San Jose Community College

San Jose, Mallipot

S.Y: 2024-2025

CHAPTER 17:

ADDRESSIING WORKIN CAPITAL

POLICIES AND MANAGEMENT OF
SHORT-TERM ASSETS AND LIABILITIES

Submitted from:
Chyna Evangelista
Financial Management 2-E

Submitted to:
Jeffrey Codillo Banday
INTRODUCTION

Working capital management is associated with short-term financial decision

making. Short-term financial decisions typically involve cash inflows and outflows
that occur within a year or less. For instances, short-term financial decisions are
involved when a firm orders raw materials or merchandise, pay in cash and
anticipates selling finished goods in one year for cash. In contrast, long-term
financial decisions are involved when a firm purchases a special equipment that
will reduce operating costs over, say, the next five years.

Working capital also involves finding the optimal levels of cash, marketable
securities, accounts receivable, and inventory and then financing that working
capital at the least cost. Effective working capital management can generate
considerable amounts of cash.

REASONS WHY WORKING CAPITAL MANAGEMENT IS IMPORTANT

1. Working capital comprises a large portion of the firm’s total assets. Although
the level of working capital varies widely among different industries, firms in
manufacturing and trading industries more often than not, keep more than half of
their assets in current assets.
2. The financial manager has considerable responsibility and control in
managing the level of current assets and current liabilities.
3. Working capital management directly affects the firm’s long-term growth and
survival because higher levels of current assets are needed to support
production and sales growth.
4. Liquidity and profitability are likewise directly affected by working capital
management. Without sufficient liquidity, a firm may be unable to pay its liabilities
as they mature. The firm’s profitability is also affected because current assets
must be financed and financing involves interest expense.

FACTORS AFFECTING THE FIRM’S WORKING CAPITAL POLICY

The significant factors affecting a firm’s working capital position are as follows:

1. The Nature of Operations. Working capital requirements differ greatly among

manufacturing, retailing and service organizations. For example, retailing firms
have a high proportion of total asset in the current category because they earn
their return form current assets such as inventory.
2. The Volume of Sales. More current assets such as, accounts receivables and
inventories, are needed to support a higher level of sales.
3. The Variation of Cash Flows. The greater the fluctuations in the firm’s cash
inflows and outflows, the greater the level of net working capital required.
4. The Operating Cycle Period. The operating cycle is the length of time cash is
tied up in a firm’s operating process. For example, 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.

TRACING CASH AND NET WORKING CAPITAL

To trace cash movement through the firm’s operation, we must measure the
operating cycle as well as the firm’s cash conversion cycle. Understanding the
following time periods is necessary in monitoring the working capital movement.

1. Operating Cycle. The length of time in which the firm purchases or produce
inventory, sell it and receive cash
2. Cash Conversion Cycle. The length of time funds are tied up in working
capital or the length of time between paying for working capital and collecting
cash from the sale of inventory.
 Inventory Conversion Period. The average time required to purchase
merchandise or to purchase raw materials and convert them into finished
goods and then sell them.
 Average Collection Period. The average length of time required to convert
the firm’s receivables into cash, that is, to collect cash following a sale.
 Payables Deferral Period. The average length of time between the purchase
of materials and labor or merchandise and the payment of cash for them.

Figure 17-1 shows the relationship between operating and cash conversion cycle

THE OPERATING CYCLE

The operating cycle of a company consists of the time period between the
procurement of inventory of raw materials and turns them into finished goods (for
manufacturing concerns), sell them and receive payment for them. To measure
the firm’s operating cycle, the following formula can be used:
Calculation of Operating Cycle

Suppose that Mermaid Industries has annual sales of ₱1 million, cost of goods
sold of ₱ 650,000, and average inventories of ₱ 116,000, and average
accounts receivable of ₱ 150,000. assuming that all mermaid industries sales
are on credit, what will be the firm’s operating cycle?

Solution:

The operating cycle will be equal to:

THE CASH CONVERSION CYCLE

The firm’s cash conversion cycle is determined by subtracting the average

payment period from the operating cycle.
HOW CAN OPERATING CYCLE BE REDUCED

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.

The following could be the reasons for longer operating cycle period:

1. Defective purchasing policy and practices that could lead to

 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
 Inability to purchase goods due to seasonal swings
[Link] 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 environment

Remedies that may be adopted to reduce the length of operating cycle period are
as follows:

1. Production Management
There should be proper production planning and coordination at all levels of
activity. Also, a continuing assessment of the manufacturing cycle, proper
maintenance of plant, equipment and infrastructure facilities and improvement of
manufacturing system, technology would help shorten manufacturing cycle thus
shortening the operating cycle.
2. Purchasing Management
The purchasing manager should ensure the availability of the right type, quantity,
and quality of materials/merchandise obtained at the right price, time and place
through proper logistics management. Further, efforts exerted towards
lengthening the credit of the suppliers, increasing the rates of trade discount and
cash discount would certainly bring favorable outcome to the company’s deferral
payment period.
3. Marketing Management
The sale and production policies should be synchronized. Production of quality
products at lower costs enhances their marketability and saleability. Storage
costs would likewise be minimized. The marketing people should strive to
continually develop effective advertisement, sales promotion activities, effective
salesmanship and appropriate distribution channels.
4. Credit and Collections Policies
Sound credit and collection policies will enable the finance manager to minimize
investment in working capital particularly on inventory and receivables.
5. External Environment
The length of operating cycle is equally influenced by external environment. The
financial manager should be aware and sensitive to fluctuations in demand,
entrants of new competitors, government fiscal and monetary policies, price
fluctuations, etc. To be able to anticipate and minimize any adverse impact of the
changes to the company.

