WORKING CAPITAL

Working Capital Is a portion of the firms capital continuously converted into a cash fund,
from its inventories, to accounts receivable and to cash. It may include: the firms safe cash;
checks for encashment; bank accounts balances; marketable securities; notes and accounts
receivables; supplies; inventories; prepaid expenses; and deferred items.

REASONS WHY A FIRM NEEDS WORKING CAPITAL:

1. For inventory replenishment in order to have sufficient stocks to attain the sales goal, and
to serve the customers demand.
2. As provision for operating expenses for the day-to-day transactions.
3. Working capital is a back up for credit sales where the firm needs to maintain its
operations until receivables are converted into cash.
4. As a safety margin for unexpected expenses, possible delays in cash inflow, or decline in
revenue.

Because of the difficulty in synchronizing cash receipts and cash disbursements, it is

advisable to have a positive cash balance so that the firm can settle obligations as they become
due. Even if anticipated cash receipts is equal to anticipated cash expenditure, it is still necessary
to maintain a sufficient cash fund. The amount of cash needed may depend on:

- the firms purchases and cash sales;

- the time period between credit sales and collection;
- time period from purchase of raw materials, payment of salaries, to accounts receivables
collection;
- amount needed for inventories investment; amount needed for other purposes, such as
payment of dividends.

Cash Management adheres to the principle that idle cash earns nothing and even if it is
deposited in a bank, it earns minimal interest.

Liquidity Management are activities towards achieving the liquidity objectives of the firm. It
requires maintenance of a sufficient amount of cash to cover the cash requirements of the
company, from various sources, including: cash sales; collection of accounts receivables, loans,
sale of assets; ownership contribution; or advances from customers.
Inventory Management the ideal level is for the firm to sell units as soon as they come out
from the production line or to acquire raw materials and supplies as needed. It consists of:

Liquidity measured in terms of inventory turnover.

Profitability measured in terms of sales and profits.

OBJECTIVES OF WORKING CAPITAL:

It must be adequate to fund all current financial requirements;

It must be liquid to meet current obligations as they fall due;
It must be allocated properly and economically , to avoid losses arising from
malversation or pilferage;
It must be properly used for achieving of the firms profit goals.

CLASSIFICATIONS OF WORKING CAPITAL:

Gross Capital includes all the current assets.

Net-working Capital the difference between total current assets and current liabilities.

SOURCES OF WORKING CAPITAL:

a. Net gains from sales.

b. Sales of current assets above book value.
c. Retiring current liabilities below book value.
d. Sales of fixed assets.
e. Capital borrowing and issuance of capital stock.
f. Exchange of current for capital debts.

USES OF WORKING CAPITAL:

a. Meeting net losses from sales.

b. Declaration of dividends.
c. Retiring current liabilities above book value.
d. Purchasing fixed assets.
e. Retiring capital debts and outstanding stock.
f. Exchanging capital for current debts.

FINANCIAL PLANNING
Financial Planning refers to the process of determining the best use of the financial resources
of an organization to attain its predetermined objectives and the procurement of the required
funds at the least cost. It formulates the way in which financial goals are to be achieved.

Financial Plan is a statement of what is to be done in the future. It requires evaluation of

current financial statements, including the balance sheet, income statement and cash flow
statement.

Budget a plan in quantitative terms or money. It is prepared in line with the attainment of
predetermines goals of the company. It may include budgets for profit plan, capital expenditures,
or cash budgets.

Cash Plans can be for a day, week, or month of operations.

TYPES OF CASH PLAN:

a. Short-term Plan concerned with anticipating and providing for short-term credit needs
and cash control for a year, consistent with the annual budget.
b. Long-term Plan consistent with corporate plans and investment plans for more than a
year, including major cash inflows and outflows.

Cash Budget shows estimated cash receipts and disbursements and the ending cash balance. It
identifies the effects of management plans on cash inflows and outflows. This will provide
information, in advance, possible cash deficiency or excess funds to serve as guide for
appropriate decisions.

Cash Flow is the continual movement of money throughout the enterprise during any period of
time.

A cash-flow problem signifies therefore that the cash is not moving as reacquired. In
most cases, this means there is sufficient cash to meet the business. Basic method of
controlling cash to determine its availability, is simply to forecast over the period ahead, the
cash which is expected to arrive, and to deduct from this cash the amount which is anticipated to
be spent.
Cash Flow Forecast - forecast which enables the finance officer to examine business cash
position over the period of time. It is divided into monthly, weekly or even daily intervals
depending into particular needs of the business.

ACCOUNTS RECEIVABLES MANAGEMENT

Accounts Receivable - are money owned to a business from the sale, on credit, of goods or
services in the normal course of business.

Trade Credit - refers to credit sales made to other businesses.

Customer Credit - refers to a credit sales made to individuals.

A business purchasing goods on credit may be offered trade credit on open account, if the
amount involve is substantial.

