WORKING CAPITAL

MANAGEMENT
Atty. Prackie Jay T. Acaylar, CPA, JD, MPA, MBA, PhD-BM, DFRILL, PD-SML, IIGRE

ABSTRACT

The purpose of this study was to know how to manage the firm’s current assets
and liabilities in such a way that a satisfactory level of working capital is maintained.
Working capital represents a company’s capacity to conduct business with its
customers, suppliers and employees. In line with this Working Capital Management is
important to company to ensure that the firm can continue its operation and that it has
sufficient ability to satisfy both maturing short-term debt and upcoming operational
expense

INTRODUCTION

Most of the daily activities of financial analysis and management are related to
investment, financing and monitoring of assets used in a company’s operation. Assets
are called working capital, which is used in its day-to-day trading operations, calculated
the current assets minus the current liabilities. Issues regarding sales, purchasing and
production are resolved by management. Working Capital Management refers to the
effort of managing your working capital it is necessity for businesses, as they require a
regular amount of cash to make routine payments, cover unexpected costs and
purchase basic materials used in the production of goods. It identifies the company’s
financial health and success as a business.
 ADDRESSING THE WORKING CAPITAL POLICIES & MANAGEMENT OF SHORT-
TERM ASSETS & LIABILITIES

⮚ WHAT IS WORKING CAPITAL?

● Working capital typically means the available current or short-term assets of a
firm such as cash, receivables, inventory and marketable securities that are used
to finance its day-to-day operations.
● These items are also referred to as «circulating capital».
● Corporate executives devote a considerable amount of attention to the
management of working capital. Positive working capital is required to ensure
that a firm is able to continue its operations and that it has sufficient funds to
satisfy both maturing short-term debt and upcoming operational expenses.

⮚ VARIOUS DEFINITIONS OF WORKING CAPITAL (WC)

There are many prevalent definitions of WC for different contexts and purposes.
 ● Gross Working Capital (GWC)- it refers to the Current Assets, assets
which in the ordinary course of business can be or will be converted into
cash within one year without undergoing a diminution in value and without
disrupting the operations of the firm. Current assets are either permanent
or temporary.

Examples of temporary current assets are:

a) Inventory buildup for seasonal peak sales.

b) Inventories and receivable arising from one-time customer order.
c) Excess cash balances held during peak production periods.
d) Cash from profitable operations.

Examples of permanent current assets are:

a) Safety stocks of inventory that are kept protecting a company from an

unexpected disruption in supply and form or shortages.
b) Accounts receivable from customer.
c) Minimum cash balances.
d) Prepayment for insurance, warehousing and other services.

● Net Working Capital (NWC)- It is the amount of available capital that a

company can readily use in its day-today trading operations, calculated as
the current asset minus the current liabilities.
 ● Net Operating Working Capital (NOWC)- The concept of net operating
working capital is similar to net working capital. The only difference is that
it considers only the operating current liabilities and operating current
asset for determining the net operating working capital.

NWC = CA – CL

● Permanent working capital- known as regular working capital which is

normally required in the normal course of the business for the working
capital cycle to flow smoothly.

Characteristic of PWC:

a) Classified on the basis of Time Factor

b) Always remain in process
c) Size increases according to the Growth of enterprise
d) Suitable for business, which is the same for all the year long
e) Constantly changes from one asset to another

● Temporary working capital- the main characteristic which can be made

out of the example is “fluctuation”. The temporary working capital,
therefore, cannot be forecasted. Seasonal cycle can be one of the
example of temporary working capital. In the Philippines, most consumer-
based industries experience peak sales during two periods: the series of
holidays in November-December and the opening of the schoolyear in
June. Household consumption has traditionally been high during these
two periods.
The distinction among permanent and temporary working capital is illustrated in the
diagram below

⮚ DAYS OF WORKING CAPITAL

● Days working capital describes how many days it takes for a
company to convert its working capital into revenue. The more days
a company has of working capital, the more time it takes to convert
that working capital into sales. The higher the days working capital
number the less efficient a company is.

