Executive Learning Institute CBM – Financial Management

J.P SARAGIH

www.managing.finance

WORKING CAPITAL
MANAGEMENT
22 May 2018

1
Total Value of Assets Total Firm Value to
Investors
Current
Liabilities Spontan
Current Assets
eous
financing

=
Long-Term
Debt
Fixed Assets Debt financing
1. Tangible
2. Intangible
Shareholders’ Capital
Equity structure
Equity
financing

Allocation of Source of 3
Funds Financing
Net Working Capital

• Working Capital includes a firm’s current assets,

which consist of cash and marketable securities in
addition to accounts receivable and inventories.
• It also consists of current liabilities, including accounts
payable (trade credit), notes payable (bank loans), and
accrued liabilities.
• Net Working Capital is defined as total current assets
less total current liabilities.

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Working Capital

Working capital is the excess of current

assets over current liabilities.

12/31/07
Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000
PRASETIYA MULYA
 1. LIQUIDITY RATIO

1.1 Current Ratio

TOTAL CURRENT ASSETS

CURRENT RATIO =
TOTAL CURRENT LIABILITIES

• Indicate the ability to pay current liabilities with current

assets (to pay its short-term obligations  creditors).

• Current Assets include cash, marketable securities, account

receivable, and inventories.
• Current Liabilities consists of account payable, short-term
notes payable,and accrued expenses.
PRASETIYA MULYA
 1. LIQUIDITY RATIO

1.2 Quick (Acid Test) Ratio

CURRENT ASSETS - INVENTORIES

QUICK (ACID TEST) RATIO =
CURRENT LIABILITIES

• All items of current assets exclude inventories (the least

liquid asset).
• Current Liabilities consists of account payable, short-term
notes payable,and accrued expenses.
• Indicate instant debt-paying ability of the firm (stricter test).

PRASETIYA MULYA
Working Capital Management
Strategies

• Financial managers use two types of strategies

for current assets: flexible and restrictive
– The flexible current asset management strategy has
a high percent of current assets to sales, whereas a
restrictive policy has a low percent of current
assets to sales
Working Capital Management
Strategies

• Flexible current asset management strategy

• Calls for management to invest large amounts in cash,
marketable securities, and inventory
• The flexible strategy is considered low-risk and low-return
• The advantage of this strategy is large working capital
balances
• The downside of this strategy is the high carrying cost
associated with owning a high level of inventory and
providing liberal credit terms to customers
Working Capital Management
Strategies

• The restrictive current asset management

strategy is a high-risk high-return alternative to
the flexible strategy
– The high risk comes in the form of shortage costs,
both financial and operating
• Financial shortage costs arise mainly from illiquidity,
shortage of cash, and a lack of marketable securities to sell
for cash
• Operating shortage costs result from lost production and
sales
Working Capital Management
Strategies

• Restrictive current asset management strategy

(continued)
– Current assets are kept at a minimum under the
restrictive strategy
• The firm barely invests in cash and inventory and has tight
terms of sale intended to curb credit sales and accounts
receivable
• If there are unpaid bills due, the firm will be forced to use
expensive external emergency borrowing; if funding
cannot be secured, default occurs on some current
liabilities and the firm runs the risk of being forced into
bankruptcy by creditors
Working Capital Management
Strategies
• The working capital trade-off: management will try to
find the level of current assets that minimizes the sum
of the carrying costs and shortage costs
– The optimal current assets investment strategy will depend
on the relative magnitudes of carrying costs and shortage
costs; this conflict is often referred to as the working
capital trade-off
– Financial managers need to balance shortage costs against
carrying costs to define an optimal strategy
– If carrying costs are larger than shortage costs, then the
firm will maximize value by adopting a more restrictive
strategy
– On the other hand, if shortage costs dominate carrying
costs, the firm will need to move towards a more flexible
policy
 Analysis by Short-Term Creditors

Babson Builders, Inc.

Use this 2014
information to Cash $ 30,000
calculate ratios to Accounts receivable, net
Beginning of year 17,000
measure the well- End of year 20,000
being of the short- Inventory
term creditors for Beginning of year 10,000
End of year 15,000
Babson Builders,
Total current assets 65,000
Inc. Total current liabilities 42,000
Sales on account 500,000
Cost of goods sold 140,000
Accounts Receivable Turnover Rate
Accounts
Net Sales
Receivable =
Average Accounts Receivable
Turnover

Accounts
$500,000
Receivable = = 27.03 times
($17,000 + $20,000) ÷ 2
Turnover

This ratio measures how many

times a company converts its
receivables into cash each year.
Number of Days to Collect Receivables

Average 365 Days

Collection = Accounts Receivable Turnover
Period

Average
365 Days
Collection = = 13.50 days
27.03 Times
Period

This ratio measures, on average,

how many days it takes to collect
an account receivable.
 Inventory Turnover Rate

Inventory Cost of Goods Sold

=
Turnover Average Inventory

Inventory $140,000
= = 11.2 times
Turnover ($10,000 + $15,000) ÷ 2

This ratio measures the number

of times merchandise inventory
is sold and replaced during the year.
Average Inventory Period

Average 365 Days

=
Inventory Inventory Turnover
Period

Average 365 Days

= = 32.6 days
Inventory 11.2 Times
Period

This ratio measures how many

days, on average, it takes to
sell the inventory.
Calculating the Cash Conversion Cycle

The Operating Cycle (OC) is the time between

ordering materials and collecting cash from
receivables.

