Working Capital

By: Mrs. Belen Apostol

Working Capital

• Refers to that part of the capital of the company which is continually circulating.

• Circulating, in which the initial cash funds of the firm are converted into inventories, then converted to cash or accounts receivable then into cash again.

Working Capital

• Working capital may be described in two ways:

1.Gross working capital – total amount of the firm’s current assets

2.Working capital – total amount of current assets minus the current liabilities

Gross Working Capital1. Cash in the firm’s safe2. Checks to be cashed3. Balances in the bank accounts;4. Marketable securities (not including stocks in

subsidiaries)5. Notes and accounts receivable6. Supplies7. Inventories8. Prepaid expenses9. Deferred items

The Need for Working Capital

• Working capital is required for the following purposes:

1. Replenishment of Inventory – a sufficient stock of inventory is required to support the sales target of the firm depending on the availability of resources.

2. Provision for Operating Expenses – to maintain the day-to-day operations of the firm.

The Need for Working Capital• Working capital is required for the following

purposes:3. Support for Credit Sales – because of extended

credit sales, a sufficient working capital is needed to maintain the firm’s operations until the receivables are converted into cash.

4. Provision of a Safety Margin – to provide for unexpected expenditures, delays in the expected cash inflow and possible decline in revenue.

Cash Requirements

• The firm needs cash to pay for expenditures that arise from time to time. Even if the anticipated cash receipts is equal to the anticipated cash expenditures, it is still necessary to maintain a sufficient cash fund for the firm to meet its cash commitments.

Cash Requirements• The amount of cash needed depends on the ff:1.The amount of the firm’s purchases and cash sales2.The time period for which the firm receives and grants credits3.The time period from the dates of purchase of raw materials

and payment of wages to the dates of cash receipts from sales

4.The amount of cash to be used for investment in inventories5.The amount of cash needed for other purposes such as cash

dividends

Accounts Receivable Requirements• For most companies, liquidity is the primary concern

where cash sales is preferred over credit sales. Extended Credit cannot be avoided for various reasons.

• Credit is used to sustain and promote production, distribution and consumption of goods and services.

• The accounts receivable contributes to cash inflow requirements of the firm. Credit terms vary according to the degree of competition between firms, availability of bank credit and pressures for increased sales.

Inventory Requirements

• The production of large stocks of inventory generate savings as a result of lower production cost.

• It provides large quantity of stocks to meet large orders from customers.

• But the maintenance of large inventory, tie up funds to be used in other purposes and may incur large storage and warehouse costs.

Inventory Requirements

• To make sales as soon as finished products come out of the production line or

• Acquire raw materials and supplies as soon as they are needed.

• Having the right inventory level to optimize the inventory requirements (EOQ)

Management of Working Capital• Working capital must always be able to cover the fund

requirements of the company as they are needed. • Objectives of Working capital1.Working capital must be adequate to cover all current

financial requirements. (quantity of inventory and maximum allowable accounts receivable)

2.The working capital structure must be liquid enough to meet current obligations as they fall due. (salaries, raw materials & supplies)

Management of Working Capital• Objectives of Working capital3. Working capital must be conserved through

proper allocation and economical use. It must be protected against losses from natural calamities, malversation or pilferage.

4. Working capital must be used in the attainment of the profit objectives of the firm. (avoidance of loss)

Liquidity Management• Liquidity – ability of the firm to pay its bills on time or meet

its current obligations. • Liquidity management – activities geared toward achieving

the liquidity objectives.• Sources of Cash inflows:1.Cash Sales – cash derived form sales which vary from

company /industry to company/ industry2.Collection of Accounts receivable – the credit policies and

patterns of company sales determines the frequency and volume of collections.

Liquidity Management• Sources of Cash inflows:3. Loans – loans from banks or other creditors 4. Sales of Assets – sale for various reasons

(obsolescence)5. Ownership contributions – additional contribution

from the owners6. Advances from customers – cash advances as soon

as orders are made before the start of production.