⮚ WHY IS WORKING CAPITAL IS IMPORTANT

● Working capital is part of the total assets of the company. Generally, it is

the difference between current assets and current liabilities. Practically
speaking, it is the daily, weekly and monthly cash requirement for the
operations of a business. Therefore, working capital management is a
process of managing short-term assets and liabilities. It makes sure that a
firm has sufficient liquidity to run its operations smoothly.
⮚ OBJECTIVES OF WORKING CAPITAL MANAGEMENT
● Smooth Operating Cycle- this implies that the operating cycle i.e. the cycle
starting from the acquisition of raw material to its conversion to cash
should be smooth.

a) It means raw material should be present on the requirement and it

should not be a cause to stoppages of production.
b) All other requirements of production should be in place before time.
c) The finished goods should be sold as early as possible once they
are produced and inventoried.
d) The accounts receivable should be collected on time.
e) Accounts payable should be paid when due without any delay.
f) Cash should be available as and when required along with some
cushion.

● Optimize Investment in Working Capital- The return on the investment

made in current assets should be more than the weighted average cost of
capital so as to ensure wealth maximization of the owners. In other words,
the rate of return earned due to investment in current assets should be
more than the rate of interest or cost of capital used for financing the
current assets.

● Minimize Cost of Working Capital Financing- The cost of capital utilized in

working capital should be minimized so as to achieve higher profitability. If
the investment in working capital involves bank finance, interest rates
should be negotiated with the bank

⮚ WORKING CAPITAL POLICY

● Moderate working capital policy – is a balance between the two policies.

Moderate policy assumes risk which is lower than aggressive and higher
 than conservative. The biggest benefit of this policy is that it has
reasonable assurance of smooth operation.
● Consevative working capital policy – lower returns for the assurance of
good access to credi. There is a disadvantage of lower return on
investment because higher investment in the current assests attract higher
interest cost which in return reduces profitability.
● Aggressive working capital policy – achieve profitability by minimizing
investment in current assets. It tries to squees with a minimal investment
in currentt assets coupled with an extensive use of short-term credit.

Image above shows that these policies describe the relationship between the sales
level and the level of current assets.

An important aspect of a working capital policy is to maintain and provide sufficient

liquidity to the firm. The decision on how much working capital be maintained
involves a trade off i.e, having a large net working capital may reduce the liquidity
risk face by the firm, but it can have a negative effect on the cash flows. Therefore,
the net effect on the value of the firm should be used to determine the optimal
amount of working capital.

⮚ WORKING CAPITAL FINANCING POLICY

● Hedging Approach – also called the matching approach. It is a process of
matching maturities of debt with the maturities of financial needs. This
approach classifies the requirements of total working capital into two
categories:
1. Permanent working capital which is the minimum amount required to carry
out the business operation. It does no vary over time.
2. Temporary working capital which is required to meet special exigencies. It
fluctuates over time.

This approach suggest that the permanent working capital requirements

should be financed with funds from long-term sources while the temporary
working capital requirements should be financed with short term-funds.

Estimated Total Investment in Current Asset of Company X explains the

hedging approach, the permanent portion of current assets required Rs.
45,000 should be financed with long-term sources and temporary
requirements in different month should be financed from short-term
sources. The line graph below shows the hedging approach to asset
financing.
● Conservative Approach – This approach suggest that the entire estimated
investment in current asset should be financed from long-term sources
and the short term sources should be used only for emergency
requirements. For the sample estimated total investment in current asset
of company X, the entire estimated requirements of Rs 52,000 in the
month of November will be financed from long-term sources while the
short term funds will be used only to meet emeergencies. Line graph
below will show the conservative approach to asset financing

The distinct feature of this approach are

1. Liquidity is severally greater;

 2. Risk is minimized; and
3. The cost of financing is relatively more as interest has to be paid even on
seasonal requirements for the entire period.

● Aggressive Approach – suggests that the entire estimated requirements of

currents aaset should be financed short-term sources and even a part o
fixed asset investment be financed from short-term sources. This
approach makes the finance-mix more risky, less costly and more
profitable. Line graph below will show the Aggressive approach to asset
financing.

