Working Capital and Cash Management Essentials

Fundamentals of Working Capital Management

• Definition of Working Capital: Businesses require two types of capital. Fixed capital refers to long-term investments in assets used over an extended period (e.g., plant, machinery). Working capital refers to a company's investment in short-term assets such as cash, inventory, short-term marketable securities, and accounts receivable.

• Net Working Capital (NWC): This is the difference between a firm's current assets and its current liabilities.

  • Formula: $\text{Net Working Capital} = \text{Current Assets} - \text{Current Liabilities}$

  • Positive Working Capital: Occurs when current assets exceed current liabilities. It indicates a company can fund current operations and invest in future growth. Example ratio: $(3:1)$.

  • Negative Working Capital: Occurs when current liabilities exceed current assets. Example ratio: $(.70:1)$.

• Efficiency Considerations: High working capital is not always ideal; it may indicate excessive inventory or a failure to invest excess cash.

• Management Goals: Working capital management involves balancing the risk and profitability associated with current assets and liabilities to contribute to the firm's value.

Cash Management System

• Definition: Cash management involves maintaining optimal levels of cash and marketable securities to meet requirements while optimizing income on idle funds.

• Officer Objectives:

  • Meeting cash disbursement needs (payment schedules).

  • Minimizing funds committed to transactions and precautionary balances.

  • Avoiding misappropriation and handling losses.

• Motives for Holding Cash:

  1. Transaction Motive: Necessary for normal business activities (purchases and sales).

  2. Precautionary Motive: A buffer held for contingencies (e.g., collection slow-downs, strikes, or unexpected cash needs).

  3. Speculative Motive: Cash held for profit-making opportunities or investments (e.g., discounted raw materials or merger proposals).

  4. Contractual Motive: Requirement by banks to maintain a compensating balance in a demand deposit account as a condition for a loan.

The Operating and Cash Conversion Cycles

• Operating Cycle: The time from the start of production to the eventual collection of cash from sales. It consists of two asset categories: inventories and accounts receivable.

  • Formula: $\text{Operating Cycle} = \text{Inventory Period} + \text{Accounts Receivable Period}$

• Cash Conversion Cycle (CCC): Also known as the net operating cycle. It measures the length of time from the initial cash outflow for goods/services to the realization of cash inflows from sales.

  • Logic: Financing the operating cycle is costly, providing an incentive for firms to shrink the CCC.

  • Formula: $\text{CCC} = \text{Operating Cycle} - \text{Days of Payables Outstanding}$

  • Expanded Formula: $\text{CCC} = (\text{Days of Inventory} + \text{Days of Receivables}) - \text{Days of Payables}$

• Interpretation:

  • Lower CCC indicates a better cash position.

  • Negative CCC is ideal (paying creditors only after getting paid by customers).

  • Example: $(63 \, \text{days} + 31 \, \text{days}) - 59 \, \text{days} = 35 \, \text{days}$. This means it takes 35 days to turn inventory into cash.

Detailed Metric Calculations

• Days of Inventory (DSI): Average number of days to sell inventory. Also called average age of inventory (AAI).

  • Inventory Turnover Formula: $\text{Inventory Turnover} = \frac{\text{COGS}}{\frac{\text{Beginning Inventory} + \text{Ending Inventory}}{2}}$

  • DSI Formula: $\text{DSI} = \frac{365 \, \text{(or 360) days}}{\text{Inventory Turnover}}$

  • Alternative DSI: $\text{DSI} = \frac{\text{Inventory}}{\text{Average COGS per day}}$

  • Case study: Fab Yulos: COGS = $P50,000$, Beg. Inv = $P10,000$, End. Inv = $P7,300$.

    • $\text{Inventory Turnover} = \frac{50000}{\frac{10000 + 7300}{2}} = 5.78$

    • $\text{DSI} = \frac{365}{5.78} = 63.15 \, \text{days}$

• Days of Sales Outstanding (DSO): Average time to collect receivables. Also called average collection period (ACP).

  • Receivable Turnover Formula: $\text{Receivable Turnover} = \frac{\text{Net Credit Sales}}{\frac{\text{Beginning Accounts Receivable} + \text{Ending Accounts Receivable}}{2}}$

  • DSO Formula: $\text{DSO} = \frac{365 \, \text{(or 360) days}}{\text{Receivable Turnover}}$

  • Case study: Fab Yulos: Credit Sales = $P100,000$, Beg. AR = $P10,000$, End. AR = $P7,000$.