SOME ASPECTS OF SHORT-TERM FINANCIAL POLICY

The working capital or short-term financial policy that a firm adopts involves
answering two basic questions.
1. What is the appropriate size of the firm’s investment in current assets?
2. How should the current assets be financed?

ALTERNATIVE POLICIES AS TO THE SIZE OF INVESTMENT IN CURRENT

ASSETS

There are at least three alternative policies regarding the total amount of current
assets carried:

1. Relaxed Current Asset Investment Policy

This is a policy under which relatively large amounts of cash, marketable
securities and inventories are carried and under which sales are stimulated 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.
2. Restricted Current Asset Investment Policy
This is a policy under which holdings of cash, securities, inventories and
receivables are minimized. Marginal carrying costs of current assets will
decrease while marginal shortage costs will increase.
3. Moderate Current Asset Investment Policy
This is 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.
COSTS RELEVANT TO INVESTMENT IN CURRENT ASSETS

Carrying costs are the cost associated with having current assets. Generally,
they consist of (a) opportunity costs associated with having capital tied up in
current assets instead of more productive fixed assets and (b) explicit costs
which are costs necessary to maintain the value of the current assets.

Shortage costs are the costs associated with not having current assets and can
include (a) opportunity costs such as, sales lost due to not having enough
inventory on hand and (b) explicit transaction fees paid (e.g., extra shipping
costs, interest expense for money borrowed) to replenish the particular type of
current asset.

Figures 17-4, 17-5 and 17-6 show the behavior and trade off between carrying
costs and shortage costs in relation to amount of current assets. On the vertical
axis, we have costs measured in pesos and on the horizontal axis, we have the
amount of current assets.
ALTERNATIVE STRATEGIES IN FINANCIAL WORKING CAPITAL

In precious section, we looked at the basic determinants of the level of

investment in current assets. Now we turn to the financing side of the question.

Effective working capital management requires a set of strategies to manage

the level, composition and financing of a firm’s current assets. Decision should
be based on the simultaneous analysis of their joint impact on return and risk.

In addition, consideration should be given on the broad categories of assets.

There are:
1. Long-Term/Permanent Assets. These consist of property, plant and
equipment, long-term investments and the portion of a firm’s current assets that
remain unchanged over the year.
2. Fluctuating or Seasonal Assets. There are current assets that vary over
the year due to seasonal or cyclical needs.
Discussion:

Policy I Flexible Financing Policy (Figure 17-8)

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.

Policy II Restricted Financing Policy (Figure 17-9)

This involves a decision to finance the valleys or troughs of asset, 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 come level of short-term financing almost of the time.

Policy III Compromise Financing Policy ( Figure 17-10)

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.

WHICH FINANCING POLICY SHOULD BE CHOSEN

on the question as to what is the most appropriate financing working capital

strategy? There is no definitive answer.

However, the following should be considered in analyzing the

advantages/disadvantages of the alternative financing policy for working capital.

1. Maturity Hedging. Most firms attempt to match the maturities of assets and
liabilities. They finance inventories with short-term bank loans and long-term
assets with short-term borrowing. This type of maturity mismatching would
necessitate frequent refinancing and is inherently risky because short-term
interest rates are more volatile than longer-term rates.
2. Cash Reserves. The flexible financing policy implies surplus cash and a little
short-term borrowing. This policy reduces the probability that a firm will
experience financial distress. Firms may not have to worry as much about
meeting recurring, short-run obligations. However, investment in cash and
marketable securities are zero net present value investments at best.
3. Relative Interest Rates. Short-term interest rates are usually lower than long-
term rates. This implies that it is, on the average, more costly to rely on long-term
borrowing as composed to short-term borrowing. If we expect rates to rise in the
future, the firm may want to lock in fixed rates for a longer time by shifting
towards a flexible financing policy. With falling rates, the opposite would of
course hold true.
4. Availability and Costs of Alternative Financing. Firms with easy and
sustained access to alternative sources will want to shift toward more restricted
policy.
5. Impact on Future Sales. A more restricted short-term financial policy
probably could reduce future sales to level that would be achieved under flexible
policy. It is also possible that prices can be charged to customers under flexible
working capital policy. Customers may be willing to pay higher prices for the
quick delivery service and more liberal credit terms implicit in flexible policy.
Calculation of Cash Conversion Cycle

Using the data from the previous example Mermaid Industries and assuming
that the average accounts payable balance is ₱ 120,000, what will be the
firm’s cash conversion cycle?

The cash conversion cycle (CCC) may also be calculated as follows: