MANAGEMENT SERVICES: WORKING CAPITAL & CASH MANAGEMENT

Working Capital Management – is concerned with the financing and management of

the current assets of the firm.
 Mix between temporary and permanent current assets and the nature of the
financing arrangement

Permanent Current Assets – are the normal increase of current assets due to
normal growth of the business
Temporary Current Assets – are the increase of current assets due to seasonal
fluctuation.

How to finance Permanent and Temporary assets

Ideal
Permanent Current Assets Long Term Financing
Temporary Current Assets Short Term Financing

3 approaches of financing current assets: Moderate (Maturity Matching) /

Aggressive / Conservative

Straight Problem 1: Cash Conversion Cycle

PDAF Corporation has an inventory conversion period of 75 days, an average
collection period of 38 days, and a payables deferral period of 30 days.
a. What is the length of the cash conversion cycle?
b. If PDAF’s annual sales are P3,421,875 and all sales are on credit, what
is the investment in accounts receivable?
c. How many times per year does PDAF turn over its inventory?

Solution:

Straight Problem 2: Working Capital Investment

Miley Corporation produces motorcycle batteries. Miley turns out 1,500 batteries
a day at a cost of P6 per battery for materials and labor. It takes the firm 22
days to convert raw materials into a battery. Miley allows its customers 40
days in which to pay for the batteries, and the firm generally pays its suppliers
in 30 days.
a. What is the length of Miley cash conversion cycle?
b. At a steady state in which Miley produces 1,500 batteries a day, what
amount of working capital must it finance?
c. By what amount could Miley reduce it working capital financing needs if
it was able to stretch its payables deferral period to 35 days?
d. Miley’s management is trying to analyze the effect of a proposed new
production process on its working capital investment. The new production
 process would allow Miley to decrease its inventory conversion period to
20 days and to increase its daily production to 1,800 batteries. However,
the new process would cause the cost of materials and labor to increase
to P7. Assuming the change does not affect the average collection period
(40 days) or the payables deferral period (30 days), what will be the
length of its cash conversion cycle and its working capital financing
requirement if the new production process its implement?

Solution:

Straight Problem 3: Working Capital Policy

Janet Corporation is investigating the optimal level of current assets for the
coming year. Management expects sales to increase to approximately P2 million
as a result of an asset expansion presently being under taken. Fixed assets
total P1 million, and the firm plans to maintain a 60% debt ratio. Janet’s
interest rate is currently 8% on both short-term and longer-term debt (which
the firm uses in its permanent structure). Three alternatives regarding the
projected current assets level are under consideration: (1) a tight policy where
current assets would be only 45% of projected sales, (2) a moderate policy where
current assets would be 50% of sales, and (3) a relaxed policy where current
assets would be 60% of sales. Earnings before interest and taxes should be 12%
of total sales, and the tax rate is 40%.
a. What is the expected return on equity under each current asset level?
b. How would the firm’s risk be affected by the different policies?

Solution:

Multiple Choice Questions:

1. Working capital management is concerned with

a. Management of current assets d. Management of seasonal
assets
b. Management of fixed assets e. Both a and c are correct
c. Financing current assets

2. An aggressive firm will utilize more ____________ and maintain

____________ liquidity than a conservative firm
 a. Short-term debt; higher d. Short-term debt; lower
b. Long-term debt; lower e. None of the above are
correct
c. Long-term debt; lower

3. Usually yield curves are ______________ _____________, but in other

periods (e.g., peak periods of economic expansion) yield curves may be
_____________ _____________
a. Upward slopping; downward slopping
b. Downward slopping; sharply peaked
c. Downward slopping; upward slopping
d. Upward slopping; normally humped
e. None of the above are correct

4. The “term structure of interest rates” is depicted by

a. The level of permanent current assets
b. The level of seasonal current assets
c. The yield curve
d. The ratio of current assets to fixed assets
e. None of the above are correct

5. The concept of “permanent” assets refers to

a. Plant and equipment d. Accounts receivable plus
cash
b. Inventory e. Total assets
c. The minimum level of current
assets

6. A yield curve which depicts long-term interest rates to be higher than

short-term interest rates is said to be
a. Inverted d. Normal
b. Complex e. Skewed
c. Humped

7. Net working capital is the difference between

a. Current asset and Current liabilities
b. Fixed assets and current liabilities
c. Total assets and Total liabilities
d. Shareholders’ investment and cash

8. As s company becomes more conservatives in working capital policy, it

would tend to have a(an)
a. Decrease in its acid-test ratio
b. Increase in the ratio of current liabilities to non-current
liabilities.
c. Increase in the ratio of current assets to units of output.
d. Increase in funds invested in common stock and a decrease in funds
invested in marketable securities.

