Chapter 17

Working Capital
Management

17-1
Working Capital Terminology

Working capital current assets.

Net working capital current assets minus
non-interest bearing current liabilities.
Working capital policy deciding the level of
each type of current asset to hold, and how
to finance current assets.
Working capital management controlling
cash, inventories, and A/R, plus short-term
liability management.

17-2
DuPont Equation

DuPont Equation demonstrate how working

capital management affects ROE.
Profit Margin x Total Assets Turnover x Equity Multiplier
Net income x Sales x Assets
Sales Assets Equity

17-3
Current Asset Investment Policies

Relaxed Investment Policy Relatively large

amounts of cash, marketable securities and
inventories are carried, and a liberal credit
policy results to high receivables.
Implications:
a. Lower ROE
b. Low asset turnover
c. Minimizes operating risks

17-4
Current Asset Investment Policies

Restricted Investment Policy Holdings of

cash, marketable securities, inventories and
receivables are constrained.
Implications:
a. Lower level of assets
b. Higher ROE
b. High asset turnover
c. Increases operating risks

17-5
Current Asset Investment Policies

Moderate Investment Policy An investment

policy that is between the relaxed and
restricted policies.

17-6
Current Asset Investment Policies

Moderate Investment Policy An investment

policy that is between the relaxed and
restricted policies.

17-7
Illustration:

Calgary Company is thinking of modifying its

working capital assets policy.
Fixed Assets = 600,000
Sales = 3,000,000
EBIT/Sales = 15 %
Interest Rate = 10 %
Tax = 40 %
Debt-Asset Ratio = 50 %

Alternative Current Asset Policies: 40%, 50% and

60% of sales. What is the ROE under each
alternative?
17-8
 Illustration:

ALTERNATIVE BALANCE SHEET ALTERNATIVE INCOME STATEMENT

Restricted (40%) Moderate ( 50%) Relaxed (60%)
Restricted (40%) Moderate ( 50%) Relaxed (60%)
CA 1,200,000.00 1,500,000.00 1,800,000.00 Sales 3,000,000.00 3,000,000.00 3,000,000.00

FA 600,000.00 600,000.00 600,000.00 EBIT 450,000.00 450,000.00 450,000.00

Interest 90,000.00 105,000.00 120,000.00

TA 1,800,000.00 2,100,000.00 2,400,000.00
EBT 360,000.00 345,000.00 330,000.00
Debt 900,000.00 1,050,000.00 1,200,000.00
Tax 144,000.00 138,000.00 132,000.00
Equity 900,000.00 1,050,000.00 1,200,000.00 Net Income 216,000.00 207,000.00 198,000.00

TLE 1,800,000.00 2,100,000.00 2,400,000.00 ROE 24.0% 19.7% 16.5%

17-9
Current Asset Financing Policies

Investment in current assets are financed by:

a. Bank loans
b. Accounts payable/Accrued liabilities
c. Long-term debt
d. Common equity

17-10
Current Asset Financing Policies

Permanent Current Assets

- Current assets that a firm must carry even at the
lowest point of its cycle
- cash, marketable securities, other CA
Temporary Current Assets
- Current assets that fluctuate with seasonal or cyclical
variations in sales
- Inventories and receivable
Current Assets Financing Policy
- The manner in which current assets are financed.
17-11
 Current Asset Financing Policies

Maturity Matching, or Self-Liquidating Approach

- A financing policy that matches the maturities of assets
and liabilities. A moderate policy where permanent
current assets are financed by long-term capital/debt
while temporary current assets are financed by short-term
debt.
Two Factors Preventing the Approach
1. Uncertainty of the lives of assets
2. Common equity financing option

17-12
 Current Asset Financing Policies

Aggressive Approach
- a financing policy where permanent current assets are
financed by short-term debt.
Reason:
1. Short-term debts have lower interest rates
Consideration:
1. Highly risky

Conservative Approach
- a policy where current assets, both permanent and
temporary, are financed by long-term capital/debt.
17-13
Moderate Financing Policy

$ Temp. C.A.
S-T
Loans

Perm C.A. L-T Fin:

Stock,
Bonds,
Spon. C.L.
Fixed Assets

Years
Lower dashed line would be more aggressive.
17-14
Aggressive Financing Policy

$ Temp. C.A.
S-T
Loans

Perm C.A. L-T Fin:

Stock,
Bonds,
Spon. C.L.
Fixed Assets

Years
Lower dashed line would be more aggressive.
17-15
Conservative Financing Policy

Marketable
$ securities
Zero S-T
Debt

L-T Fin:
Stock,
Perm C.A. Bonds,
Spon. C.L.

