Working capital management subject for masteral in business

1. Marvin S. FALLORINA
Mark Gerone F. GROSPE
Erika C. PLANAS
MBA 207 Advanced Financial Management

2. 1. Describe the risk-return tradeoff involved in managing a firm’s working capital.
2. Explain the principle of self-liquidating debt as a tool for managing firm
liquidity.
3. Use the cash conversion cycle to measure the efficiency with which a firm
manages its working capital.
4. Evaluate the cost of financing as a key determinant of the management of a
firm’s use of current liabilities.
5. Understand the factors underlying a firm’s investment in cash and marketable
securities, accounts receivable, and inventory.

3.  Working capital management is a business strategy designed to ensure that a
company operates efficiently by monitoring and using its CURRENT ASSETS and
LIABILITIES to their most effective use.
 If current assets are less than current liabilities, an entity has a working capital deficiency,
also called a working capital deficit. CA < CL (less than 1) .
 These involve managing the relationship between a firm's short-term assets and its short-
term liabilities.
 Decisions relating to working capital and short term financing.
Working capital management decision include:
1. How much inventory should we carry?
2. To whom should credit be extended?
3. Should the firm purchase items for its inventories on credit or pay on cash?
4. If credit is used, when should payment he made?

5. Current assets include anything that can be easily converted into cash within 12
months. These are the company's highly liquid assets. Some current assets include cash,
accounts receivable, inventory, and short-term investments.
Current liabilities are any obligations due within the following 12 months. These
include accruals for operating expenses and current portions of long-term debt
payments.
Current ratio = current assets ÷ Current liabilities
(test of short-term debt-paying ability)
Working capital = current assets – current liabilities
(measures the company’s ability to repay current liabilities using only current assets)
Acid-test ratio = (Cash +Marketable securities + Accounts receivable +
Short term notes receivable) ÷ Current liabilities
(test of short-term debt-paying ability without having to rely on inventory.

6. Firm A Firm B
Current Assets 50,000.00 5,000.00
Current Liabilities 25,000.00 2,500.00
Net Working capital 25,000.00 2,500.00
Current ratio 2.0 2.0

7. Cash Receivables Payables
Inventory

9. Risk-Return Tradeoff is an informal rule that states that the
potential return rises with an increase in risk.
Working capital decisions will change the firm’s liquidity and involve a
risk-return tradeoff.
 Invest in Current Assets reduces the company’s risk of liquidity at the expense of lowering rate
of return of investment in assets.
 Use of Current Liabilities (short term financing) by using long term sources enhance company’s
liquidity, however, it reduce company’s profitability

10. Self liquidating debt is any type of financing used to
purchase an asset that produces enough income to
repay the debt itself. Traditionally, the debt is a term
loan, but it could also be a line of credit, private
equity or any other kind of debt.

11. TEMPORARY
 Temporary investments in assets, or
simply temporary assets, are
composed of current assets that will
be liquidated and not replaced
within the current year. These
include cash and marketable
securities, accounts receivable, and
seasonal fluctuation in inventories.
PERMANENT
 Permanent investments in assets are
composed of assets that the firm
expects to hold for a period longer
than one year. These include the
firm’s minimum level of current
assets, such as accounts receivable
and inventories, as well as fixed
assets.

12. Spontaneous
Financing sources that
arise naturally or
spontaneously out of the
day-to-day operations of the
business.
Ex.: Trade credit or accounts
payable, accrued expenses related
to wages and salaries as well as
interest and taxes
Temporary
Current liabilities the firm
incurs on a discretionary
basis. Unlike with
spontaneous sources of
financing, the firm’s
management must make
an overt decision to use one
of the various sources of
temporary financing.
Ex.: Unsecured bank loans and
commercial paper as well as
loans secured by the firms
inventories
Long term sources of
discretionary financing
used by the firm.
Ex.: Unsecured bank loans and
commercial paper as well as
loans secured by the firms
inventories
Permanent

14. The operations of corporations typically follow a
three-step cycle which commences with the
purchase of inventory, followed by the sale of goods
on credit and ends with the collection of accounts
receivable. The cycle is referred to as the cash
conversion cycle (CCC).
CCC = Operating cycle – Accounts payable Deferral
Period
Operating cycle measures the time period that
elapses from the date that an inventory item is
purchased until the firm collects the cash from its sale
(if the sells on credit, this date is when the account
receivable is collected).
Operating cycle = Inventory conversion Period +
Average Collection Period

