Chapter 17

Addressing Working Capital Policies and Management of Short-term Liabilities

Working Capital Management involves finding the optimal levels of cash, marketable
securities, accounts receivable, and ending inventory and financing that working capital at the
least cost. Effective working capital management can generate considerable amounts of cash.
Reasons Why Working Capital is important:
-comprises a large of portion of firms total assets. (i.e. firms in manufacturing and trading
industries keep more than half of their assets in current assets)
-financial manager has considerable responsibility and control in managing the level of current
assets and current liabilities
-directly affects the firms long-term growth and survival because higher levels of current assets
are needed to support production and sales growth.
-liquidity and profitability are likewise directly affected by working capital management.
Factors affecting firms working capital policy:
1. Nature of Operations working capital requirements differ greatly among manufacturing,
retailing, and service organizations.
2. The Volume of Sales more current assets such as accounts receivable and inventories are
needed to support higher level of sales.
3. The Variation of Cash Flows The greater the fluctuations in the firms cash inflows and
outflows, the greater the level of net working capital required.
4. The Operating Cycle Period the length of time cash is tied up in a firms operating process.
(i.e. the operating cycle of a manufacturing firm is the length of time required to purchase raw
materials on credit, produce and sell a product, collect the sales receipts and repay the credit.
Shortening the operating cycle reduces the amount of time funds are tied up in working capital
and thus lowers the level of working capital required.)
OPERATING CYCLE
The length of period between the procurement of inventory of raw materials and turns into
finished goods, sell them, and receive payment from them.
Operating Cycle = Inventory Conversion Period + Average Collection Period
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Technological Institute of the Philippines

Inventory Conversion Period = 365 days/Inventory Turnover

Inventory Turnover = Cost of Sales/Average Inventory

Average Inventory = (Beginning Inventory Ending Inventory)/2

Average Collection Period = 365 days/Receivable Turnover

Receivable Turnover = Credit Sales/Average Receivable

Average Receivable = (Beginning Receivable + Ending Receivable)/2

Cash Conversion Cycle

The firms cash conversion cycle is determined by subtracting the average payment period from the
operating cycle.
Cash Conversion Cycle = Operating Cycle Average Payment Period

Average Payment Period/Payable Deferral Period = (Average Payable x 365)/Cost of Sales

*The shorter the cash conversion cycle, the better because that will lower interest charges.
Note: The aim of every management should be to reduce the length of operating cycle or the number of
operating cycles in a year in order to reduce the need for working capital. It is therefore necessary that
the financial managers be able to identify the reasons for prolonged operation cycle and how it could be
reduced.
Possible reasons for Longer Operating Cycle:
1. Defective purchasing policy and practices
-purchase of raw materials or merchandise in excess/short of requirements
-buying inferior, defective materials thus lengthening the production time
-failure to get credit from suppliers
-failure to get trade/cash discount, and
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Technological Institute of the Philippines

-inability to purchase goods due to seasonal wings

2. Lack of proper production planning, coordination, and control that could result to protracted
manufacturing cycle.
3. Defective inventory policy
4. Use of outdated machinery, technology as well, poor maintenance, and upkeep of plant, equipment,
and infrastructure facilities.
5. Defective credit policy and receivable collection procedures.
6. Lack of proper monitoring of external equipment
Remedies that may be adopted to reduce the length of operating cycle:
1. Production Management
2. Purchasing Management
3. Marketing Management
4. Credit and Collection Period
5. External Environment
Costs relevant to Investment in Current Assets:
1.) Carrying Costs are costs associated with having current assets which include:
a.) Opportunity costs costs associated with having capital tied up in current assets instead of more
productive fixed assets
b.) Explicit costs costs that are necessary to maintain the value of the current assets. (e.g. storage
costs)
2.) Shortage Costs are costs associated with not having current asset which include:
a.) Opportunity costs sales due to not having enough inventory on hand
b.) Explicit transaction fees costs that are paid for particular type of current asset. e.g. (extra
shipping costs, interest expense for money borrowed)
Policies as to the Size of Investment in Current Assets:
1. Relaxed Current Asset Investment Policy - policy under which relatively large amounts of cash,
marketable securities, and inventories are carried and under which sales are stipulated by granting
liberal credit terms resulting in a high level of receivables. In this policy, marginal carrying costs of
current assets will increase while marginal shortage costs will decrease.
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Technological Institute of the Philippines

2. Restricted Current Asset Investment Policy policy under which holdings of cash, securities,
inventories, and receivables are minimized. Marginal carrying costs of current assets will decrease while
marginal shortage of costs will increase.
3. Moderate Current Asset Investment Policy a policy that is between the relaxed and restricted
policies. This policy dictates that the firm will have just enough current assets so that the marginal
carrying costs and marginal shortage costs are equal, thereby minimizing total cost.

Effective working capital management requires a set of strategies to manage the level, composition, and
financing of a firms current assets. Decisions should be based on the simultaneous analysis of their joint
impact on return and risk.
Thus, consideration should be given on the broad categories of assets. These are:
1. Long Term/Permanent Assets consists of property,plant, and equipment, long term investments,
and the portion of firms current assets that remained unchanged over the year.
2. Fluctuating or Seasonal Assets current assets that vary over the year due to seasonal or cyclical
needs.
Financing Policies:
1. Flexible Financing Policy this involves the decision to finance the peaks of asset requirement with
long-term debt and equity. It provides the firm with a large investment surplus in cash and marketable
securities most of the time.
2. Restricted Financing Policy - this involves a decision to finance the valleys or troughs of assets, with
long-term debt and equity but will have to seek short-term financing for all peak demand fluctuations
for current assets as well as for in between demand situations. This policy is considered the most
conservative but the least convenient because it involves seeking some level of short-term financing
almost all of the time.
3. Compromise Financing Policy this involves a firm financing the seasonally adjusted average level of
asset demand with long-term debt and equity. It uses both short-term financing and short-term
investing as needed. With this compromise approach, the firm borrows in the short-term to cover peak
financing needs but it maintains a cash reserve in the form of marketable securities during slow
period. As current assets build up, the firm draws down this reserve before doing any short-term
borrowing. This allows for some run-up in current assets before the firm has to resort to short-term
borrowing.
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Technological Institute of the Philippines

Factors to be considered in choosing the appropriate Financing Policy:

1. Maturity Hedging matching the maturities of assets and liabilities.
2. Cash Reserves - surplus cash and marketable is held idle and therefore do not earn interest.
3. Relative Interest Rates short-term interest rates are usually lower than long-term rates.
4. Availability and Costs of Alternative Financing
5. Impact on Future Sales Customers may be willing to pay higher prices for the quick delivery of
service and more liberal credit terms implicit in flexible policy.

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Technological Institute of the Philippines