Board Exam Question

The primary objective of

working capital management is
to

a. maximize the balance of

current assets and current
liabilities.
b. maximize the balances of the
individual accounts in the
working capital
c. maximize the company’s
current liabilities.
d. achieve a balance between
2
risk and return.
WHY WORKING CAPITAL
SIGNIFICANT IN FINANCIAL
MANAGEMENT?

• Working capital represent a

margin of safety for short-
term creditors
• The amount of working
capital represents the
extent to which current
assets are financed from
long term sources. 3
FACTORS AFFECTING LEVEL OF
CURRENT ASSETS

General nature of the business and

product

Trading and manufacturing

companies usually require higher
proportions of current assets
than service and utility
companies do.
3
Effect of sales pattern
The working capital needs
will be affected by the nature of
the change in sales or business
activity. If the change in sales is
brought about by cyclical or
seasonal changes, the periodic
build-up of receivables and
inventory is temporary and
financing need is considered
short-term. This is so because the
conversion of these investments
into cash will come in the normal
course of operation.
If the change in sales is due to
secular or permanent changes,
the incremental working capital
required is permanent and will
require long-term financing.
Length of the manufacturing
process

The longer the period of

time required to manufacture
the products of the company,
the higher the level of working
capital requirement is.
Industry Practices

The industry or line of

business with greater proportion
of assets readily convertible to
cash can afford to have a lower
working capital investment and
a higher level of current
liabilities.
Terms of purchases and sales
The longer the credit
period granted by suppliers
of merchandise is, the lower
the requirement for
permanent working capital
is. Meanwhile, the longer the
credit period given to
customer of the firm is the
higher the requirement for
working capital is.
KIND OF CURRENT ASSETS

Permanent Current Assets

Permanent balance of
cash, receivables and
inventory that you have to
maintain all through out
the year.
Temporary Current Assets

These are the

incremental or the
additional current assets
that you need to hold at
the time of season.
WORKING CAPITAL FINANCING
POLICIES

Moderate or Maturity
Matching

Matching the maturity of

a financing source with
specific financing needs.
Temporary
Current
Assets
Short-term
Financing
Permanent
Current
Assets
Long-term
Financing
Fixed
Assets
Illustration

Andrea Torres Company has P8,000,000

in assets. The assets are further
subdivided into:

Temporary current assets P2,000,000

Permanent current assets 4,000,000
Fixed assets 2,000,000
Total assets P8,000,000
Illustration
Short-term rates are 5 percent.
Long-term rates are 8 percent. Earnings
before interest and taxes are P4,000,000.
The tax rate is 40 percent.

Requirement:
If long-term financing is perfectly
matched (synchronized) with long-term
assets needs, and the same is true of
short-term financing, what will earnings
after taxes be?
Conservative or Relaxed

Operations are
conducted with too
much working capital;
involves financing almost
all asset investments with
long-term capital.
Temporary
Current
Assets
Short-term
Financing
Permanent
Current
Assets
Long-term
Financing
Fixed
Assets
Illustration

Ellen Adarna Company has P8,000,000

in assets. The assets are further
subdivided into:

Temporary current assets P2,000,000

Permanent current assets 4,000,000
Fixed assets 2,000,000
Total assets P8,000,000
Illustration
Additional information:
Short-term rates are 5 percent.
Long-term rates are 8 percent. Earnings
before interest and taxes are P4,000,000.
The tax rate is 40 percent.

Requirement:
Assume one-half of temporary-level
of current assets is financed by short-
term financing, what will earnings after
taxes be?
Aggressive or Restricted

Operations are
conducted on a minimum
amount of working
capital; uses short-term
liabilities to finance, not
only temporary, but also
part or all of the
permanent current asset
requirement.
Temporary
Current
Assets
Short-term
Financing
Permanent
Current
Assets
Long-term
Financing
Fixed
Assets
Illustration

Kim Domingo Company has P8,000,000

in assets. The assets are further
subdivided into:

Temporary current assets P2,000,000

Permanent current assets 4,000,000
Fixed assets 2,000,000
Total assets P8,000,000
Illustration

Short-term rates are 5 percent.

Long-term rates are 8 percent. Earnings
before interest and taxes are P4,000,000.
The tax rate is 40 percent.

Requirement:
Assume that all the temporary-level
of current assets and 60 percent of
permanent-level of current assets are
financed by short-term financing, what
will the earnings after taxes be?
END… FOR NOW
Guscho Co. is a merchandising
company. The entity is suffering from
losses this year. You have been assigned
by your department head to provide
consultation and to supply solution to
arrest the possible increase of losses that
the entity will probably experience in the
future. All of the information needed for
investigation will be disclosed by the
entity from which you may utilize to help
solve the problem.
 Financial statements for Guscho Co.
for the fiscal year ending December 31
appear below. The company did not
issue any new ordinary or preference
share during the year. The interest rate on
bonds payable was 6% and income tax
rate was 30%. Shareholders are given 15%
dividend pay-out ratio. All of the
company’s sales are on account. The
entity even produced a budgeted
income statement that will be used in the
coming year, but that also did not turn
quite well. Such will also be disclosed by
 Guscho Co.
Statement of Financial Position
(pesos in thousands)

