Financial Management
Report #7
Working Capital
Management
Prepared by:
RAY ASTER G. MOMO
FRANCES VANESSA P. NEQUINTO
RUBY JEAN C. MORALES
CHENIE LYNN P. SINOY
November 21, 2019
WORKING CAPITAL MANAGEMENT
Basic definitions
• Net operating working capital (NOWC):
o Operating CA – Operating CL =
(Cash + Inv. + A/R) – (Accruals + A/P)
• Working capital:
o Total current assets used in operations.
• Net working capital:
o Current assets – Current liabilities.
Current Asset Investment Policy
• RELAXED INVESTMENT
o Relatively large amounts of cash, marketable securities, and inventories are carried, and a
liberal credit policy results in a high level of receivables.
• MODERATE INVESTMENT
o An investment policy that is between the Relaxed and Restricted policies.
• RESTRICTED INVESTEMENT
o Holding of cash, marketable securities, inventories, and receivables are constrained.
Current Asset Financing Policy
Types of Current Asset
Permanent CA - Current assets that a firm must carry even at the trough of its cycles.
Temporary CA - Current assets that fluctuate with seasonal or cyclical variations in sales
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Maturity Matching Approach (Self-Liquidating or Moderate Approach)
o Matching asset and liability maturities
o “All of the fixed assets plus Permanent current assets are financed with Long-term capital,
but Temporary current assets are financed with short-term debt.
▪ Two Limitations to Maturity Matching
• There is uncertainty about the lives of assets
• Some common equity must be used, and common equity has no maturity.
Aggressive Approach
o Financing some of its permanent assets with short-term debt.
o Or, all of the current assets and part of the fixed assets were financed with short-term debt.
▪ Advantage: take advantage of the fact that the yield curve is generally upwardsloping; hence, short-term rates are generally lower than long-term rates.
▪ Disadvantage: strategy of financing long-term assets with short-term debt is risky.
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Conservative Approach
In this situation, the firm uses a small amount of short-term credit to meet its peak
requirements, but it also meets a part of its seasonal needs by “storing liquidity” in the form of
marketable securities. This is a very safe, conservative financing policy.
Choosing Between the Approaches
The factors discussed in the different approaches should be considered, but the final decision will reflect
managers’ personal preferences and judgments.
Cash Conversion Cycle (CCC)
– The length of time 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.
Calculating the Targeted CCC
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Inventory Conversion Period
- The average time required to convert raw materials into finished goods and then to sell them.
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Average Collection Period (ACP)
- The average length of time required to convert the firm’s receivables into cash, that is, to collect
cash following a sale.
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Payables Deferral Period
- The average length of time between the purchase of materials and labor and the payment of cash
for them.
CCC = Inventory Conversion Period + Average Collection Period - Payables Deferral Period
Calculating the Actual CCC from Financial Statements
Cash Budget - A table that shows cash receipts, disbursements, and balances over some period.
Target Cash Balance - The desired cash balance that a firm plans to maintain in order to conduct
business.
Cash in terms of liquidity
➢ Currency
➢ Demand Deposits
Techniques to optimize demand Deposits
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Hold marketable securities rather than demand deposits to provide liquidity
Borrow on short notice
Forecast payments and receipts better
Speed up payments
Use credit cards, debit cards, wire transfers and direct deposits
Synchronize cashflows
Marketable Securities
2 categories of Marketable Securities
1. Operating short-term securities - held primarily to provide and are bought and sold as needed to
provide funds for operations.
2. Other short-term securities - holdings in excess of the amount needed to support normal
operations.