⮚ THE IMPORTANCEE OF MANAGING SHORT- TERM, CURRENT ASSET AND

LIABILITIES
● Short term Financial Management – managing current assets and current
liabilities – is on of the financial manager’s most important and time-
consuming activities.
● The goal of short term financial management is to manage each of the
firms current assets and liabilities to achieve a balance between
profitability and risk that contributes positively to overall firm value.
● Central to short term financial management is an understanding of the
firm’s cash conversion cycle.
 CASH AND MARKETABLE SECURITIES MANAGEMENT

⮚ THE IMPORTANCE OF CASH AND MARKETABLE SECURITIES

● Cash and marketable securities are the most liquid of a company’s assets.
Cash is the medium of exchange that permits management to carry on the
various functions of the business organization. Marketable securities
consists of short-term investment a firm makes with its temporary idle
cash. It can be sold quickly and converted into cash when needed. Unlike
cash, however, marketable securities provide a firm with interest income.
This refers to the holding of a cash to meet routine cash requirements to
finance the transactions which a firm carries on in the ordinary course of
business. A firm enters into a variety of transactions to accomplish its
objective which have to be paid for in the form of cash.

⮚ WHAT IS CASH?
● Cash is legal tender—currency or coins—that can be used to exchange
goods, debt, or services. Sometimes it also includes the value of assets
that can be easily converted into cash immediately, as reported by a
company.

⮚ WHAT IS MARKETABLE SECURITIES

● Marketable securities are liquid financial instruments that can be
quickly converted into cash at a reasonable price. The liquidity of
marketable securities comes from the fact that the maturities tend to
be less than one year, and that the rates at which they can be
bought or sold have little effect on prices.
 ⮚ MARKETABLE SECURITY HOLDINGS CAN BE DIVIDED INTO TWO
CATEGORIES;

● Operating short term securities, which are held primarily to provide liquidity
and are bought and sold as needed to provide funds for operations
● Other short-term securities, which are holdings in excess of the amount
needed to support normal operations. Highly profitable firms such as
Microsoft often hold far more securities than are needed for liquidity
purposes. Those securities will eventually be liquidated, and the cash will
be used for such things as paying a large one-time dividend, repurchasing
stock, retiring debt, acquiring other firms, or financing major expansions.
This breakdown is not reported on the balance sheet, but financial
managers know how much of their securities will be needed for operating
versus other purposes. In our discussion of net working capital, the focus
is on securities held to provide operating liquidity.
Image below shows the firm’s cash conversion cycle

⮚ THE CASH CONVERSION CYCLE (CCC)

Is a metric that expresses the time (measured in days) it takes for a company to
convert its investments in inventory and other resources into cash flows from
sales. Also called the Net Operating Cycle or simply Cash Cycle, CCC attempts
 to measure how long each net input dollar is tied up in the production and sales
process before it gets converted into cash received.

● CURRENCY- Fast-food operators, casinos, hotels, movie theaters, and a few

other businesses hold substantial amounts of currency, but the importance of
currency has decreased over time due to the rise of credit cards, debit cards, and
other payment mechanisms. Companies such as McDonald’s need to hold
enough currency to support operations, but if they held more, this would raise
capital costs and tempt robbers. Each firm decides its own optimal level, but
even for retailers, currency generally represents a small part of total cash
holdings.
● DEMAND (OR CHECKING) DEPOSITS- are far more important than currency for
most businesses. These deposits are used for transactions—paying for labor and
raw materials, purchasing fixed assets, paying taxes, servicing debt, paying
dividends, and so forth. However, commercial demand deposits typically earn no
interest, so firms try to minimize their holdings while still ensuring that they are
able to pay suppliers promptly, take trade discounts, and take advantage of
bargain purchases.

The following techniques are used to optimize demand deposit holdings:

1. Hold marketable securities rather than demand deposits to provide liquidity.

2. Borrow on short notice.
3. Forecast payments and receipts better.
4. Budget is the key tool used to improve cash forecasts.
5. Speed up payments.
6. Use credit cards, debit cards, wire transfers, and direct deposits.
7. Synchronize cash flows.

⮚ UNDERSTANDING CASH CONVERSION CYCLE

 The cash conversion cycle (CCC) is one of several measures of management
effectiveness. It measures how fast a company can convert cash on hand into
even more cash on hand. The CCC does this by following the cash as it is first
converted into inventory and accounts payable (AP), through sales and accounts
receivable (AR), and then back into cash.