15. CCC = Operating cycle – Accounts payable Deferral Period
or
CCC = Days of Sales Outstanding (DSO) + Days of Sales in Inventory (DSI) – (Days of Payables Outstanding (DPO)

17. (a) It reduces its inventory conversion period by manufacturing and selling more quickly;
(b) It reduces its receivable collection period by speeding up collection;
(c) It lengthens the payables deferral period by slowing down its own payments to suppliers; and
(d) It manages its processing and clearing time to reduce it when collecting receivables from
customers and to increase it when paying to suppliers.
Company can take any of the options available as long as it does not increase itscosts or depress
its sales.

18. Unsecured current liabilities
 Unsecured current liabilities include
trade credit, unsecured bank loans,
and commercial paper. These forms
of credit are unsecured in that they
are backed only by the lender’s faith
in the ability of the borrower to
repay the funds when due.
Secured current liabilities
 Secured current liabilities include
loans that involve the pledge of
specific assets as collateral in the
event the borrower defaults on the
payment of principal or interest.

21. The cost of short-term credit is given by:
Interest = Principal x Rate x Time
Annual Percentage Rate (APR) = Interest
Principal x Time

22. Trade credit given by firm’s suppliers generally include discount for early
payment.
For example:
Credit terms of 3/10, net 30
means that a 3% discount is offered for payment within 10 days or
the full amount is due in 30 days.
Thus, 3% is the penalty incurred if not paying within 10 days or for
delaying payment from 10th to 30th day (20 days)

23. A line of credit entitles the firm to borrow up to the stated amount. In exchange,
the firm is generally required to maintain a minimum balance (known as
compensating balance).
The borrower who agrees to hold a compensating balance promises the lender
to maintain a minimum balance in an account. The bank is free to use the
compensating balance in loans made to other borrowers.
The compensating balance increases the annualized cost of loan to the
borrower

24. The primary types of current assets that most firms hold are:
Cash and Marketable
securities
Accounts receivable Inventories

25. CASH AND MARKETABLE SECURITIES
Cash and marketable securities are held to pay
the firm’s bills on a timely basis.
TRADEOFF - Holding too little could lead to default. However, holding
excessive cash and marketable securities is costly since they earn very low
rates of return.

26. ACCOUNTS RECEIVABLE
Cash flow from sales cannot be invested until
accounts receivable are collected.
Efficient collection policies and procedures will
improve firm profitability and liquidity.
Determinants of the Size of a Firm’s Investment in Accounts Receivable
1. The level of credit sales as a percentage of total sales.
2. The level of sales. Higher the sales, greater the accounts receivable.
3. The credit and collection policy.

28. Terms of sale identify the possible discounts for early payment, the
discount period, and the total credit period. It is generally stated in the
form a/b, net c
Terms of sale identify the possible discounts for early payment, the
discount period, and the total credit period. It is generally stated in the
form a/b, net c
As the quality of customer declines, it increases the costs of credit
investigation, default costs, and collection costs.
To determine customer quality, firm can analyze the liquidity ratios, other
obligations, and overall profitability of the firm.
Credit score is also a popular way to evaluate the credit risk of
individuals and firms. Credit score is a numerical evaluation of each
applicant based on the applicant’s current debts and history of making
payments on a timely basis.

29. Control of accounts receivables focuses on the control and elimination of past-due receivables.
This can be done by analyzing various ratios such as average collection period.
The manager can also perform “ aging of accounts receivable” to determine in dollars and
percentage the proportion of receivables that are past due.
RIES

30. INVENTORIES
Inventory management involves the control of assets that are
produced to be sold in the normal course of the firm’s
operations. It includes raw materials inventory, work-in-
process inventory, and finished goods inventory.
How much inventory a firm carries depends upon the
target level of sales, and the importance of inventory

31.  Working capital management requires monitoring a company's assets and liabilities to
maintain sufficient cash flow to meet its short-term operating costs and short-term debt
obligations.
 Managing working capital primarily revolves around managing accounts receivable,
accounts payable, inventory, and cash.
 Working capital management involves tracking various ratios, including the working
capital ratio, the collection ratio, and the inventory ratio.
 Working capital management can improve a company's cash flow management and
earnings quality by using its resources efficiently.
 Working capital management strategies may not materialize due to market
fluctuations or may sacrifice long-term successes for short-term benefits.

33. End of Presentation
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