Fixed Assets

Years
17-16
 Choosing Financing Approach

Short-Term Debt Disadvantages

1. Interest cost fluctuate widely and unstable eating up
profit
2. Temporary economic and market recession will
adversely affect its financial ratios and render it unable to
repay debt.
Short-Term Debt Advantages
1. Short-term loans can be negotiated much faster
2. Short-term debt may offer greater flexibility

17-17
Illustration:

V Press and H Press had the following Balance Sheets as

of Dec. 31, 2015
BALANCE SHEET

V H EBIT:
CA 100,000.00 80,000.00
30,000
FA 100,000.00 120,000.00
Tax rate:
TA 200,000.00 200,000.00
40%
CL 20,000.00 80,000.00

NCL 80,000.00 20,000.00

CS 50,000.00 50,000.00

RE 50,000.00 50,000.00

TLE 200,000.00 200,000.00

What is the ROE if

A. Interest rate is 10% for CL and 13% for NCL.
B. Interest rate becomes 20% for CL and 16% for
NCL for the succeeding debts 17-18
 Illustration:

ALTERNATIVE INCOME STATEMENT

V-1 V-2 H-1 H-2
EBIT 30,000.00 30,000.00 30,000.00 30,000.00
Interest -CL 2,000.00 4,000.00 8,000.00 16,000.00
Interest -NCL 10,400.00 10,400.00 2,600.00 2,600.00
EBT 17,600.00 15,600.00 19,400.00 11,400.00
Tax 7,040.00 6,240.00 7,760.00 4,560.00
Net Income 10,560.00 9,360.00 11,640.00 6,840.00
ROE 10.6% 9.4% 11.6% 6.8%

Which is more risky? V or H and why?

17-19
 Cash Conversion Cycle

The length of time where funds are tied up in

working capital or the length of time between
paying for working capital and collecting cash
from the sale of the working capital.

Inventory Average Payables = Cash

Conversion Collection Deferral Period Conversion Cycle
Period + Period (ACP) _

Average time Average time to Average time

required to convert convert AR to cash required to pay
materials to FG current liabilities
then sell (credit period)
60 days 60 days 40 days 80 days
17-20
 Illustration:

Annual Sales 1,216,666

COS 1,013,889
Inventory 250,000
AR 300,000
AP 150,000

Inventory Average Payables = Cash

Conversion Collection Deferral Period Conversion Cycle
Period + Period (ACP) _

Inventory/ Receivables/ Payables/

COS per day Sales per day COS per day
90 days 90 days 54 days 126 days

17-21
Exercise:

ZOCCO Corporation has an inventory conversion period of

75 days, average collection period of 38 days and payable
deferral period of 30 days.

1. What is the length of CCC?

2. If the annual credit sales are 3,421,875, what is the
investment in AR?
3. How many times per year does Zocco turn over its
inventory?

17-22
Suggested Answer:

ZOCCO Corporation has an inventory conversion period of

75 days, average collection period of 38 days and payable
deferral period of 30 days.