9. All of the following statements in regard to working capital are correct

except
a. Current liabilities are an important source of financing for many
small firms.
b. Profitability varies inversely with liquidity.
c. The hedging approach to financing involves matching maturities of debt
with specific financing needs.
 d. Financing permanent inventory build-up with long-term debt is an
example of an aggressive working capital policy.

10. Compared to other firms in the industry, a company that maintains

a conservative working capital policy will tend to have a
a. Greater percentage of short-term financing.
b. Greater risk of needing to sell current assets to repay debt.
c. Higher ratio of current assets to fixed assets.
d. Higher total asset turnover.

11. During 2006, Mason Company’s current assets increased by P120,

current liabilities decreased by P50, and net working capital
a. Increased by P70. c. Decreased by P70.
b. Did not change. d. Increased by P170.

12. Rico Company used the working capital basis of preparing its Fund
Flow Statement. The following data are presented for the year just ended:
Depreciation expense P48,500
Amortization of patents 12,000
Cash dividend declared 27,000
Cash dividends paid 34,000
Sale of common stock 175,000
Amortization of bonds discount 1,500
Gain on sale of equipment 9,5000
Working capital provided by operations 121,000
Purchase of land 310,000
Decrease in deferred income taxes 18,000

Calculate the net income or loss for the period from the above data.
a. P68,500 b. P86,500 c. P113,500 d. P351,500

14. During 2010, Mason Company's current assets increased by P120,

current liabilities decreased by P50, and net working capital:
a. Increased by P70 c. Increased by P170
b. Decreased by P170 d. Decreased by P70

CASH MANAGEMENT
Summary of concepts
 Cash is necessary but low-earning asset
 Financial managers attempt to minimize cash balances and yet maintain
sufficient amounts to meet obligations in a timely manner
 Reasons for holding cash balances
o Transactions balances
o Compensating balances
o Precautionary balances

 Temporarily, excess cash balances are transferred into interest-earning

marketable securities
 Financial manager attempts to get maximum use of minimum balances by
speeding inflows and slowing outflows
o Playing the float
o Improving Collection
 Decentralized collection centers
 Wire transfer of funds
  Lock box system
o Extended disbursement float to take advantage of slower clearing
of checks

Straight Problems

OPTIMUM CASH BALANCE

1. Liquid Industries forecasts cash outlays of P48 million for the next
fiscal year. A financial analyst for the company has estimated the
conversion cost of converting marketable securities to cash to be P900
per conversion transaction and the annual operating cost holding cash
instead of marketable securities to be 8%. Presently, the company converts
cash to marketable securities and vice- versa on a monthly basis.
Required: Using the Baumol model, calculate the following:
a. The optimal cash conversion amount.
b. The average cash balance.
c. The number of conversion to be made during the year.
d. The total cash costs.
e. The net advantage if the company follows the optimal conversion
model.

EFFECTIVE INTEREST RATE

2. EIR Corporation wants to raise P 5 million through the short-term
borrowings. The company gathered data from several banks and financing
institutions and assembled the following:
Lending A B C D E
institutions
Amount to be P5 M P5 M P5 M P5 M P5 M
borrowed
Nominal interest 10% 12%,discounted 11.5% 14% 15%,discounted
rate
Compensating None 5% 4% None 10%
balance
Average deposit None None None None P200,000
balance even if the
loan is not granted

Term of the loan 1 yr. 1yr. 1yr. 1yr. 1yr

Interest earned by
the compensating n/a 6% 6% 6% 6%.
balance

Required: For each of the terms of the loan offered by the lending institutions,
calculate the effective interest rates.

