financing is
generally more expensive than short-term financing. This lower cost in favor of
short-term financing must be weighed against the risk that short-term rates
are more volatile than long-term rates. Additionally, if long-term rates expected
to rise, the financial manager may want to lock in long-term financing needs
before they do.
The firm has a number of risk-return decisions to consider. Though long-
term financing provides a safety margin for the availability of funds, its higher
cost may reduce the profit potential of the firm. On the asset side, carrying
highly liquid current assets assures the bill-paying capability of the firm – but
detracts from profit potential. Each firm must tailor the various risk-return
trade-offs to meet its own needs. The peculiarities of a firm’s industry will have
a major impact on the options open to its management.
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Current Asset Management Concept

Current asset management is that the less liquid an asset, the higher the
required return.
1. Cash management
- The primary goal should be to keep the cash balances as low as
possible, consistent with the notion of maintaining adequate funds for
transactions purposes and compensating balances. Cash moves
through the firm in a cycle, as customers make payments and the
firm pays its bills. We try to speed the inflow funds and defer their
outflow in managing the company’s cash balances. The increased use
of electronic funds transfer systems both domestically and
internationally is reducing float and making collections and
disbursements more timely. The use of electronic payment
mechanisms, such as automated clearinghouses and the new Check
21 Act, have changed the way management manages their collections
and payments. We are now moving towards a checkless society.
- One principle of cash management is not to let excess cash sit in
banks and checking accounts when those cash balances could be
earning a rate of return. Excess short-term funds may be placed in
marketable securities – with a wide selection of issues, maturities and
yields from which to choose.
2. Receivable management
- Calls for determination of credits standards and the forms of credit to
be offered as well as the development of an effective collection policy.
There is no such thing as bad credit – only unprofitable credit
extension. It should also be understood that the accounts receivable
policy is related to the inventory management policy.
3. Inventory management
- The least liquid of current assets, so it should provide the highest
yield. We recognize three different types: raw materials, work in
progress and finished goods. We manage inventory levels through
models such as the economic ordering quantity (EOQ) model, which
helps us determine the optimum average size that minimizes the total
cost of ordering and carrying inventory. The just-in-time inventory
management model (JIT) focuses on the minimization of the holding
inventory, through quality production techniques and close ties
between manufacturers and suppliers. Both EOQ and JIT models are
compatible and can work together in the management of inventory.
It seems like a simple concept, but it needs to be stated that the
company that manages its current assets efficiently will minimize (or optimize)
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its investment in them, thereby freeing up funds for other corporate uses. The
result will be higher profitability and return on total assets for the firm.

Short-term Financing Concept

A firm in search of short-term financing must be aware of all the
institutional arrangements that are available. Trade credit from suppliers is
normally the most available form of short-term financing and is a natural
outgrowth of the buying and reselling of goods. Larger firms tend to be net
providers of trade credit, while smaller firms are net users.
Bank loans are usually short term in nature and are self-liquidating,
being paid back from funds from the normal operations of the firm. A
financially strong customer will be offered the lowest rate with the rates to
other customers scaled up to reflect their risk category. Bankers use either the
prime rate or LIBOR as their base rate and add to that depending on the
creditworthiness of the customer. Banks also use compensating balances as
well as fees to increase the effective yield to the bank.
An alternative to bank credit for the large, prestigious firm is the use of
commercial paper which represents a short-term unsecured promissory note
issued by the firm. Through generally issued at a rate below prime, it is an
impersonal means of financing that may “dry up” during difficult financing
periods.
Firms are increasingly turning to foreign markets for lower cost sources
of funds. They may borrow in the Eurodollar market (foreign dollar loans) or
borrow foreign currency directly from banks in an attempt to lower their
borrowing costs.
By using accounts receivable and inventory as collateral for a loan, the
firm may be able to turn these current assets into cash more quickly than by
waiting for the normal cash flow cycle. By using a secured form of financing,
the firm ties its borrowing requirements directly to its asset buildup. The firm
may also sell its accounts receivable to a factor. These secured forms of
borrowing may be expensive but may fit the credit needs of the firm,
particularly the needs of a small firm that cannot qualify for lower cost bank
financing or the commercial paper market,
Finally, the financial manager may wish to consider the use of hedging
through the financial futures market, the consequences of rapid interest rate or
currency changes can be reduced through participation in the futures market.
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Cash / Fund Management