1. 75 + 38 30 = 83 days
2. 3,421,875/365 = 9,375 x 38 days = 356,250
3. 365 days / 75 days = 4.87 times

17-23
Minimizing Cash Holdings

Use a lockbox
Insist on wire transfers and debit/credit
cards from customers
Synchronize inflows and outflows
Reduce need for safety stock of cash
Increase forecast accuracy
Hold marketable securities
Negotiate a line of credit

17-24
Cash Budget

Forecasts cash inflows, outflows, and ending

cash balances.
Used to plan loans needed or funds available
to invest.
Can be daily, weekly, or monthly, forecasts.
Monthly for annual planning and daily for actual
cash management.
A table that shows cash receipts,
disbursements, and balances over some
period.
17-25
SKIs Cash Budget for January and
February
Net Cash Inflows
January February
Collections $67,651.95 $62,755.40
Purchases 44,603.75 36,472.65
Wages 6,690.56 5,470.90
Rent 2,500.00 2,500.00
Total payments $53,794.31 $44,443.55
Net cash flows $13,857.64 $18,311.85

17-26
SKIs Cash Budget

Net Cash Inflows

January February
Cash at start if no
borrowing $ 3,000.00 $16,857.64
Net cash flows 13,857.64 18,311.85
Cumulative cash 16,857.64 35,169.49
Less: Target cash 1,500.00 1,500.00
Surplus $15,357.64 $33,669.49

17-27
Cash Budget Template

Expected (Target) cash balance, beginning

Add: Budgeted cash receipts
Total cash available
Less: Budgeted cash disbursements
Ending cash balance ending

17-28
 Illustration:
Data:
Collections during the month of sale 20%
Collections during the 1st month of sale 70%
Collections during the 2nd month of sale 10%
Percent of bad debts 0%
Discount on first month collections 2%
Purchases as a % of next months sales (paid next month) 70%
Lease payments monthly 15,000
Construction cost payment on Oct 100,000
Target Cash Balance 10,000
Wages and salaries As given
Other expenses As given
Taxes As given

17-29
 Illustration:

May June July August September October November December January February
Budgeted Cash
Receipts

Sales 200,000.00 250,000.00 300,000.00 400,000.00 500,000.00 350,000.00 250,000.00 200,000.00

Collections:
Month of Sale
(20%) less discount 39,200.00 49,000.00 58,800.00 78,400.00 98,000.00 68,600.00 49,000.00 39,200.00
1st month after
month of sale (70%) 140,000.00 175,000.00 210,000.00 280,000.00 350,000.00 245,000.00 175,000.00 140,000.00
2nd month after
month of sale (10%) 20,000.00 25,000.00 30,000.00 40,000.00 50,000.00 35,000.00 25,000.00 20,000.00

Total collections 39,200.00 189,000.00 253,800.00 313,400.00 408,000.00 458,600.00 344,000.00 249,200.00 165,000.00 20,000.00

17-30
 Illustration:
May June July August September October November December

Budgeted Cash
Disbursements
Purchases
(70%) of next
month's sale 175,000.00 210,000.00 280,000.00 350,000.00 245,000.00 175,000.00 140,000.00 -
Payments:
Payment of
purchases 175,000.00 210,000.00 280,000.00 350,000.00 245,000.00 175,000.00 140,000.00
Wages and
salaries 30,000.00 40,000.00 50,000.00 40,000.00 30,000.00 30,000.00
Lease
payments 15,000.00 15,000.00 15,000.00 15,000.00 15,000.00 15,000.00

Other expenses 10,000.00 15,000.00 20,000.00 15,000.00 10,000.00 10,000.00

Taxes 30,000.00 20,000.00

Plant
construction 100,000.00

Total payments - 175,000.00 265,000.00 350,000.00 465,000.00 415,000.00 230,000.00 215,000.00

17-31
 Illustration:

July August September October November December January

Cash balance,
beginning - (11,200.00) (47,800.00) (104,800.00) (61,200.00) 52,800.00 87,000.00
Add: Budgeted cash
receipts 253,800.00 313,400.00 408,000.00 458,600.00 344,000.00 249,200.00
Total cash available 253,800.00 302,200.00 360,200.00 353,800.00 282,800.00 302,000.00
Less: Budgeted cash
disbusements 265,000.00 350,000.00 465,000.00 415,000.00 230,000.00 215,000.00
Ending cash balance (11,200.00) (47,800.00) (104,800.00) (61,200.00) 52,800.00 87,000.00

17-32
 Illustration:

Cash balance, beginning - (11,200.00) (47,800.00) (104,800.00) (61,200.00) 52,800.00