SOLUTION
FLOATS
SMARTS Company has a daily cash receipt of P85, 000. A recent analysis of its
collection indicated customers’ payments were in the mail an average of 2.5
days. Once received, the payments are processed in 1.5 days. After payments are
deposited, it takes an average of three days for these receipts to clear the
banking system.

Required:
1. How much collection float (in days) does the firm currently have?
2. If the firm’s opportunity cost is 11%, would it be economically
advisable for the firm to pay at an annual fee of P6, 500 to reduce
collection float by four days.
SOLUTION

LOCKBOX SYSTEM
A firm that has an opportunity cost of 9% is contemplating installation of a
lockbox system at an annual cost of P90, 000. The system is expected to reduce
mailing time by 2.5 days and reduce clearing time by 1.5 days. If the firm
collects P300, 000 per day, determine the net benefit (cost) of the installing
the lockbox system.

SOLUTION

CONCENTRATION BANKING
Mills Corporation sells to national market and bills all credit customers from
the Makati office. Using continuous billing system, the firm has collection of
P1.2 Million per day. Under consideration is a concentration banking system
that would require customers to mail payments to the nearest regional office to
be deposited in local banks.

Mills estimates that the collections period for accounts will be shortened by
an average of 2.5 days under this system. The firm also estimates that annual
service charges and administrative cost of P300, 000 will result from the
proposed system. The firm can earn 14% on equal-risk investments.

Required:
1. How much cash will be made available for other uses if the firm accepts
the proposed concentration banking system?
 2. What savings will the firm realize on the 2.5-day reduction in the
collection period?
3. The net benefit (cost) of the concentration banking.

SOLUTION

CONTROLLED DISBURSING
A large Bulacan firm has annual cash disbursements of P360 million made
continuously over the year. Although annual service and administrative cost
would increase by P100, 000, the firm is considering writing all the
disbursement checks on a small bank in Pangasinan. The firm estimates that this
will allow an additional 1.5 days on cash usage. If the firm earns a return on
other equally risky investments of 12%, determine the net advantage
(disadvantage) of using this technique of cash disbursements.

SOLUTION

Multiple Choice Questions

Cash flow management

1. Which of the following actions would not be consistent with good management?
a. Increased synchronization of cash flows.
b. Minimize the use of float.
c. Maintaining an average cash balance equal to that required as a compensating balance or that which
minimizes total cost.
d. Use of checks and drafts in disbursing funds.

2. Which of the following investment is not likely to be a proper investment for temporary idle cash?
A. Initial public offering of an established profitable conglomerate.
B. Commercial paper.
C. Treasury bills.
D. Treasury bonds due within one year.

3. A precautionary motive for holding excess cash is

A. To enable a company to meet the cash demands from the normal flow of business activity.
B. To enable a company to avail itself of a special inventory purchase before prices rise to higher
levels.
 C. To enable a company to have cash to meet emergencies that may arise periodically.
D. To avoid having to use the various types of lending arrangements available to cover projected cash
deficits

4. The following practices will impact the cash flow of the company:
A. Sale personnel are unequivocally responsible for collecting their credit sales.
B. Sales commissions are based on collected invoices.
C. Statement of accounts receivable are reconciled with customers and regularly sent for
confirmation.
D. Automatic transfer of funds is arranged with banks regarding deposits of branches.
Of the above, which will result to better cash flow?
A. All statements. C. Statements 3 and 4 only.
B. Statements 1, 3, and 4, only. D. Statement 4 only.

5. A compensating balance
A. Compensates a financial institution for services rendered by providing it deposits of funds.
B. Is used to compensate for possible losses on a marketable securities portfolio.
C. Is a level of inventory held to compensate for variations in usage rate and lead-time.
D. Is the amount of prepared interest on a loan.

