Business Finance

CHAPTER 3
Planning and Working
Capital Management
Working Capital
Management
 Learning Objective
• To understand the composition of working
capital and the working capital financing policies
 Working Capital
What is WORKING CAPITAL?

 Working capital refers to the current assets used in the

operations of the business including cash, accounts
receivable, inventories, and prepaid expenses.
 The amount of resources that a company sets aside to
these working capital accounts can be reduced by
current liabilities. The difference between these current
assets and current liabilities used in the operations of the
business is net working capital.
 Working Capital
Why is management of working capital
accounts important?

 The management of working capital accounts is

important because they deal with the day-to-day
operations of the business. If the company fails in the
management of these accounts, there will be no
expansion to talk about or this can lead to the closure of
the company.
 Good management of working capital accounts allows
the company to pay maturing obligations on time. This
helps in developing good business relationships with
suppliers and other vendors such as utility companies.
 Working Capital
Why is management of working capital
accounts important?

 Good management of working capital accounts also

relieves managers of unnecessary stress and gives them
more executive time to improve the business operations.

 Efficient management of working capital accounts can

improve company’s earnings through savings in financing
costs and minimizing possible impairment losses from
inventories.
Working Capital Financing Policies
What are the THREE TYPES OF WORKING
CAPITAL FINANCING POLICIES?

1. Maturity-matching working capital financing policy

2. Aggressive working capital financing policy
3. Conservative working capital financing policy
 Maturity-Matching Working Capital
Financing Policy
Based on the MATURITY-MATCHING
WORKING CAPITAL FINANCING POLICY…

 Permanent working capital requirements should be financed

by:
Long-term sources including long-term debt and equity
such as common stocks and preferred stocks.
 Temporary working capital requirements should be financed by:
Short-term sources of financing including short-term bank
loans, which are called working capital loans.
 Aggressive Working Capital
Financing Policy
Under the AGGRESSIVE WORKING
CAPITAL FINANCING POLICY…

 Some of the permanent working capital requirements are

financed by short-term sources of financing.
 Managers of some companies adopt this policy because long-
term sources of funds have higher cost as compared to short-
term sources of financing. By financing some of the permanent
working capital requirements with short-term sources of
financing, financing cost is minimized which in turn, improves
net income.
 However, adopting this policy increases default risk.
 Conservative Working Capital
Financing Policy
Based on the CONSERVATIVE WORKING
CAPITAL FINANCING POLICY…

 Some of the temporary working capital requirements are

financed by long-term sources of financing.
 Possible reasons why some companies adopt this policy are:
(1) management does not probably want to be stressed too
much so that they can concentrate their efforts on other
important concerns that will also benefit the company; and
(2) management would also like to preserve their financial
flexibility.
 Management of Working Capital
Accounts
Here are the suggested internal
controls over CASH.

1. Separating the cashiering function from the recording

or accounting function
A basic internal control system should not allow the
assignment of custodial function and recording function
to one person, unless you are the owner.
 Management of Working Capital
Accounts
Here are the suggested internal
controls over CASH.

2. Issuing official receipts for collections and

summarizing collections in a daily collection report
It is important to know the collections from business
every day as these collections reflect the health of the
company.
 Management of Working Capital
Accounts
Here are the suggested internal
controls over CASH.

3. Depositing collections
A good internal control over cash is by depositing all
collections intact. The daily collection reports are now
compared with the deposit slips to find out if all
collections are indeed deposited.
 Management of Working Capital
Accounts
Here are the suggested internal
controls over CASH.

4. Adopting the check voucher system for payments

 If all collections need to be deposited, then payments
must be made through a check voucher system.
 For companies with big operations, there must also be
two signatories in the check to provide check and
balance and to minimize the probability of issuing a
flawed check, either to the wrong payee or an incorrect
amount.
 The check must also be cross-checked by drawing two
lines on the payee section of the check to render the
check for deposit only and not for encashment.
 Management of Working Capital
Accounts
What are the PARTS of a CASH BUDGET?

1. Cash receipts
This section includes collections from receivables,
proceeds from loans or issuance of new shares of
stocks, and advances from stockholders.

2. Cash disbursements
This section includes payments to suppliers and other
service providers, payments for loans, and cash
dividends.
 Management of Working Capital
Accounts
What are the PARTS of a CASH BUDGET?