Add: Budgeted cash receipts 253,800.00 313,400.00 408,000.00 458,600.00 344,000.00 249,200.00
Total cash available 253,800.00 302,200.00 360,200.00 353,800.00 282,800.00 302,000.00
Less: Budgeted cash disbusements 265,000.00 350,000.00 465,000.00 415,000.00 230,000.00 215,000.00

Ending cash balance (11,200.00) (47,800.00) (104,800.00) (61,200.00) 52,800.00 87,000.00

Target cash balance 10,000.00 10,000.00 10,000.00 10,000.00 10,000.00 10,000.00

Surplus cash or (Loan needed) (21,200.00) (57,800.00) (114,800.00) (71,200.00) 42,800.00 77,000.00

Maximum required loan (114,800.00)

Maximum available for investment
(excess cash) 77,000.00

17-33
 Exercise:
At the end of the current month, Gipit Company expects to have a cash
balance of P 25,000. For the next three months, it expects to generate
sales as follows:
July P 88,000
August P 95,000
September P 74,000

The company sells its goods on cash basis only. Aside from its income
from the sale of goods, the company also earns rental income of P 20,000
per month from the commercial spaces that it lets to a number of tenants.

Gipits operating expenses amount to 40 percent of its gross revenue. All

expenses are paid in the month they are incurred. Non-cash expenses
such as depreciation and amortization amount to P 30,000 per month.

Requirement: Prepare a cash budget with details for each month.

17-34
 Suggested Answer:

July August September

Cash balance, beginning - 94,800.00 193,800.00

Add: Budgeted cash receipts 108,000.00 115,000.00 94,000.00
Total cash available 108,000.00 209,800.00 287,800.00
Less: Budgeted cash disbusements 13,200.00 16,000.00 7,600.00
Ending cash balance 94,800.00 193,800.00 280,200.00

Budgeted Cash Receipts

Sales 88,000.00 95,000.00 74,000.00
Collections:
Month of Sale (100%) 88,000.00 95,000.00 74,000.00
Rental income 20,000.00 20,000.00 20,000.00
Total collections 108,000.00 115,000.00 94,000.00

17-35
 Suggested Answer:

July August September

Budgeted Cash Disbursements
Payments:
Payment of operating expense 13,200.00 16,000.00 7,600.00
Total payments 13,200.00 16,000.00 7,600.00

Cash balance, beginning - 94,800.00 193,800.00

Add: Budgeted cash receipts 108,000.00 115,000.00 94,000.00
Total cash available 108,000.00 209,800.00 287,800.00
Less: Budgeted cash disbusements 13,200.00 16,000.00 7,600.00
Ending cash balance 94,800.00 193,800.00 280,200.00
Target cash balance 25,000.00 25,000.00 25,000.00
Surplus cash or (Loan needed) 69,800.00 168,800.00 255,200.00

Maximum required loan -

Maximum available for investment
(excess cash) 255,200.00 17-36
How could bad debts be worked
into the cash budget?
Collections would be reduced by the
amount of the bad debt losses.
For example, if the firm had 3% bad debt
losses, collections would total only 97% of
sales direct write-off
Lower collections would lead to higher
borrowing requirements.

17-37
Cash and Marketable Securities

Cash
Currency (bills and coins)

Cash Equivalents
Demand (checking) deposit
Marketable securities

17-38
Cash and Marketable Securities

Demand deposits are used for:

Paying for raw materials and labor
Purchasing fixed assets
Paying taxes
Servicing debt

17-39
Techniques To Optimize Demand Deposit Holdings

Hold marketable securities rather than demand

deposits to provide liquidity
Borrow on short notice
Forecast payments and receipts better
Speed up payments (lockbox, bayad center,
gcash)
Use credit cards, debit cards, wire transfers and
direct deposit
Synchronize cash flows

17-40
Cash and Marketable Securities

Lockbox is a post office box operated by a

bank to which payments are sent. Used to
speed up effective receipt of cash
Marketable Securities are highly liquid, easily
convertible to cash and be traded, and
interest earning short-term instrument
Treasury bills
Commercial papers
Bank certificates of deposit
Money market funds
14-41