Cash Management• Sufficient cash must be maintained to cover the

firm’s expenditures.• Major approaches in cash management:1.Exploit techniques of money mobilization to

reduce operating requirements for cash2.Expend major efforts to increase the precision

and reliability of cash flow forecasting3.Use maximum efforts to define and quantify the

liquidity reserve needs of the firm;

Cash Management

• Major approaches in cash management:1.Develop explicit alternative sources of

liquidity2.Search aggressively for more productive uses

of surplus money assets.

Cash Management

• Money Mobilization – remittances from far flung branches which would take days before they are converted to cash and check payments sent through mail.

• Time lag – the mail traveling time of the check payment; the check clearing time

• Solution – to open bank accounts in the far-flung branches. Money deposited reduces the number of days between the actual payment and its availability.

Cash Management• Improved Cash Flow forecasting – forecast should

be precise and reliable providing the firm with realistic approaches to planning and budgeting.

• Advantages:1.Surplus funds are more fully invested2.Alternative methods of meeting the outflows can

be explored3.The creation of special reserves for major future

outlays will be minimized

Cash Management• Defining and Quantifying the Liquidity Reserve

Needs of the Firm. • Reserve Cash must be maintained for

uncertainties and contingencies. • Steps:1. Identification of contingencies requiring

protection;2.Assessment of probabilities of the contingencies

occurring

Cash Management• Defining and Quantifying the Liquidity Reserve

Needs of the Firm. • Steps:3. Assessment of the probabilities of the

contingencies occurring at the same time.4. Assessment of the probable amount of cash

required if each of the contingencies happens.

Cash Management• Defining and Quantifying the Liquidity Reserve

Needs of the Firm. • If reserves will not be provided the amount of

possible loss must be ascertained. If reserves will be provided the cost of carrying should be ascertained. The losses and cost must be computed by multiplying the losses or cost with probability estimates.

Cash Management• Development of Alternative Sources of

Liquidity• Exploitation of unused borrowing capacity. • Interbusiness financing – credit flowing from

large business to small business.

Cash Management• Search for More Productive Uses of Cash

Surplus• Cash surplus may be utilized to earn higher

returns. • Planning activities must also be geared

towards eliminating the unproductive or less productive gap.

Accounts Receivable Management• Once the accounts receivable are not properly

managed, the financial viability of the firm may be impaired.

• The purpose of credit extension is to maximize sales. • More sales = More credit• Increased sales may be offset by bad-debt losses• Accounts receivable management determines the

cost and profitability of credit sales.

Accounts Receivable Management• Accounts receivable management projects

cash flows from receivables which provides an essential input in the firm’s financial plan.

• Elements of the cost of credit1.Bad debts cost2.Cost of invested funds3.Administrative cost

Accounts Receivable Management• Bad Debts cost – uncollected and written off

accounts receivable. • Cost of invested funds – rate at which the firm

could borrow funds to finance credit sales. • Administrative costs – include letters,

telephone charges, clerical and administrative time spent on an account and credit investigation expenses

Accounts Receivable Management• Functions of the Credit Department1. gathering and organizing of information necessary for

decisions on the granting of credit to particular customers

2. Assuring that efforts made to collect receivables when they become due

3. Determining and carrying out appropriate efforts to collect accounts of customers who cannot or do not intend to pay.

Accounts Receivable Management• Sources of Credit Information – a variety of

sources may be used to obtain credit information concerning customers:

1.Personal interviews2.References3.Credit bureaus4.Credit-reporting agencies5.banks

Accounts Receivable Management• Personal interviews – provide basic information concerning

an applicant for credit. The applicant usually fills up a credit application blank which contains the following

1.Name of applicant2.Residence and former address3.Occupation or business4.Business address5.Bank where the applicant maintains an account; 6.Property owned

Accounts Receivable Management• If the credit applicant is a company, more

information is required.• References also provide a valuable source of

information.• The credit applicant is usually required to

furnish names of at least three references who have valuable insights into the character and ability of the applicant.

Accounts Receivable Management• Credit bureaus – institutions organized for the

exchange of ledger information among associated creditors.