6. Assume that each day writes and received checks totaling P10,000. If it takes 5 days for checks to clear and be
deducted from company’s account and only 4 days for the deposits to clear, what is the float?
a. P10,000 b. P0 c. P(10,000) d. P50,000

7. RMN is a retail mail order firm that currently uses a central collection system that requires all checks to be sent
to its flotation headquarters. An average of 6 days is required for mailed checks to be received, 3 days for RMN
to process them and 2 days for the checks to clear through its bank. A proposed lockbox system would reduce
the mailing and processing time to 2 days and the check clearing time for 1 day. RMN has an average daily
collection of P150, 000. If RMN adopts the lockbox system, its average cash balance will increase by
a. P1,200,000 b. P75,000 c. P600,000 d. P450,000

8. A firm has a daily cash receipt of P 100,000 and collection time of 2 days. A pack has offered to reduce the
collection time on the firm’s deposits by 2 days for a monthly fee of P500. If money market rates are expected
to average 6% during the year, the net annual benefit (loss) from having this service is
a. P3,000 b. P12,000 c. P0 d. P6,000

11. A firm has daily cash receipts of P300,000. A bank has offered to provide alockbox service that will reduce the
collection time by 3 days. The bank requires a monthly fee of P2,000 for providing this service. If monthly market
are expected to average 6%during the year, the additional annual income (loss) of using the lockbox system is
a. P(24,000) b. P12,000 c. P30,000 d. P54,000

12. A company obtained a short-term bank loan of P250,000 at an interest of 6%. As a condition of the loan, the
company is required to maintain a compensating balance of P50,000 in its checking account. The company’s
checking account earns interest at an annual rate of 2%. Ordinarily, the company maintains a balance of P25,
000 in its checking account for transaction purposes. What is the effective interest rate of the loan?
a. P6.44% b. 7% c. 5.08% d. 6.06%

13. Hager Company’s bank requires a compensating balance of 20% on a P100,000loan. If the stated interest on
the loan is 7 %, what is the effective cost of the loan?
a. 5.83% b. 7% c. 6.40% d. 8.75%
14. Butuan Company recently received a commercial bank loan of 16% discounted rate with a 20% compensating
balance. The term of the loan is one year. The effective cost of borrowing is:
a. 19.05% b. 20% c. 22.85% d. 25%

15. Cool and Sweet obtained a short-term bank loan for P1Million at an annual interest of 12%. As a condition of
the loan the company is required to maintain a compensating balance of P200, 000 in its savings account which
earns interest at an annual rate of 6%. The company would otherwise maintain only P100, 000 on the saving
account for transactional purposes. The effective cost of the loan is:
a. 13.20% b. 12.67% c. 12% d. 13.5%

16. Simile Inc. has a total annual cash requirement of P9,075,000 which are to be paid uniformly. Simile has the
opportunity to invest the money at 24% per annum. The company spends, on the average, P40 for every cash
conversion to marketable securities.
What is the optimal cash conversion size?
a. P60,000 b. P55,000 c. P45,000 d. P72,500

17. Hyperbole Corporation estimates its total annual cash disbursements of P3,251,250 which are to be paid
uniformly. Hyperbole has the opportunity to invest the money at 9% per annum. The company spends, on
the average, P25 for every cash conversion to marketable securities and vice versa.
What is the opportunity cost of keeping cash in the bank account?
a. P3,825 b. P1,912.50 c. P4,190 d. P188.55

18. What are the expected annual savings from a lock-box system that collects 150 checks per day averaging P500
each, and reduces mailing and processing times by 2.5 and 1.5 days respectively, if the annual interest rate is
7%?
a. P5,250 b. P13,125 c. P21,000 d. P300,000

19. You plan to borrow P10,000 from your bank, which offers to lend you the money at a 10 percent nominal, or
stated, rate on a one-year loan. What is the effective interest rate if the loan is a discount loan?
a. 10% b. 11.11% c. 12.45% d. 14.56%

20. What is the effective rate of a 15% discounted loan for 90 days, P200,000, with 10% compensating balance?
Assume 360 days per year.
a. 20% b. 15% c. 17.4% d. 22.2%

21. The Premiere Company obtained a short-term bank loan for P1,000,000 at an annual interest rate 12%. As a
condition of the loan, Premiere is required to maintain a compensating balance of P300,000 in its checking
account. The checking account earns interest at an annual rate of 3%. Premiere would otherwise maintain
only P100,000 in its checking account for transactional purposes. Premiere’s effective interest costs of the
loan is
a. 12% b. 14.25% c. 16.30% d. 15.86%