MODULE 7– WORKING CAPITAL MANAGEMENT 1

MODULE 7 – WORKING CAPITAL MANAGEMENT

INTRODUCTION

Working capital management is all about the company’s managerial accounting strategy
that aims to monitor and utilize the two components of working capital, the CURRENT
ASSETS and CURRENT LIABILITIES, to ensure the most financially efficient operation
of the company.
The primary purpose of working capital management is to make sure the company
always maintains sufficient cash flow to meet it short-term operating costs and short-
term debt obligations.
Any firm, from time to time, employs its short term assets as well as short term financing
sources to carry out its day to day business. This management of both current assets as
well as current liabilities is described as working capital management.

LEARNING OUTCOMES:

After reading this module, the learner should be able to:

1. Explain the importance of working capital and its management

2. Describe the different elements of working capital and explain how they can be
effectively managed

TIME:

The time allotted for this module is six (3) hours.

LEARNER DESCRIPTION

The participants in this module are 3rd year BSBA students

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MODULE CONTENTS:

Lesson 7.1: ELEMENTS, TYPES, AND OBJECTIVES OF WORKING CAPITAL

MANAGEMENT

Elements of Working Capital Management

 Working capital management commonly involves monitoring cash flow, assets
and liabilities through ratio analysis of key elements of operating expenses,
including working capital ratio, collection ratio, and the inventory turnover ratio
 Efficient working capital management helps with a company’s smooth financial
operation, and can also help to improve the company’s earnings and profitability.
 Management of working capital includes management of cash, accounts
receivables, inventory, and accounts payable.

Types of Working Capital

1. Gross and Net Working Capital: The total of current assets is known as gross
working capital whereas the difference between current assets and current liabilities is
known as the net working capital.

2. Permanent Working Capital: The type of working capital is the minimum amount of
working capital that must always remain invested. In all cases, some amount of cash,
stock and/or accounts receivables are always locked in. These assets are necessary for
the firm to carry out its day to day business. Such funds are drawn from long-term
sources and are necessary for running and existence of the business.

3. Variable Working Capital: Working capital requirements of a business firm might

increase or decrease from time to time due to various factors. Such variable funds are
drawn from short term sources and are referred to as variable working capital.

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Objectives of Working Capital Management

1. Maintaining the working capital operating cycle and to ensure its smooth
operation
- Maintaining the smooth operation of the operating cycle is essential for the business to
function. The operating cycle refers to the entire life cycle of the business. From the
acquisition of the raw materials to the smooth production and delivery of the end
products – working capital management strives to ensure smoothness, and it is one o
the main objectives of the concept.

2. Mitigating the cost of capital

- Minimizing the cost of capital is another very important objective that working capital
management strives to achieve. The cost of capital is the capital that is spent on
maintaining the working capital. It needs to be ensured that the costs involved for
maintenance of health working capital are carefully monitored, negotiated, and
managed.

3. Maximizing the return on current asset investments.

- Maximizing the return on current investments is another objective of working capital
management. The Return On Investment (ROI) on current invested assets should be
greater that the weighted average cost of the capital so that wealth maximization is
ensured.

The Working Capital Cycle

It refers to the minimum amount of time which is required to convert net current assets
and net current liabilities into cash. It is the amount of time between the payment of
goods supplies and the final receipt of cash accumulated from the sale of the same
goods.

Lesson 7.2: APPROACHES TO WORKING CAPITAL MANAGEMENT

The short-term interest rates are, in most cases, cheaper compared to their long-term
counterparts. This is du e to the amount of premium which is higher for short-term
loans. As a result, financing the working capital from long-term sources means more
cost. However, the risk factor is higher in case of short-term finances. In case of short-
term sources, fluctuations in refinancing rates are a major cause for concern, and they
pose a major threat to business.

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There are mainly three strategies that can be employed in order to manage the working
capital:

1. The Conservative Approach

 It involves low risk and low profitability
 In this strategy, apart from the permanent working capital, the variable
working capital is also financed from the long-term sources
 This means an increased cost capital
 However, it also means that the risks of interest rate fluctuations are
significantly lower.

2. The Aggressive Approach

 The main goal of this strategy is to maximize profits while taking higher
risks
 In this approach, the entire variable working capital, some parts or entire
permanent working capital and sometimes and fixed asset5s are funded
from short-term sources.
 This results in significantly higher risks
 The cost capital is significantly decreased in this approach that maximizes
the profit

3. The Moderate or the Hedging Approach

 This approach involves moderate risks along with moderate profitability. In
this approach, the fixed assets and the permanent working capital are
financed from long-term sources whereas the variable working capital is
sourced from the short-term sources.