ACCOUNTS RECEIVABLE & INVENTORY

⮚ THE NATURE OF ACCOUNTS RECEIVABLE

● Accounts Receivable are amounts that the customer owe the company for
normal credit purchases. Since accounts receivable are generally
collected within two months of the sale, they are considered a current
asset. Accounts receivable are usually appear on balance sheet below
short-term investment and above inventory. The nature of a company’s
accounts receivable balance depends on the sector and industry in which
it operates, as well the particular credit policies the corporate management
has in place. A company documents it’s A/R as a current asset on what’s
called a balance sheet.

Image below are example of Accounts Receivable

⮚
UNDERSTANDING OF ACCOUNTS RECEIVABLE (AR)
 ● Accounts receivable refers to the outstanding invoices a company has or
the money clients owe the company. The phrase refers to accounts a
business has the right to receive because it has delivered a product or
service. Accounts receivable, or receivables represent a line of credit
extended by a company and normally have terms that require payments
due within a relatively short time period. It typically ranges from a few days
to a fiscal or calendar year.

⮚ THE NATURE OF INVENTORY MANAGEMENT

● Inventory represents finished and unfinished goods which have not yet
been sold by a company. Inventories are maintained because time lags in
moving goods to customers could put sales at risks and maintained as
buffers to meet uncertainties in demand, supply and movement of goods.
For accounting definition an organization’s inventory counts as current
asset on an organization’s balance sheet because the organization can, in
principle, turn it into cash by selling it.

⮚ EXPLAIN THE WORKING CAPITAL POLICIES OF AN ORGANIZATION

● Working Capital Policies of a company refers to the level of investment in
current assets for attaining their targeted sales. Two important decision in
working capital management are – the level of current assets and the
means of financing current assets.

⮚ CATEGORIES OF INVENTORY MANAGEMENT

● Raw Materials – materials and components scheduled for use in making
a product.
● Purchased Parts – It is thought as an item by a form of logistics which
are procured by other companies.
● Work in Progress – materials and components that have began their
transformation to finished goods.
● Finished goods – goods ready for sale to customer
 ● Supplies – have been bought already but not yet used or consumed.

⮚ TECHNIQUES OF INVENTORY MANAGEMENT

1. Economic order quantity (EOQ) – is a formula for the ideal order quantity a
company needs to purchase for its inventory with a set of variable like total cost
of production, demand rate, and other factors. The goal of this technique is to
minimize related costs.

2. Determination of stock levels – this technique is essential for the control of

materials. It is required to avoid over and under stocking materials. More amount
of stocks and inadequate stocks both are harmful to the organization.

3. ABC Analysis – This inventory categorization technique splits subject into three
categories to identify items that have a heavy impact on overall inventory cost.
● Category A serves as your most valuable products that contribute the
most overall profit
● Category B is the products that fall somewhere in between the most and
least valuable
● Category C is for the small transactions that are vital for overall profit but
don’t matter much individually to the company altogether

4. Inventory turnover ratio – is a ratio showing how many times a company has sold
and replaced inventory during a given period. A company can then divide the
days in the period by the inventory turnover formula to calculate the days it takes
to sell the inventory on hand.

5. JIT (Just in time) Inventory system – is a technique that arranges raw material
orders from supplier in direct connection with production schedules. JIT is a great
way to reduce inventory cost.
6. VED Analysis – is an inventory management technique that classifies inventory
based on its functional importance. It categorize stock under three heads based
on its importance and necessity for an organization for production or any of its
other activities.

7. FSN Analysis – a technique that the items are classified according to their rate of
consumption. The items are classified into three groups:
F – means fast moving
S – means slow moving
N – means non-moving

8. Min-max method – is a basic reordering mechanism that is supported by many

ERPs and the other types of inventory management software. The “Min” value
represents a stock level that triggers a reorder and the “Max” value represents a
new targeted stock level following the reorder.

9. Perpetual Inventory – is a method of accounting for inventory that records the

sale or purchase of inventory immediately through the use of computerized point-
of-sale systems and enterprise asset management software.

10. Automatic order system – a computerized order-entry system that sends buy or
sell orders to the appropriate specialist.