• Credit bureaus’ services include the following:1.Reports2.Bulletins3.Credit guides 4.Special services

Accounts Receivable Management• Credit reporting agencies – consist of more

specialized forms of credit bureaus. • Banks constitute a valuable source of credit

information.

Accounts Receivable Management• Evaluation of Credit Risk • Before credit is granted, risk is evaluated.• Basic criteria:1.Capital 2.Capacity3.Character4.Conditions

Accounts Receivable Management• Capital – financial resources of the credit

applicant. (Balance Sheet)• Capacity – ability of the applicant to operate

successfully. (Income Statement)• Character – reputation for the honesty and

fair dealing of the applicant• Conditions – environment required for the

extension of credit.

Inventory Management• Refers to the activity that keeps track of how

many of the procured items needed to create a product or service are on hand, where each item is, and who has responsibility for each of them.

• Two aspects of inventory management1.Liquidity – inventory turnover2.Profitability – inventory level at a given level of

sales and profit

Inventory Management• A successful inventory management

program’s main objective is to strike a balance among three elements as follows:

1.Customer service2.Inventory investment (in pesos/dollars)3.Profit

Inventory Management• Customer Service –the period between the order is

made and the date of delivery. - shorter periods are preferred. The shortest

lead time, has a better chance of improving its sales.

• Inventory Investment – funds tied up in inventory should be kept to a minimum without sacrificing customer service. Investment in inventory eat away company profits in the form of interest, insurance, taxes, obsolescence and storage

Inventory Management• Profit – the level of inventory carried by the

company affects profitability. - the company must determine the level

which would bring the highest return on equity.

Inventory Management• Functions of Inventory1.Serve to offset errors contained in the forecast

of the demand for the company’s products2.Permit more economical utilization of

equipment, buildings, and manpower when the nature of the business is such that fluctuations in demand exists

3. It permits the company to purchase or manufacture in economic lot sizes

Inventory Management

• Forms of Inventory1.Raw materials 2.Work –in-process3.Finished Goods

Inventory Management

• Raw materials – all parts, sub assemblies and components purchased for use in the production process

• Work in process – raw materials and labor added .

• Finished goods – completed the manufacturing process ready for sale.

Inventory Management• Methods of Achieving Inventory goals1.ABC method2.Economic Order Quantity method3.Safety Stock 4.Anticipation Stock

Inventory Management• ABC method – classifies inventory into three

categories: A, B and C- A – comprising a large portion of the

inventory value, in which tight control is applied.- B – comprises those accounting for a

substantial part of the total inventory value, requiring less tight control.

- C- account only for a small proportion of the total inventory value and is the least controlled.

Inventory Management• Economic Order Quantity (EOQ) – determine

what quantity to order so as to minimize total inventory costs.

• Two major costs:1.Carrying cost – warehouse storage cost2.Ordering cost (filling in purchase requisition)• The two cost tend to offset each other. Ordering

in large quantity allows volume discounts but involves higher storage cost

Inventory Management• Economic Order Quantity (EOQ) – balances the two costs.

EOQ = 2 US CI

Where: U = annual usageS = restocking or ordering costC = cost per unitI = annual carrying cost (expressed in percentage

of inventory value)

Inventory Management• If the annual usage is 1,000 units, restocking

cost is P1,000.00, cost per unit is P50,000.00 and annual carrying cost is 10%

EOQ = 2(1000)(P1,000.00) = 20(P50,000.00)(10%)

Inventory Management• Safety Stocks are part of the inventory used to

absorb random fluctuations in purchases, production and sales.

• Anticipated stock – portion of the inventory used for expected seasonal, cyclical and secular changes in inventory.

Components of Liquidity ManagementLiquidity Management

Cash Management Accounts Receivable Management

Inventory Management

Money Mobilization

Effective Cash Flow Forecasting

Liquidity Reserve Definition and Quantification

Productive Use of Surplus assets

Determine Cost & Profitability of Credit Sales

Projection of Cash Flows from Receivables

Direction and Control of Credit Extension

Customer Service

Inventory Investment

Profit Aspects