Working Capital Management Notes

Finance Overview

• Working capital management (WCM) is crucial for CMA exams (Part 2, Section B - Financial Management) and CPA board exams (Financial Management).
• WCM involves understanding asset growth, financing, and managing working capital alongside capital budgeting.
• Qualitative analysis helps interpret future company prospects and the interplay of risk, return, and financing strategies.
• Key components of WCM include managing current assets (cash, marketable securities, receivables, inventories) and understanding short-term financing.
• Equations and formulas are essential, but understanding the logic behind them is more important than memorization.

Asset Growth

• Asset growth patterns impact a company's financial health.
• Stagnant Asset Growth: Indicates a company at maturity, facing potential decline. Requires exploring new business ventures.
• Growing Asset Growth: Driven by increasing sales, leading to additional investments in inventories and receivables.
• Increased assets necessitate corresponding increases in liabilities or capital.
• Retained earnings from operating activities can fund asset growth.
• Sustaining growth rate is the rate at which a company can grow without external financing.

Working Capital Policies

• Working capital policies integrate financing strategies, including long-term sources.
• They involve balancing liquidity and profitability through short-term financing sources.
• Policies relate to the level of current assets needed to achieve desired sales.
• Higher price-to-earnings ratios indicate better future growth prospects that investors are willing to pay a premium for.
• Balance risk, profitability, and liquidity, considering the risk-return trade off. Higher risk typically yields higher profitability, and vice versa.

Types of Working Capital Policies

• These concepts are theoretical; their practical application varies.
• Aggressive/Restricted:
  • Low current assets lead to low short-term financing costs.
  • Potentially high profitability but exposes the company to liquidity risk.
• Conservative:
  • High current assets require more short-term borrowing.
  • Sacrifices profitability for liquidity, reducing risk.
• Moderate/Maturity Matching/Hedging:
  • Balances aggressive and conservative approaches.
  • Risk is lower than aggressive but higher than conservative.
• Choice depends on the business nature and lifecycle stages.

Management of Cash

• Financial manager's primary task is managing cash inflow and outflow.
• Objective: Maintain liquidity without sacrificing profitability, avoiding idle funds.
• Collection should exceed disbursements.
• Avoid idle funds, connect to the "Parody of the Thrift" in economics (John Maynard Keynes).

Reasons for Holding Cash (Keynesian Economics)

• Transaction Motive:
  • Excess cash needed for daily operations.
• Safety Motive:
  • Reserves for possible contingencies.
• Speculation Motive:
  • Taking advantage of opportunities (e.g., buying low, selling high).
• Bank Relationship Requirements:
  • Maintaining compensating balances in exchange for services.
  • Banks earn money from these balances, reducing the need for higher interest rates or fees.

Cash Conversion Cycle

• Starts with the purchase of inventories.
• Purchase of Inventories:
  • Cash balance declines, inventory levels increase.
• Point of Sale:
  • Cash/Receivables increase, inventory decreases.
• Point of Collection:
  • Cash balance increases, receivables decrease.
• Point of Payment:
  • Cash balance decreases, accounts payable decreases.
• $Operating Cycle = Average Age of Inventory + Average Age of Receivables$
• $Cash Conversion Cycle = Operating Cycle - Average Age of Trade Payables$
• Objective: Negative or zero cash conversion cycle.
  • Collect receivables and sell inventory quickly.
  • Prolong disbursements as much as possible.
• Two Main Strategies in Cash Management:
  • Minimize collection float.
  • Maximize disbursement float.

Understanding Float

• Float is the time between a cash payment and its availability to the payee.
• Types of Float:
  • Collection float
  • Disbursement float
• Float Sources:
  • Mail float due to postal service delays.
  • Processing float caused by internal controls.
  • Clearing float resulting from bank processing times.
• Electronic transactions reduce float, posing challenges for financial managers.

Calculations

• Net Float = Collection Float - Disbursement Float (in days or pesos)

Strategies to Speed Up Collections

• Lockbox System: Direct customer payments to a post office box.
• Pre-authorized Checks: Eliminate check clearing float.
• Remote Deposits: Use remote collection centers.
• Concentration Banking: Deposit checks to the bank where the account is held for faster clearing.
• Depository Transfer Checks: Proof of investments.
• Wire Transfers (including GCash):
  • Fast but can have high charging rates and risks (GCash is not regulated by the Central Bank of the Philippines).

Controlling Disbursements

• Control Dispersing: Predicting payroll withdrawals to optimize deposit timing.
• Playing the Float: Maximizing disbursement float.
• Staggered Funding: Similar to controlled dispersing.
• Drafts: Allow prolonging disbursement (site draft when seen, time draft at a later date).
• Overdraft System: Black American Card (charge and delay payment).
• Zero Balance Account: Maintain zero balance, depositing funds only when disbursements are needed.