Significance of Adequate Working Capital

1. It ensures liquidity
2. It ensures prompt and on-time payments to the creditors
3. It ensures good credit history
4. It ensures that dividends are regularly paid
5. It ensures an uninterrupted flow of production

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Lesson 7.3: FACTOS FOR DETERMINING THE AMOUNT OF WORKING CAPITAL

NEEDED

The following are some of the factors that determine the amount of liquid cash and
assets required for any firm to operate smoothly:

1. Nature of Business: A trading company requires large working capital. Industrial

companies may require lower working capital. A banking company, for example,
requires the maximum amount of working capital.

2. Size of the business unit: The amount of working capital depends directly upon the
volume of business. The greater the size of a business unit, the larger will be the
requirements of working capital.

3. Terms of purchase and terms of sale: Use of trade credit may lead to lower
working capital while cash purchases will demand larger working capital. Similarly,
credit sales will require larger working capital while cash sales will require lower working
capital.

4. Turnover of inventories: If inventories are large and their turnover is slow, we shall
require larger capital but if inventories are small and their turnover is quick, we shall
require lower working capital

5. Process of manufacture: Long-running and more complex process of production

requires larger capital while simple, short period process of production require lower
working capital

6. Importance of Labor: Capital intensive industries, e.g. mechanized and automated

industries generally require less working capital while labor intensive industries such as
small scale and cottage industries require larger working capital.

Lesson 7.4: IMPORTANCE OF WORKING CAPITAL

Working capital is a vital process of a business and can provide the following
advantages to a business:

1. Higher Return on Capital: Firms with lower working capital will post a higher return
on capital so shareholders will benefit from a higher return for every peso invested in
the business.

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2. Improved Credit Profile and Solvency: The ability to meet short term obligations is
a pre-requisite to long-term solvency and often a good indication of counterparty’s credit
risk. Adequate working capital management will allow a business to pay on time its
short-term obligations which could include raw materials, salaries, and other operating
expenses.

3. Higher Profitability: According to a research, the management of account payables

and receivables is an important driver of small business’s profitability

4. Higher Liquidity: A large amount of cash can be tied up in working capital, so a

company managing it efficiently could benefit from additional liquidity and be less
dependent on external financing.

5. Increased Business Value: Firms with more efficient working capital management
will generate more free cash flows which will result in a higher business valuation and
enterprise value.

6. Favorable Financing Conditions: A firm with a good relationship with its trade
partners and paying its suppliers on time will benefit from favorable financing terms
such as discount payments from its suppliers and banking partners.

7. Uninterrupted Production: A firm paying its suppliers on time will also benefit from
a regular flow of raw materials, ensuring that the production remains unitterupted and
clients receive their goods on time.

8. Ability to Face Shocks and Peak Demand: An efficient working capital

management will help a firm to survive through a crisis or ramp up production in case of
an unexpectedly large order.

9. Competitive Advantage: Firms with an efficient supply chain will often be able to sell
their products at a discount versus similar firms with inefficient sourcing.

Lesson 7.5: CASH MANAGEMENT

 To some people, the term cash management conjures up images of placing in

cash a bank for safe keeping. Interestingly enough, the field of cash
management has broadened considerably. Cash concepts and techniques are
applied to a wide range of activities and situations outside the cash parlance
alone. As it goes beyond, cash becomes more important than just merely
receiving and placing it in a bank and disbursing it. There are lot of good reasons
why one has to manage cash well.

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Cash is considered as vital asset and its proper management support company
development and financial strength. An effective cash management program designed
by companies can help to realize this growth and strength. Cash is vital element of any
company needed to acquire supply resources, equipment and other assets used in
generating the products and services. Marketable securities also come under near
cash, serve as back pool of liquidity which provides quick cash when needed.

Motives for Holding Cash

The influences that affect the firm’s cash balance can be classified in terms of the three
motives put forth by economist John Maynard Keynes: (1) the transactions motive, (2)
the precautionary motive, and (3) the speculative motive.

1. The Transactions Motive. Balances held for transaction purposes allow the firm to
meet its cash needs that arise in the ordinary course of doing business.

2. The Precautionary Motive. Precautionary balances serve as a buffer. This motive

for holding cash relates to the maintenance of balances used to satisfy possible, but as
yet unknown, needs.

3. The Speculative Motive. Cash is held for speculative purposes in order to take
advantage of potential profit-making situations.

Cash is the most liquid asset of a company but also the asset most vulnerable to
theft. Because of this, there must be proper internal controls over cash that need to be
observed to safeguard the asset.

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The following internal controls over cash are suggested:

1. Separating the cashiering function from the recording or accounting function

> A basic internal control system should not allow the assignment of custodial function
and recording function to one person, unless you are the owner. This may lead to
temptation of stealing cash from the company or manipulating records.

2. Issuing Official Receipts for collections and summarizing collections in a daily

collection report
> It is important to know the collections from business every day as these collections
reflect the health of the company. The daily collection report is going to be useful for
the next control measure for cash- depositing collections.