SHORT-TERM SOURCES FOR FINANCIAL CURRENT ASSETS

⮚ THE DIFFERENT SHORT-TERM SOURCE FOR FINANCIAL CURRENT

ASSETS

● Short Term Finance- refers to financing for a small period normally less
than a year. It also known as Working Capital Financing.
 ● The most important difference between long term and short term finance
is the time period and the purpose. Short term finance is for less than
one year and long term could be for , years. Short term finance is used
for working capital requirement, however long term finance is for big
finnace requirements.

⮚ SHORT TERM FINANCING

● Short-term financing is aimed to meet the demand of current asset and
pay the current liabilities of the organization. In other words, it helps in
minimizing the gap between current assets and current liabilities. There
are diffirent means to raise capital from the market for small duration.
Here are some source of short term classified into two Internal and
external sources.

⮚ INTERNAL SOURCES

1. Depreciation Fund - depreciation is the estimated money value of the reduction

in working capacity or in the intrinsic value of an asset due to either use of the
asset or due to mere efflux of time. It is allocated by charging a fair proprotion of
the depreciable amount in each accounting period during the expected useful life
of the asset. In other words, the allocation of the depreciable amount of an asset
over its estimated useful life is depreciation.

2. Provision of taxation – is the provision made out of current profits to meet the tax
obligation. There is a time gap between the provision made and payment of the
actual tax liability. So it serves as a source of short-term finance during the
intermediate period.

3. Outstanding Expenses – are the expenses that are unpaid at the end of the
accounting period, which means they are payable but not yet paid. This may
apply to salaries, wages, telephone expense, rentals, electricity expense, water
 charges etc. All the outstanding expenses comes under nominal accounts and
must be credit.

⮚ EXTERNAL SOURCES

1. Trade Credit – is a helpful tool for growing businesses, when favourable

terms are agreed with a business supplier. This arrangement effectively puts
less pressure on cashflow that immediate payment would make. The typical
amount involved and the terms will depend entirely on your trading activity.
The reverse is also common, where a business customer or clients will
request trade credit terms. There are advantage and disadvantage of trade
credit.

Advantages
● An agreement can be very easy to organize
● An agreement is relatively easy to maintain, as long as the conditions
are met
● Can be used by most business, for supplies of goods or services
● Businesses are protected by late payment legislation
● A potentially low-cost of working capital

Disadvantages

● Possible loss of early payment discount

● Failure to comply with the conditions could lead to the loss of a
supplier
● Provision of cashflow advantage rather than additional finance
● There are no guarantees, as customers may pay later

2. Commercial paper – is a common form of unsecured, short-term debt issued

by a corporation. It is typically issued for the financing of payroll, accounts
payable, inventories and meeting other short-term liabilities. This is usually
 issued at a discount from face value and reflects prevailing market interest
rate.

3. Advances from customers – may be defined as the part of payment made in

advance by the customer to the enterprise for the procurement of goods and
services in the future. It is also called Cash before Delivery (CBD).

Advantages of customer advances are follows:

● Free from interest burden

● No security required
● No Repayment Obligation

Disadvantages of customer advances

● Limited to selected Enterprise

● Limited Period Offer
● Limited amount of advance

4. Bank Credit – are available to finance the purchase of inventory and

equipment as well as to obtain operating capital and funds for business
expansion. These loans are a time-honored and reliable method of financing
a small business, but banks often only finance firms with substantial
collateral and a long track record, and terms they offer are often very strict.

Advantages of Bank Credit

● Keep control of the company
● Bank loan is temporary
● Interest is Tax deductible
 Disadvantage of Bank Credit

● Tough to qualify
● High Interest rates

CONCLUSION

This paper provides thorough review regarding issues in the area of effective
working capital management and its implication such as liquidity, accounts receivable,
bills payable, profitability, etc. at a certain level of working capital, the value of firm is
maximized and how to manage your company to avoid bankruptcy. It also showed
techniques on how to inventory your goods which may help the company to prevent
stockouts, manage multiple locations, and ensure accurate recordeeping.

REFERENCES

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%20approach%2C%20the,known%20as%20'matching%20approach'.

[Link]

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Book

Principles of Managerial Finance: A financial Analysis Approach

By: Cesar G Saldana

Acaylar, P.J.T., “Financial Management (The Ultimate Guide to Graduate School)”,

Naonao Book Publishing, 2024