Assets This Year

Current assets:
Cash P 1,000
Accounts receivable, net 9,000
Inventory 12,000
Prepaid expenses 600
Total current assets 22,600
Property and equipment:
Land 9,000
Buildings and equipment, net
13,400
 Guscho Co.
Statement of Financial Position
(pesos in thousands)
Assets This Year
Total property and equipment P 22,400
Total assets P 45,000
Liabilities and Shareholders’ Equity

Current liabilities:
Accounts payable P 1,140
Accrued payable 825
Bank loan, short term 2,500
Notes payable, short term 7,345
Total current liabilities 11,810
 Guscho Co.
Statement of Financial Position
(pesos in thousands)
Long-term liabilities
Notes payable, long-term 15,255
Bonds payable 12,000
Total liabilities 39,065
Shareholders’ equity:
Preference shares 1,000
Ordinary shares 2,000
Additional paid-in capital 4,000
Total paid-in capital 7,000
Retained earnings (3,094)
Total shareholders’ equity 3,906
Total liabilities and shareholders’ equity
P 42,971
 Guscho Co.
Statement of Comprehensive Income
(pesos in thousands)
This Year
Sales 60,000
Cost of goods sold 41,750
Gross margin 18,250
Selling and administrative expenses:

Selling expenses 11,500

Administrative expenses 6,065
Total selling and administrative expenses
17,565
Net operating income (loss) 685
Interest expense 1,920
 Guscho Co.
Statement of Comprehensive Income
(pesos in thousands)
This Year
Net income(loss) before taxes (1,235)
Income taxes -
Net income(loss) (1,235)
Dividends to preference shareholders
-
Net income(loss) remaining for ordinary
shareholders (1,235)
Dividends to ordinary shareholders
-
Net income(loss) added (deducted) to
retained earnings (1,235)
 Guscho Co.
Statement of Comprehensive Income
(pesos in thousands)

This Year
Retained earnings (deficit), beginning
of year (1,859)
Retained earnings (deficit), end of
year P (3,094)
Requirements:
A. Financial Statements Analysis

Compute the following financial data for

short-term creditors for this year:
1. Working capital P 10,790
2. Current ratio 1.91
3. Capital Intensity ratio 0.75
4. Variable liability ratio 0.03
B. Working Capital
Part A (Additional Information)
• Current assets are financed by short-term
and long-term debt financing.
• Permanent current assets are 35% of the
total current assets.
• Temporary current assets are 65% of the
total current assets.
• Short-term rate applied is 3%.
• Long-term rate applied is 8%.
• The entity is using conservative approach
which means that all permanent and half of
temporary current assets were financed by
long-term debt..
Requirements:

1. Utilize the preceding information to

provide for the following requisites:
• Permanent current assets.
• Temporary current assets.
• Short-term credit used to finance
current assets.
• Long-term credit used to finance
current assets.
2. Use the entity’s current year operations
and find out what will happen to the
income statement of the entity if it
chooses the following rather than
conservative approach:

• Moderate approach (Note: temporary

current assets will be financed by short-
term, permanent current assets will be
financed by long-term)
• Aggressive approach (Note: temporary
current assets will be financed by short-
term, half of the permanent current assets
will be financed by short-term while other
will be financed by long-term)
Additional information:
Part B
The entity projected its next year’s income
statement. As a consultant gaining
experiences, your firm wants you to utilize
your consulting skills and guide the entity to
finally achieve better outcomes by
recommending ways that should be done to
keep the last year’s financial statements as
well as this year’s outcomes from ever
happening again. In order to do that, the
entity wants you to find out if there are
additional funds needed in order to pursue
the projected outcomes.
 Guscho Co.
Projected Income Statement
(pesos in thousands)
Next Year
Sales 75,000
Cost of goods sold 55,600
Gross margin 19,400
Selling and administrative expenses:

Selling expenses 11,500

Administrative expenses 5,500
Total selling and administrative expenses
17,000
Net operating income (loss) 2,400
Interest expense 1,920
 Guscho Co.
Projected Income Statement
(pesos in thousands)

Next Year

Net income(loss) before taxes 480

Income taxes (30%) 144
Net income(loss) 336
• Total current sales is expected to
increase by 25% next year.
• The corporation is at full capacity so
its asset must grow in proportion to
projected total sales.
• The projected after-tax profit margin
is 12% and the forecasted dividend
payout ratio is 60%.
Additional information:
Part C
The entity is currently using
spontaneous sources for its accounts
payable. The entity usually buys goods
but doesn’t take the discount because
they can’t generate proceeds within
such limited time. Furthermore, the
entity doesn’t take discounts seriously
for it believes it won’t affect financial
statements significantly. When your firm
looked for possible explanation, they
found out that discounts and interest
Additional information:
Part C
expense have something to do with the
outcome, but your firm never investigate
further. Now, your firm wants you to
prove their theory. Stated below are the
additional data which may help you
(pesos is in thousands).

Cost of Goods Sold(Annually): This Year

Inventory, beginning P 9,000

Purchases 36,000
 Additional information:

Freight-in 750
Inventory, ending (4,000)
Cost of Goods Sold P 41,750

• The credit term is 10/15, n/30

• The bank interest charge for monthly
payment is 5%.
Requirement
What will happen to the current year’s
net income after tax if the entity would
have considered taking the discount
every month by borrowing funds from a
bank?