3. Depositing collections
> A good internal control over cash is by depositing all collections intact. The daily
collection reports are now compared with the deposit slips to find out if all collections
are indeed deposited.

4. Adopting the check voucher system for payments.

> If all collections need to be deposited, then payments must be made through a check
voucher system. There must be two signatories in the check to provide check and
balance. Having two signatories minimizes the probability of issuing a flawed check,
either to the wrong payee or an incorrect amount.

The check must also be cross-checked by drawing two lines on the payee section of
the check. This requires depositing of a check. It cannot be encashed.

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Common Misuses of Cash

LAPPING- Case of misappropriating a collection from one customer and concealing

this defalcation by applying a subsequent collection made from another customer.
This involves series of postponements of entries on collection of a receivable and is
made possible because of poor internal control.

KITTING- Happens when a check drawn from one depository bank and deposited in
another depository bank at the end of the month year. There will be no entries made
on this drawing and depositing. As a result, the cash in a depository bank increases
to cover the shortage while on the other depository bank, it has not yet posted the
check deposited to other bank.

FRAUDULENT DOCUMENTS AND EVIDENCE. Some employees will make

documents and pieces of evidence which are not really true.

Lesson 7.6: ACCOUNTS RECEIVABLE MANAGEMENT

Providing a credit terms to customers is one way of generating sales. Management

of accounts receivable is important. Imagine a situation where a company cannot
collect its accounts receivable. If this situation always happens, start looking for
another job. If a company cannot collect its accounts receivable, eventually it will
have to shut down its operations.

How can management minimize the potential loss from uncollected accounts
receivable? Credit evaluation is the key. Management of accounts receivable should
also include having good billing and collection system.

In any case the 5 C’s of credit can be used in the credit evaluation.

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1. Character – This refers to the integrity and reputation of the customer

2. Capacity – This refers to capacity to pay. The operations of the business especially
the operating cash flows are given emphasis in the criterion
3. Capital – This refers to the amount of capital invested by the owner or, in this case,
the customer, into his company
4. Collateral – This can be guarantees or collateral provided by the customer to support
his exposure with the company
5. Condition – This one describes the environment where the company operates which
may affect the ability of the customers to pay. This may include economic or political
conditions.

Collecting Cash

Having sent out the invoice quickly and accurately, the methods a company could
use to use ensure customers pay in a timely fashion include:

1. Monthly statements – They can be produced quickly and easily by any

computerized sales ledger system and sent to customers.

2. Chasing letters – These should be directed to a specific person preferably at a

reasonable senior level.

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3. Chasing phone calls – These can often have a great impact as all businesses have
to answer the telephone and hence they have a nuisance value which can generate
results.

4. Personal approach – A personal approach from a senior person in the company to a

senior person at the customer can often yield results

5. Stopping Supplies – This is a cash collection tool that must be used with care. If the
product being sold is built specifically to the customers design, and you are the only
supplier who currently makes the product, then it is a powerful tool, in the short term,
you are the only suppliers, and hence, payment is likely to be forthcoming.

6. Legal Action – This is costly and is likely to lead to the customer being lost

7. External debt collection agency – As with legal action this is costly and is likely to
lead to the loss of the customer.

Lesson 7.7: INVENTORY MANAGEMENT

Managing inventories is very important for merchandising companies and

manufacturing companies. This is even more important for companies which deal
with highly perishable products. This is also important for companies which are
dealing with products prone to technological obsolescence such as those involved in
electronic products and computer microchips. Not managing inventories properly
can lead to substantial amount of impairment losses.

Management should warrant a good inventory system because the effects of

mismanagement of inventory could result in the following:

1. Under-stocking – this is a serious problem as this can result in the following:

-Missed deliveries
-Lost sales
-Unsatisfied customers
-Production bottlenecks and worst, work stoppage

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2. Overstocking- these are the possible effect of this:

- Holding cost might be too high
- Funds could have been used for a more productive venture thus improving operating
performance

With these possible effects, inventory should be taken with utmost care and must
address two major concerns

1. Timing of order
2. Size of order

To effectively manage the inventory one must have the following:

- A system to keep track of the inventory on hand and on order
- A reliable forecast of demand
- Knowledge of lead time
- Reasonable estimates of inventory holding cost, ordering cost and shortage cost
- Classification system for inventory

The following are the internal controls that should be considered by management to
safeguard inventories.

1. Separating custodial functions from the recording functions.

2. Aging of inventories. It allows management to identify the fast-moving and slow
moving items
3. ABC Analysis. This approach classifies inventories into three categories: A, B,
and C. Inventories which are considered most important are classified A; those at
the middle are classified B; and the least are classified as C. The main reason is to
provide the kind of security due to each category of inventories.

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