Inventories
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Supplies
Rae Materials
Work in Process
Finished Goods
Liquidity ratio: Inventory turnover ratio = Sales / Inventories
Accounts Receivable
Credit Policy
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Credit period – ex. 30 days
Discounts – trade discounts/sales discounts
Credit standards – customers credit History
Collection Policy – procedures use to collect past due accounts, ex. collection agencies
Accounts Payable
Trade Credit - Debt arising from credit sales and recorded as accounts receivables by the buyer and as an
account payable by the buyer
➢ Other credit sales are offered with recourse
Terminologies
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Lock Box – A post office box operated by a bank
Accounts Receivable – Funds Due from a customer
Credit Policy – A set of rules that include the firms credit period, discounts, credit standards, and
collection procedures
Discounts – Price Reductions given for early payment
Credit Standards – The Financial strength customers must exhibit to qualify for credit
Collection Policy – Degree of toughness in enforcing the credit terms
Credit Terms – Statement of the credit period and any discount offered
Credit score- A numerical score that indicates the likelihood that a person or business will pay on
time
Trade Credit – Debt arising from credit sales and recorded as accounts receivables by the buyer
and as an account payable by the buyer
BANK LOAN
Another important source of short-term financing for business and individuals
Promissory Note
Promissory note is a document specifying the terms and conditions of a loan, including the amount, interest
rate, and repayment schedule.
Key Features of promissory notes:
1. Amount
2. Maturity
3. Interest rate
4. Interest only versus amortized
5. Frequency of interest payments
6. Discount interest
7. Add-on loans
8. Collateral
9. Restrictive Covenants
10. Loan Guarantees
Line of credit is an informal agreement between a bank and a borrower indicating the maximum credit the
bank will extend to the borrower. It is an arrangement in which a bank agrees to lend up to a specified
maximum amount of funds during a designated period. Neither the legal obligation nor the fee exists under
the informal line of credit
Revolving line of credit is a formal, committed line of credit extended by a bank or other lending institution.
The bank has a legal obligation to honor a revolving credit agreement, and it receives a commitment fee.
Cost of Bank Loans
Interest rates are higher for riskier borrowers, and rates are also higher on smaller loans because of the
fixed costs involved in making and servicing loans. If a firm can qualify as a “prime credit” because of its
size and financial strength, it can borrow at the prime rate, which at one time was the lowest rate banks
charged.
Prime rate is a published interest rate charged by commercial banks to large, strong borrowers.
Calculating Banks’ Interest Charges: Regular (or “Simple”) Interest.
Regular (simple) Interest is the situation when interest only is paid monthly.
Simple interest rate per year =
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑅𝑎𝑡𝑒
𝐷𝑎𝑦𝑠 𝑖𝑛 𝑦𝑒𝑎𝑟
Interest charge for month = (Rate per day)(Amount of loan)(Days in Month)
Effective interest rate depends on how frequent interest must be paid. The more frequent interest is paid,
the higher the effective rate. If the interest is paid once a year, the nominal rate also will be the effective
rate.
Calculating Banks’ Interest Charges: Add-on Interest
Add-on interest is an interest that is calculated and added to funds received to determine the face amount
of an installment loan
Approximate annual rate𝐴𝑑𝑑−𝑜𝑛 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑖𝑑
(𝐴𝑚𝑜𝑢𝑛𝑡 𝑅𝑒𝑐𝑒𝑖𝑣𝑒𝑑 ) ÷ 2
COMMERCIAL PAPER
Commercial Paper is an unsecured, short-term promissory notes of large firms, usually issued in
denominations of $100,000 or more with an interest rate somewhat below the prime rate. Commercial
paper is sold primarily to other business firms, insurance companies, pension funds, money market mutual
funds, and banks in denominations of at least $100,000.
ACCRUALS
Accruals are continually recurring short-term liabilities, especially accrued wages and accrued taxes. They
arise automatically from a firm’s operations; hence they are spontaneous funds.
Spontaneous funds are funds that generated spontaneously as the firm expands
USE OF SECURITY IN SHORT-TERM FINANCING
It is better to borrow on an unsecured basis, since the bookkeeping costs of secured loans are often high.
However, firms often find that they can borrow only if they put up some type of collateral to protect the
lender or that, by using security, they can borrow at a much lower rate.
Secured loan is a loan backed by collateral, often inventories or accounts receivable.