Management Advisory Services
Topic : Working Capital Management Prof. Ma. Teresa B. De Jesus
Financial management defined
- concerned with the efficient and effective utilization of financial resources of an entity to attain its
predetermined objectives relative to profitability, liquidity, solvency and stability.
A. Working capital management defined
It refers to the efficient and effective utilization of working capital to attain predetermined objectives
of the company relative to profitability of operations , liquidity of financial resources, and minimization of risks
and company costs.
Net Working capital = Current Assets – Current liabilities
B. Nominal Annual Cost rate of Trade credit : cost of giving up cash discount
Discount rate 360 days
100 % - Discount rate X Days credit is outstanding - Discount period
C. CASH MANAGEMENT
1. Factors that contribute to Effective Cash Management
a. carefully constructed cash budget
b. synchronization cash inflows and outflows
c. speeding collections and slowing payment by increasing float and use of draft.
2. Formula used in Cash management
a. Cash conversion period
= Inventory conversion period + Receivables conversion period - Payables deferred period
Incremental cost of the factor mechanism
b. Breakeven transfer size = X Difference in transfer time in days
Applicable Daily Interest rate ____________
c. Optimal Cash balance = 2 X Annual Cash Balance X Transaction Cost
Opportunity cost of holding cash
3. Various types of Floats
a. Mail float – time required for a check to move from the debtor to creditor
b. Processing float - time it takes for a creditor to deposit the check after receipt
c. Deposit collection float – time required for a check to clear.
4. Reasons for holding Marketable Securities
a. Substitute for cash balances b. Temporary investment
5. Types of risks related to Investment in Marketable Securities
a. Liquidity risk – risk as to whether an asset can be sold or near its current market price.
b. Interest rate risk – changes in security prices that occur with changes in interest rates.
c. Default risk - risk that an issuer will not be able to make promised interest
payments or to repay principal amount on schedule.
d. Purchasing power risk - risk that inflation will reduce purchasing power of a given sum of
money.
8. General policy in holding Marketable Securities in relation to working capital financing policy.
Working capital financing policy . MS Policy
a. Aggressive a. Will hold MS when inventories and receivables are low .
Least risky policy but has lowest expected return.
b. Conservative b. Will never carry MS and will borrow heavily to meet
peak needs. Most risky but has highest expected return.
c. Matching Maturities or c. Will also carry marketable securities during the peak season
Moderate and will meet peak seasonal increases in inventories and
receivables with short-term loans.
MAS - Working Capital Management _____________________________
D. RECEIVABLES MANAGEMENT
- refers to the formulation and administration of plans and policies related to sales on account and
ensuring the maintenance of receivables at a predetermined level and their collectibility as planned.
Managing of Receivables will require the establishment of
3. Credit policy 2. Billing Policy 3. Collection Policy
The following are aids in analyzing investment in accounts receivable :
1. Receivable turnover 3. Average collection period of receivables
2. Ratio of accounts receivable to net credit sales 4. Aging of accounts
E. INVENTORY MANAGEMENT
- involves determining how much inventory to hold , when to place orders, and how many units to order.
- the primary objective is to maintain inventory at a level which best reconciles turnover and profit
considerations and consequently maximize return on investment.
ABC Approach classifies inventory into some measure of importance, & allocating control efforts accordingly.
2. Aids in Analyzing Investment in Inventory
a. Inventory turnover c. Number of days sales in Inventory
b. Ratio of Average Inventory to Sales
3. Relevant costs of Inventory
a. Carrying Costs
1. Storage – space costs 4. Foregone return on capital invested in inventory
2. Insurance on Inventory 5. Risk of Obsolescence , deterioration, breakage,
3. Taxes on Inventory pilferage, spoilage etc.
4. Warehousing costs ( heat, light, rent , security )
b. Ordering Costs
1. Receiving ( unloading, unpacking, inspecting )
2. Preparing purchases or production orders
3. Processing all related documents
4. Extra cost of numerous small production runs, overtime, setups and training
5. Inspecting goods upon arrival for quality and quality
6. Extra purchasing or transportation for frequent orders
7. Costs of moving the goods to temporary storage
c. Stockout costs ( Shortage costs)
1. Loss of sales c. Late charges
2. Loss of customer goodwill d. Cost of lost production or disruption of production schedule
Basic Formula :
a. Economic Order Quantity ( EOQ)
- order size that minimizes total cost.
2 X Annual Demand X Cost per order
EOQ = Annual Carrying Cost
Total costs = Annual Ordering Costs + Annual Carrying Costs
= Annual Demand ( Cost per order ) + EOQ (Carrying cost
EOQ 2 per unit )
b. Reorder point = Lead time usage + Safety Stock ( if any )
Lead time usage = Usage per day X Lead time ( in days)
4. Inventory Control Systems
a. Two bin method d. Out-sourcing
b. Red –line method e. Computerized system
c. Just-in-time system