Appropriate Level of Cash

• Baumol Model:
  • Uses the Economic Order Quantity (EOQ) concept to balance the cost of converting cash to marketable securities and the opportunity cost of idle cash.
  • $ECQ = \sqrt{\frac{2 \times Conversion Cost \times Annual Demand for Cash}{Opportunity Cost Percentage}}$
• Miller-Orr Model:
  • Considers collections, disbursements, and maintaining a cash balance.
  • $Return Point = \sqrt[3]{\frac{3 \times Conversion Cost \times Variance of Daily Net Cash Flows}{4 \times Daily Opportunity Cost in Percentage}}$
  • $Upper Limit = 3 \times Return Point$

Management of Marketable Equity Securities

• The objective is to choose securities to maximize value, considering liquidity and earnings.
• Factors include:
  • Safety of principal: Recover initial investment upon maturity.
  • Possible earnings: Passive income (interest) and capital gains.
  • Marketability: Ability to sell or convert to cash when needed.
  • Taxability

Types of Investments

• Government: Treasury bills and notes.
• Private Institutions: Certificates of deposit, commercial paper, bankers' acceptances.
• Also offer higher interest rates: Money market mutual funds., Repurchase agreements.

Management of Receivables

• Evaluate credit standards (Five C's of Credit).

Five C's of Credit

• Character:
  • Subjective but most important.
  • Borrower's willingness to pay.
• Capacity:
  • Ability to pay based on income and expenses.
• Collateral:
  • Assurance that the debt will be settled.
• Capital:
  • Borrower's investment in the asset.
• Conditions:
  • Loan terms and restrictions.
• Extension of Credit Policies Determines Collection in the Future
• Trade off decision making

Economic Principles

• Every trade off decision has an associated costs.
• Extend credit up to equilibrium:
  • Marginal Revenue = Marginal Cost.

Effects of Credit Terms

• Factors affecting include discount period, cash discount, credit period, and credit limits.
• Relaxing credit standards:
  • Advantage: Increased credit sales
  • The disadvantages - Accounts receivable, Bad debts, Collection efforts
  • Cost opportunity = iddle cash.
• Incremental investment in receivables.
• Evaluate how manipulations in these credit terms will affect receivables.

Debt Collection Policies

• Speed up collections by minimizing collection float.
• Demand letters.
• Personal visits.
• Collection agency (factoring of receivables).
• Legal action (last recourse).
• Restructuring.
• The benefits or the incerase the related cost has to assessed with these debt collection policies.

Stringent Collection Policies

• Effects:

  • Potential decrease in sales volume.
  • Decreased accounts receivable.
  • The lower of 15,000 has to assessed with.
  • In what follows, please note that some edits were made. With the original text.

• The lower of 15,000 has to assessed with these debt collection policies. What will happen if we don't meet these collection policies.

Inventory Management

• Balance inventories
• Consider costs.

Inventory Shortage

• Potential reasons:

  • Supplier

• Supplier issues.

• Safety stocks

• Financial manager's roles:

  • Proper order size
  • Optimal safety stock
    Factor that will affect decision: Acquisition, Quality, Discounts

Inventory Factors

• Acquisition Cost
  • Acquisition dictates - carrying cost
• Quantity Discounts
  • Discount Analysis
• Ordering Cost
  • Treating the order
• Holding Cost (Carrying Cost)
• Cost to preserve inventory
• Safety Stock
• Stock out

Cost of Capital

• Cost of capital in the form of cash

• Cost of capital investment opportunities

• Merchandising (purchase inventory, deplete)

• Manufacturing - more difficult

• EOQ Application - applicable to merchant firms

EOQ

• The question that is asked must balance concerns
• Safety stock (Safety Stock and Just in Time - inventory)
• Order on time, is on hand.
• We should have balance if you use "to and four".
• The more difficult of the simulation.

Reorder Point

• Inventory should be placed order should be placed.

• The order, when they get delivered.

• The point where the order gets delivered.

• The safety stock reorder point, the order with and without the safety stock

• Safety Stock reorder point level with and without.

Inventory Management Calculations

• Determine the: The size - the size is "just right" (not overstocked).
• Determine size one (level) of the size two for optimum. Level.

Economic Order Quantity Calculations - Derivation

• Annualized or (carry) costs +Annualized (order) costs at TQ
• Cost = optimization - Cost optimization = equalized in TQ
• Cost = optimization

Cost formula

• There are four of costs annual carrying, average inventories multiplied with per year. Multiplied by (Carry) cost in uniz:

• Annual (usage / order) gives the # of costs order multiplied by cost orders. This is the annual cost order

• EOQ formula origin - in formula there is a cost, at large quantity small, at small quantity the costs will affect.

• We have inverse and direct cost.

• EOQ is the basis to compute average age of inventories with average levels

• Safetly levels

• Calculations of Monte Carlo Safety Stocks.

• Incremental carrying costs vs. incremental stack cost to use

• The inventory level, is a test is very useful, because inventory is related.

• Management vs. strategic managment of system.

Short Term Financing

• Definitions, what are are the definitions or short term definition. What the short definition.

• The definition for under on year.

• Current seasonal asset, seasonal - asset value (fluctuations)

• Definitions versus effective rate - this is important, because this happens

• The effective rate - Nominal rate calculations

• Depend on the financing side of the operations

• (borrowed) interest fee or is loan discount, the cost (interest is loan collateral)

• Nominal and percentage - approach
  *Simple versus compound is one of the calculations. They are important. This is an important discussion. Because in discussion. This

• Is in for both. What is not in what has to used

Source for Financing

• Sources, financing and unsecured (no collateral)

• Character of the individual.

• Secured and has credit rating.

• Commercial credit company secured: Secured has with what intended settlement