Open Account - an arrangement under which goods or services are sold to a customer on credit,
but with no formal debt contract. This requires statements to notify its customers of their current
indebtedness.

BENEFITS AND COST OF GRATING CREDIT:

Increase in sales and profit.

Opportunity Cost of Investment holding of funds with accounts receivables rather
than investing them to some other forms of profitable investments.
Cost of bad debts and delinquent accounts.
o Bad Debts are those accounts which have proven to be uncollectible and are
written off.
o Delinquent Accounts are those where payments have not been made on due
dates.
Cost of administration the processing and collection.
Cost of additional investment acquisition of plant and equipment to increase.

Credit Period - the period between the date that a buyer is invoiced and the date when payment
is due.

Discount Period an expression of the price reduction a buyer will receive if payment is made
within the discount period.
TYPICAL EXAMPLE OF CREDIT TERMS:

a) n/30 no discount, the credit period is 30 days.

b) 2/10, n/30 discount rate is 2%, discount period is 10 days, credit period is 30 days.

Collection Policy is the companys effort to collect delinquent accounts either informally or by
a debt collection agency. This is also the firms method of monitoring the age of accounts
receivables and dealing with past-due accounts (Ross). It involves a trade-off between the cost of
collection, and the benefits of lower bad debts losses and a short average collection period,
which in turn will results in reduction in the companys investment in accounts receivable.

How a credit policy may begin:

Standard Reminder Notice Personal Letter Telephone Calls Personal

Visit Legal Action (the last resort which is very expensive and may involve long
delays). Alternative: employ a debt collection agency, but this too can be expensive.

SHORT-RUN OPERATIONS: Financial Decisions

Short-term Financial Decisions usually more simple than long-term financial decisions.

MAJOR TYPES OF SHORT-TERM ASSETS:

1. Inventory
o For a manufacturer inventory includes raw materials, work in process, and
finished goods not yet sold.
o For the wholesaler and retailer - inventory consist mostly of merchandise in the
warehouse or on selling shelves.
2. Short-term Investments a kind of liquid assets which includes bills of exchange,
overnight deposits with the short-term money market and short-term bank deposits.
3. Accounts Receivables are short-term credit extended to customers, such as 30, 60, 90-
day credit.

Current Assets are assets that are normally converted into cash within a year.

Current Liabilities are debt or obligations due for payment within a year. It may include:
accounts payable and short term loans.
 o Accounts Payable - a liability to a creditor carried on open account, usually for
purchases of goods and services.
o Short-term Loans - any loan that must be repaid or refinanced within one year.

FORMULA:

Flow of Resources a cycle where cash is converted into physical assets, which are in turn
converted back into cash.

In the case of a manufacturer, this working capital cycle begins when cash is used to
purchase raw materials. Cash is also used to pay for the resources needed in the production
process - converting raw materials into finished goods.

How to minimize the effects of cash flow problems?

One way to minimize the effects of cash flow problems would be to hold a large amount
of cash and other liquid assets. These reserves would provide a long lead time during which
cash flow problems could be identified and, if possible, rectified before they become serious.

LONG-RUN OPERATIONS: Financial Decisions

Long-term Financial Decisions introduces long-run variables in financial management

relating directly or indirectly to profits, liquidity, solvency and control.

Long-run variables for financial decision making includes elements that are treated in
making short-run operating decisions, plus the capital factors that are constant or fixed in the
short run.

LONG-RUN FACTORS:

o Price Control
o Quality Control
o Cost and Expenses

Capital Expenditures involve use of funds or commitment to use funds that would affect
long-run operations. These are outlays that are made for controlling long-run prices, quality of
products, fixed or variable costs and expenses. These are:
 Expenditures for price control investments in fixed capital assets (tangible and
intangible) may be effective means of tightening price controls either by exercising
control over supply, demand, or both.
Expenditures for sales expansion.
Expenditures for production control and expansion.
Expenditures for research and development.
Expenditures for general and administrative needs.
Strategic expenditures.

Capital Budgeting needed in order to plan and control capital expenditures. This provides a
system for evaluating the firms alternatives, and chooses the best that will give the company
higher or better yield, if not the best. It involves: capital expenditures, valuation, and
investment.

Capital Expenditures - refer to cash outlays intended to lessen cost and increase income of the
firms for long-term, such as purchase of fixed assets, major research for new products,
innovative strategies and advertising.

Valuation a process when management is confronted a proposal to analyse real worth.

Investment - made when a firm spends some of its funds for a project.

AIMS IN CAPITAL BUDGETING:

Set priorities.
Prepare cash plan.
Determine acquisition and construction plan.
Avoid duplication.
Modify plans.