3. Net cash flow for the period

 This is computed by deducting cash disbursements
from the collections for the period.
 This also provides information regarding the amount
of excess cash or cash deficit for the period.
4. Target cash balance
The target cash balance is the amount of cash that
management wants to maintain at all times given its
present level of operations, stability of cash flows,
and the macroeconomic and political conditions.
 Management of Working Capital
Accounts
What are the PARTS of a CASH BUDGET?

5. Cumulative excess cash or funding requirements

 This is the most important part of the cash budget
where the possible funding requirements are shown
on a cumulative basis.
 This part of the cash budget is very important in
planning because if the management can estimate
the amount of cash they will need in the future and
when it will possibly arise, this early, management
can identify the possible sources of cash.
 Management of Working Capital
Accounts
What are the PRIMARY REASONS
for HOLDING CASH?

 The primary reasons for holding cash are for transaction

and compensating balance purposes.
TRANSACTIONS COMPENSATING BALANCES
• Purchases of inventories • Have something to do with
• Salaries having deposit accounts and
• Utility services loans with banks
• Loans • Minimum amount of deposit that
• Dividends has to be maintained with the
• Other transactions that bank with which a company
affect the business incurred a loan
 Management of Working Capital
Accounts
What are the SECONDARY REASONS
for HOLDING CASH?

 The secondary reasons for holding cash are for

precautionary and speculative purposes.
PRECAUTIONARY SPECULATIVE
When there are economic and
If there is an economic
political crises, a lot of things can be
crisis, management may put on sale. Valuation of real estate
want to maintain a higher properties and stocks traded in the
level of cash for stock exchanges can go down to
emergencies and to serve as unreasonable levels because owners
buffer for any possible just want to get rid of them. For
slowdown in business people with cash, these periods are
activities. perfect opportunities to buy and
invest.
 Management of Working Capital
Accounts
How can a company MINIMIZE THE
POTENTIAL LOSS from UNCOLLECTED
ACCOUNTS RECEIVABLE?
 Minimizing loss from exposure to accounts receivable
starts with its origination. This means the customer who
is given credit terms must be credit worthy.
 In large companies, there is a credit committee
composed of representatives from sales and marketing
and finance departments who decide which customers
should be given credit terms.
 Small companies also implement the same principle
but on a much smaller scale and in a less formalized
manner because they do not have the same resources.
 Management of Working Capital
Accounts
What are the 5 Cs in CREDIT EVALUATION?

1. Character
This refers to the integrity and reputation of the
customer.
2. Capacity
This refers to the capacity to pay.
3. Capital
This refers to the amount of capital invested by the
owner or, in this case the customer, into his/her
company.
 Management of Working Capital
Accounts
What are the 5 Cs in CREDIT EVALUATION?

4. Collateral
This can be guarantees or collateral provided by the
customer to support his/her exposure with the
company.
5. Condition
This describes the environment where the company
operates which may affect the ability of a customer to
pay including economic and political conditions, the
state of competition in the industry where the
company operates, and the prospects of its industry.
 Management of Working Capital
Accounts
What are the INTERNAL CONTROLS that
should be considered TO SAFEGUARD
INVENTORIES?

1. Separating the custodial functions from the recording

or accounting functions
Just like cash, this internal control measure is also true
for inventories and for other types of assets.
 Management of Working Capital
Accounts
What are the INTERNAL CONTROLS that
should be considered TO SAFEGUARD
INVENTORIES?

2. Aging of inventories
 Aging of inventories allows management to identify
the fast-moving items and the slow-moving items.
 Management must decide what to do with slow-
moving items before they further lose their values.
One way to dispose slow-moving items is by
bundling them with other products of the company.
 Management of Working Capital
Accounts
What are the INTERNAL CONTROLS that
should be considered TO SAFEGUARD
INVENTORIES?
3. ABC Analysis
 This approach classifies inventories into three
categories: A, B, and C. Inventories which are
considered most important are classified as A; those
at the middle are classified as B; and the least
important are classified as C.
 The main reason for classifying them is to provide
the kind of security due to each category of
inventories, meaning the more valuable items have
to be given better security.
 Self-Test Questions
1. Why is management of working capital important?
2. What are the three working capital financing
policies? Describe each briefly.
3. What are the four internal control measures for
cash? Explain each.
4. What is a cash budget?
5. Why is cash budget important in a company?
6. How can you differentiate primary reasons from the
secondary reasons for holding cash? Provide an
example for each.
 Self-Test Questions
7. What are the 5 Cs of credit?
8. Why is aging of accounts receivable important?
9. Why is aging of inventories important?
10. What is ABC analysis in inventory management?
11. Why is it important to keep a good relationship with
suppliers?