Person can manage cash having a sound knowledge of what cash all
about. Knowing the whole environment of this account so that we can plan,
direct, and control and be able to minimize its earning potential and safeguard
its handling. Considering the following types of cash:
a. Cash on hand – represents the remaining cash collection of the day
waiting to be deposited the following banking day because the new trend
now is to deposit the receipt during the day immediately. In this case, the
business enterprise can minimize the risk of losing the money through
theft and an unauthorized use of the cash. So, the cash left are those
receipts after banking system has closed for the day.
b. Cash in bank – represents already deposited in the bank that could be
either savings account, demand deposit, and combo account.
c. Cash fund – ideally, company cash has to be maintained under imprest
system of cash handling that could be either petty cash fund, change
fund, and dividend fund.
d. Cash equivalent – short term and highly liquid investments readily
convertible to cash and so near their maturity with a purpose of which is
to maximize the earning potential of cash of the company.
How is Cash Processed?
The policy set up must be able to provide feedback on potential errors to
management. Here are sample policies on cash handling:
1. The company should adopt the imprest system of handling cash.
2. The company should maintain the combo account for easier tracking of
banking transactions.
3. The company should place its money in various banking companies so as
to distribute the risk involved in banking.
4. The levels of authority for bank be the check signatories should be
observed.
5. Official receipts can only be issued when cash is received. Check
payments received from customers or other person or company will be
covered by provisional receipts.
6. All funds should be kept and maintained by the office fund collection.
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Inventory Management
It all starts with cash. The operating cycle says that the moment the
company has cash, basically they have to convert it to inventory. When they
have inventory, they are going to sell and convert the inventory into a
receivable, then they will collect the account to eventually convert it back to
cash.
Manufacturing concern business enterprise has three more inventory
accounts that will be added aside from the normal supplies and merchandise
inventory account. These are:
a. Raw materials inventory – materials which the company purchased and
its use in the production.
b. Work-in-process inventory – partially finished products at the end of the
month.
c. Finished goods inventory – products that are already finished and ready
to be sold to customers.
The company might be using other costing method but this should be
converted to what is generally accepted for fair presentation of financial
statement.
a. Beginning inventory
b. Purchases
c. Goods available for sale
d. Ending inventory (balance sheet)
e. Cost of goods sold (income statement)
Why do we have to manage inventory?
Management should warrant a good inventory system because the effects
of mismanagement of inventory could result in the following:
a. Understocking – this means that stocks are not sufficient to meet the
demands of the business.
b. Overstocking – this means that stocks are more than enough for the
demand of the business.
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Receivable Management
Receivables are financial assets that represent a contractual right to
receive cash or other financial assets from another entity or customer.
These are the examples of receivables:
a. Traditional accounts receivable is not supported by a promissory note. It
is normally supported by a credit invoice issued by the company and has
credit terms. The credit terms stated in the invoice are basis of the
accounting department on whether the customer’s account is not yet due
or past due already. This will also be the basis for recognizing an
impairment loss arising from a receivable account.
b. Notes receivable – is supported by a formal promise to pay in the form of
a note.
c. Loans receivable – is a receivable arising from banks and other financial
institution.
How is the industry practice in managing receivable?
A company that has a large customer environment should tie up with
various banking companies.
1. Customers can now deposit their payment directly to the banking
system. This system will cut some of the possible:
1.1. Cost of collectors’ services
1.2. Opportunity of losing money
1.3. Forms which company uses as proof of payment
2. Automatic debt arrangement with the banking system – account of
customers will automatically be debited for the amount they have to pay
to the company.
3. Phone banking – customer can now pay in the comforts of their homes
and within their time and convenience.
4. Online banking – some customers can have access to their bank
accounts through the internet and in so doing they can pay their
accounts.
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III. LEARNING / CHAPTER ACTIVITIES

Activity 5
Name: _____________________________
Subject: ___________________________
Concept Discussion Learning Activity:
1. What is the reason why do we need to study working capital
management?
2. What is the importance of controlling cash and how does it eliminate
misuse of cash?
3. What is inventory and how does its control measures improve risk
management
4. What are to the importance of receivable management and its
participation in the operating performance of the company?
5. Why do we need to manage short-term debt or current liabilities well?
6. How will you illustrate in a model the formula in working capital
management that is current asset less current liabilities? Thoroughly
explain.

Research-based Learning Activity

1. Continue researching a Publicly Listed Companies with a working capital
management.
1.1. Identify the Problem
1.2. Present the Background of their working capital
1.3. Propose Three (3) Alternative Solution with Pros and Cons
1.4. Select the Best Solution
1.5. Recommendation

IV. REFERENCES

Books:

a. Anastacio, M. F., (2016) Fundamentals of Financial Management, Rex

Book Store Inc.
b. Brigham, E. & Houston, J. (2015) Financial Management, Cengage
Learning Philippine Edition
c. Block, S. & et. al. (2011) Corporate Finance Foundations, McGraw-Hill
Irwin
d. Cabrera, M. E. (2015) Financial Management, GIC Enterprises & Co. Inc.
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Online Resources:
a. https://www.scribd.com/doc/98098428/WORKING-CAPITAL-
MANAGEMENT-ppt#download