The Cash Conversion Cycle (CCC) is the time

between when a firm pays it’s suppliers (payables)
for inventory and collecting cash from the sale of the
finished product.

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Calculating the Cash Conversion Cycle

• Both the OC and CCC may be computed as shown

below.

• AAI = Average Age of Inventory (inventory period)

• ACP = Average Collection Period
• APP = Average Payment Period
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Calculating the Cash
Conversion Cycle (cont.)

MAX Company, a producer of paper dinnerware, has

annual sales of $10 million, cost of goods sold of 75% of
sales, and purchases that are 65% of cost of goods sold.
MAX has an average age of inventory (AAI) of 60 days,
an average collection period (ACP) of 40 days, and an
average payment period (APP) of 35 days.

Using the values for these variables, the cash conversion

cycle for MAX is 65 days (60 + 40 - 35) and is shown on
a time line in the followings:
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Calculating the Cash
Conversion Cycle (cont.)

Time Line for MAX Company’s Cash Conversion Cycle

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Calculating the Cash
Conversion Cycle (cont.)

The resources MAX has invested in the cash

conversion cycle assuming a 365-day year are:

Obviously, reducing AAI or ACP or lengthening APP will

reduce the cash conversion cycle, thus reducing the amount
of resources the firm must commit to support operations.
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KEBUTUHAN MODAL KERJA

• Days Receivables = 3 bulan

• Days Inventory = 1 bulan
• Days Payables = 2 bulan
• Omzet per bulan = 100 juta
• Harga Pokok Penjualan = 70%

• Kebutuhan Modal Kerja =

(3 + 1 – 2) x (100 juta x 70%) = 140 juta
Working Capital in Various
Industries

Company Industry AR Days Inventory A/P Days CCC

BOEING Aerospace / Defense 24 63 49 38

HILTON Hotel 26 29 18 37

INTEL Semiconductors 37 73 53 57

KROGER Grocery Stores 4 37 31 10

MATTEL Toys and Games 54 49 35 68

MERCK Drug Manufacturers 49 122 35 136

NORDSTROM Apparel Stores 51 73 39 85

ORACLE Application Software 80 0 32 48

PULTE HOMES Residential Construction 4 260 11 253

SOUTHWEST Regional Airlines 9 23 80 -48

Source: CORPORATE FINANCE; Berk, Jonathan and Demarzo, Peter; Pearson 24

Strategies for Managing the CCC

1. Turn over inventory as quickly as possible without

stock outs that result in lost sales.
2. Collect accounts receivable as quickly as possible
without losing sales from high-pressure collection
techniques.
3. Manage, mail, processing, and clearing time to reduce
them when collecting from customers and to increase
them when paying suppliers.
4. Pay accounts payable as slowly as possible without
damaging the firm’s credit rating.
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Just-in-Time Inventory Management

• In this system the exact day-by-day, or even

hour-by-hour raw material needs are delivered
by the suppliers, who deliver the goods “just in
time” for them to be used on the production
line
– A big advantage in this system is that there are
essentially no raw material inventory costs and no
chance of obsolescence or loss to theft
– On the other hand, if the supplier fails to make the
needed deliveries, then production shuts down
 Preparing the Operating Budgets

Direct Materials Budget

 Shows both the quantity and cost of direct materials to be purchased.

 Formula for direct materials quantities.

Illustration 9-6

 Budgeted cost of direct materials to be purchased = required

units of direct materials x anticipated cost per unit.
 Inadequate inventories could result in temporary shutdowns
of production.
 Preparing the Operating Budgets

Illustration – Hayes Company

Because of its close proximity to suppliers,
 Hayes Company maintains an ending inventory of raw materials
equal to 10% of the next quarter’s production requirements.
 The manufacture of each Rightride requires 2 pounds of raw
materials, and the expected cost per pound is $4.
 Assume that the desired ending direct materials amount is 1,020
pounds for the fourth quarter of 2014.
 Prepare a Direct Materials Budget.
 Preparing the Operating Budgets

Illustration – Hayes Company

Illustration 9-7
Effects of inventory valuation on Income Statement

AVERAGE FIFO LIFO

SALES 27000 27000 27000
COGS
Beginning Inventory 8000 8000 8000
Purchase 22000 22000 22000
Ending Inventory -12000 -14500 -9800
COGS 18000 15500 20200
GROSS PROFIT 9000 11500 6800

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P1 Valuing Accounts Receivable

Some customers may not pay their account.

Uncollectible amounts are referred to as bad debts.

There are two methods of

accounting for bad debts:
Direct Write-Off Method
Allowance Method
P1
Direct Write-Off Method

TechCom determines on January 23 that it cannot

collect $520 owed to it by its customer J. Kent.