STEPS IN CAPITAL BUDGETING SYSTEM:

1. Budget request preparation and submission.

2. Budget approval.
3. Budget appropriation.
4. Budget progress reports.
5. Budget post approval reviews.

Break-even point: variable and fixed expenses

Break-even Point - the point where the difference between the sales income and the variable
expenses equals fixed expenses for the period.

Variable Expenses are directly proportional to sales income. If sales increase of decreases,
such expenses should move in direct proportion to the changes.

Fixed Expenses remain constant whatever the sales activity may be. These are not directly
proportional to units of products sold, except for time factor.

RULES IN CONTROLING EXPENSES:

Variable expenses should be controlled as a percentage of activity. In other words, if sales

doubles, variable expenses become twofold, and vice versa.
Fixed expenses should be controlled as an amount, not as percentage of sale. They should
not move directly with activity. Just because sales rise or fall this should not necessarily
affect the fixed expenses. They should remain the same

FORMULAS:

Sales Value = Break-even Point in Units x Contribution Margin

TIME VALUE OF MONEY

Value of money, at present and in the future, can be influence by some economic factors
including inflation, cost of goods or the buying power of the peso. The money we have now can
be invested to yield a higher amount in the future.

FORMS OF INVESTMENT:

a) Productive assets such as equipment.

b) Interest-bearing investment such as savings.
Financial Managers tasked with mentally moving money between the present and the future.

Money that the firm has today should not be left idle or it will lose real value. It should be
put to work earning interest or creating income for the firm.

FUTURE VALUE

Future Value - describes the amount of money one could expect to have in the future, with its
known present value. It includes the total amount of the principal and interest. This is sometimes
called the maturity value of money.

Interest the fee that a borrower or debtor has to pay the lender or creditor, for assuming the
risk of the loan, for the current use of a certain sum of money.

Simple Interest expresses as an annual percentage, even if the period of the loan is not exactly
a year.

WHERE:
I = PRT
I interest earned

P principal (amount borrowed/loaned)

R rate of interest (expressed as an annual percentage rate)

T time of the loan (expressed as component of a year)

Compound Interest an interest posted to the account or charged to the loan at regular interval.
The time period of the loan remains one year, however, during the year the interest calculated
will be posted to the account quarterly, or four times during the year.

WHERE:
MV = P+V
MV maturity value

Compound Interest Chart or Table of Future Value at the End of t Periods another
approach in computing for the compound interest in the Appendix.
 The appendix will show the n column, referring to the compounding period. To
calculate n, multiply the time period of the loan (T) by the number of compounding periods for
the year.

Maturity Value = P x TV (n,i)

Daily Compound Interest Chart also available in the Appendix. The hand column indicates
the length of the loan in terms of years. The top row provides the annual interest rates. At the
intersection of the row and column is the factor value, which when multiplied by the principal
will be the maturity value of the loan.

Maturity Value = P x TV (T,R)

Future Value Calculations often used to calculate the effect that inflation will have on a
firms future investment.

PRESENT VALUE

Present Value Chart concept of the moneys present value. It has a column labelled n, which
corresponds to the number of compounding periods, and an interest rate (i), which is the

periodic interest rate. Unlike the compound chart, the table values are all less than 1.0. The
factors in the present value table are in decimal form. If converted into percent, they will express
the percent of the maturity value that must be invested today. The complement (100% - the table
value) is the percent of the final investment that is earned.

PV = MV x TV (n,i)
WHERE:

P the present peso amount that needs to be invested or the principal

MV the maturity value desired

i the annual interest rate the number of compounding periods

n the number of years x the number of compounding periods

 PV refer to table of present value to be received after t periods)

ANNUITY

Annuity a series of cash flows of equal amount equally spaced in time. Commonly involve in
pensions and many types of personal loans, as well as in some commercial loans and financial
instruments, such as bonds.

Annuity Due- annuity where the first cash flow or payment made at the beginning of the period.

Ordinary Annuity - payments that occur at the end of the first time period. It consists of equal
amounts, equally spaced in time.

Annuity Tables based on ordinary annuity, that is, payments are made at the end of the period.

Present Value of an Ordinary Annuity the formula is used frequently which can then be adapted
to apply to other types of annuities. Another term is discounted cash flow.

The cash flow pattern of an ordinary annuity of n cash flows, of c pesos each is shown below:

0 _____ 1 _____ 2 _____ 3. _ n-1 _ n_____

PhpC PhpC PhpC PhpC PhpC

a. Using a calculator to discount each individual cash flow:

PV = C/1 + i + C/(1+i)^n
WHERE:

C - ordinary annuity

i interest rate

n the number of years

b. Using Table of Present Value

PVA = R ( IF)
WHERE:
 R value of each payment

IF present value annuity interest factor at i% n years.

Future Value of Annuity the computation for the value of an annuity at the date of the final
cash flow, which are regular savings for a target future sum, or periodic payments for
amortization or instalment payment.

CVA = R ( IF )

Chapter 4
Working Capital

And
Cash Flow
Management