    • $\text{Receivable Turnover} = \frac{100000}{\frac{10000 + 7000}{2}} = 11.76$

    • $\text{DSO} = \frac{365}{11.76} = 31.04 \, \text{days}$

• Days of Payables Outstanding (DPO): Average number of days to pay creditors.

  • Payables Turnover Formula: $\text{Payables Turnover} = \frac{\text{Net Credit Purchases (or Cost of Sales)}}{\frac{\text{Beginning Accounts Payables} + \text{Ending Accounts Payables}}{2}}$

  • DPO Formula: $\text{DPO} = \frac{365 \, \text{(or 360) days}}{\text{Payables Turnover}}$

  • Case study: Fab Yulos: COGS = $P50,000$, Beg. AP = $P7,500$, End. AP = $P8,100$.

    • $\text{DPO} = \frac{8100}{\frac{50000}{365}} = 59.12 \, \text{days}$

Cash Flow Statement (CFS)

• Purpose: Monitoring the movement (inflow and outflow) of cash. Distinct from Income Statements as it excludes non-cash revenue/expenses.

• Structure:

  1. Operating Activities: Cash from products/services. Includes receipts from sales, interest, taxes, and payments to suppliers/employees.

     • Adjustments: Depreciation and Amortization (D&A) are non-cash expenses and must be added back to net income.

     • Working Capital Changes: Increase in inventory or receivables is a cash outflow (subtracted); decrease is a cash inflow (added).

  2. Investing Activities: Sources/uses of cash from company investments. Items include Capital Expenditures (CapEx) for equipment/land/buildings and activities like Mergers & Acquisitions (M&A).

  3. Financing Activities: Sources of cash from investors/banks and payments to shareholders. Includes issuing/repurchasing stock, dividends, and debt principal repayment.

• Key Distinction: Cash is not net income. Net income includes credit sales reported on income statements, whereas CFS strictly reports cash transitions.

Summarized Financial Data and Activities

Jollibee Foods Corporation (2013 vs. 2012)

• Revenue: $80,282,769,199$ (2013) vs. $71,059,039,154$ (2012).

• Cost of Sales: $65,284,763,064$ (2013) vs. $58,435,498,743$ (2012).

• Net Income: $4,722,806,527$ (2013) vs. $3,711,995,652$ (2012).

• Current Assets: $18,384,176,985$ (2013) vs. $15,623,201,915$ (2012).

• Current Liabilities: $15,618,612,677$ (2013) vs. $16,621,233,643$ (2012).

ABC Company - Net Working Capital Activity

• Assets: Cash ($P60,000$), Marketable Securities ($P10,000$), Accounts Receivable ($P40,000$), Inventory ($P50,000$). Total = $P160,000$.

• Liabilities: Accounts Payable ($P30,000$), Accrued Expense ($P20,000$), Notes Payable ($P5,000$), Current Portion-Long term debt ($P10,000$). Total = $P65,000$.

• Calculation: $160,000 - 65,000 = P95,000$ (Positive NWC).

Amelia Laundry Shop - Projected Cash Flow (Expansion Plan)

• Assumptions: Collection increase of 25% ($P68,750$ per month), expenses constant ($P97,000$ total), loan of $P150,000$ in May.

• March: Beg. Balance ($278,000$) + Cash In ($68,750$) - Cash Out ($97,000$) = End Balance ($249,750$).

• April: Beg. Balance ($249,750$) + Cash In ($68,750$) - Cash Out ($97,000$) = End Balance ($221,500$).

• May: Beg. Balance ($221,500$) + Cash Sales ($68,750$) + Loan ($150,000$) - Cash Out ($97,000$) = End Balance ($343,250$).

Quartz Corporation - September 2023 Transactions

• Inflows: Customers ($P720,000$), Sale of Asset ($P80,000$), Issuing stock ($P40,000$).

• Outflows: Interest ($P15,000$), Salaries ($P240,000$), Rent ($P25,000$), Utilities ($P30,000$), Inventory Increase ($P40,000$), Land Purchase ($P350,000$), Machineries Purchase ($P110,000$), Dividends ($P193,000$).