Notice that the specific customer is noted in the

transaction so we can make the proper entry in the
customer’s Accounts Receivable subsidiary ledger.
P1 DIRECT WRITE-OFF METHOD –
RECOVERING A BAD DEBT

On March 11, J. Kent was able to make full payment to

TechCom for the amount previously written-off.
P1 Allowance Method

At the end of each period, estimate total bad

debts expected to be realized from that period’s
sales.

Two advantages to the allowance method:

1. It records estimated bad debts expense in the period
when the related sales are recorded.
2. It reports accounts receivable on the statement of
financial position at the estimated amount of cash to
be collected.
P1 Recording Bad Debts Expense
TechCom had credit sales of $300,000 during its first year of
operations. At the end of the first year, $20,000 of credit
sales remained uncollected. Based on the experience of
similar businesses, TechCom estimated that $1,500 of its
accounts receivable would be uncollectible.
P1 Statement of Financial Position
Presentation
TechCom had credit sales of $300,000 during its first year of
operations. At the end of the first year, $20,000 of credit
sales remained uncollected. Based on the experience of
similar businesses, TechCom estimated that $1,500 of its
accounts receivable would be uncollectible.
P1
Writing Off a Bad Debt

TechCom decides that J. Kent’s $520 account is

uncollectible.
P1
Writing Off a Bad Debt

The write-off does not affect the realizable

value of accounts receivable.
P1
Recovering a Bad Debt

To help restore credit standing, a customer sometimes

volunteers to pay all or part of the amount owed on an
account even after it has been written off.

On March 11, Kent pays in full his $520 account

previously written off.
P2
Estimating Bad Debts Expense

Receivables Methods
 Percent of Receivables
 Aging of Receivables
P2

Percent of Receivables Method

1. Compute the estimate of the

Allowance for Doubtful Accounts.
Year-end Accounts Receivable × Bad Debt %

2. Bad Debts Expense is computed as:

Total Estimated Bad Debts Expense
– Previous Balance in Allowance Account
= Current Bad Debts Expense
P2

Percent of Receivables Method

Musicland has $50,000 in accounts receivable and a $200 credit
balance in Allowance for Doubtful Accounts on December 31, 2011.
Past experience suggests that 5% of receivables are uncollectible.

Desired balance in Allowance for

Doubtful Accounts.
$ 50,000
× 5.00%
= $ 2,500
P2
Aging of Accounts Receivable
Four Types of Billing Disputes

• Total Price / Fee charged.

• Quality of the service rendered or
goods provided.
• Hard to understand / incomplete / not
detailed bills.
• Billing error e.g. billed again for a
paid amount.

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CONTOH SCORING
(objective, consistent, efficient)
• Rasio nilai pasar dengan kredit yang diminta:
– > 200% 40
– > 150% - 200% 25
– > 120% - 150% 15
• Kepemilikan tempat usaha
– Milik sendiri 3
– Kredit 2
– Sewa 0
• Hasil trade checking relasi bisnis positif
– Lebih dari dua relasi bisnis 7
– Dua relasi bisnis 3
– Tidak ada 0
• Pengelolaan Usaha
– Tidak tergantung seseorang 3
– Tergantung pada seseorang 0
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Spontaneous Liabilities: Analyzing Credit
Terms

• Giving Up the Cash Discount

Payment
Options

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 Improving Financial Performance

 Cash Discounts: For prompt payment, e.g. ‘2% 10th, net 30’ (or ‘2/10 net 30’) – i.e.
2% discount if payment is within 10 days of the invoice date, but otherwise pay full
amount within 30 days (the latter option is the equivalent to a supplier’s 20-day
loan). Take the discount or not?

Annualized interest 365 days

Discount %
rate from not taking = x
a cash discount 100% – Discount % No. of days of the
‘loan’

For the proposed discount, this results in the following:

Annualized interest
rate from not taking 2% 365 days
the 2% 10th, net 30 = x
100% – 2% 20 days
cash discount
= 0.02041 x 18.25
= 0.3724
= 37.24% 47
Annual Rate for NOT taking the supplier discount

DISCOUNT /
DAYS 10 15 20 25

1% 36.87% 24.58% 18.43% 14.75%

2% 74.49% 49.66% 37.24% 29.80%

3% 112.89% 75.26% 56.44% 45.15%

4% 152.08% 101.39% 76.04% 60.83%

5% 192.11% 128.07% 96.05% 76.84%

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Accounts Receivable Management:
The Five Cs of Credit

• Character: The applicant’s record of meeting past

obligations.
• Capacity: The applicant’s ability to repay the
requested credit.
• Capital: The applicant’s debt relative to equity.
• Collateral: The amount of assets the applicant has
available for use in securing the credit.
• Conditions: Current general and industry-specific
economic conditions.

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THANK YOU
On May 31, a company had a balance in its
accounts receivable of $103,895. Prepare journal
entries to record the following transactions for
June.

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Evaluate each inventory error separately and determine whether it overstates or understates cost of goods sold and net income.

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