TOPIC 1 WORKING CAPITAL MANAGEMENT

TOPIC 1

WORKING CAPITAL
MANAGEMENT

ROSMARIA ISMAIL DPA40103 FINANCIAL MANAGEMENT 2
COMMERCE DEPARTMENT
POLITEKNIK MELAKA

1.1 WORKING CAPITAL POLICIES AND CASH MANAGEMENT

1.1.1 Objective of working capital management. 1.1.4 Motives for holding cash:
1.1.2 Working capital principles: a) Transaction
b) Precautionary
a) Hedging c) Speculative
b) Aggressive
c) Conservative 1.1.5 Cash surplus in marketable securities
1.1.3 Working capital management cycle: 1.1.6 Cash budget
a) Operating cycle
b) Cash conversion cycle (CCC) 2

1

WORKING CAPITAL
MANAGEMENT

3

INTRODUCTION

Main function of Finance Manager WC  represents a significant
 managing the firm’s Working proportion of Total Assets

Capital (CA & CL)

WC referred to as For a firm to be liquid @ solvent, it
NET CURRENT ASSETS is imperative that net CA are
POSITIVE

4

WORKING CAPITAL

▰ Working capital comprises of current assets minus its current liabilities. 5
▰ Current assets comprise principally of inventories, accounts receivables,

cash and short-term securities.

▻ These assets are termed ‘current’ as the assets concerned can be

converted into cash within one year (<12 months) or less.

▰ Current liabilities comprise principally of accounts payable, accruals,

short-term borrowings and taxes payable.

▻ These are obligations owed by the firm that are expected to come due

within one year or less.

OBJECTIVE OF WORKING CAPITAL

▰ The TWO (2) main objectives of working capital management to

ensure it has sufficient liquid resources to continue in business
and to increase its profitability.

 The objective of profitability supports the primary financial

management objective, which is shareholder wealth
maximization.

 The objective of liquidity ensures that liabilities can be met

as they fall due.

6

FACTORS AFFECTING WC LEVEL

Type of business • Manufacturing & retail firm have higher WC
(inventory)

Volume of sales • A higher level of sales  higher level of WC

Seasonality • Peak seasons (i.e : festive seasons) require
Length of operating a higher level of WC

& cash cycle • A longer operating & cash cycle increases
the level of WC

7

POLICY OF WORKING CAPITAL

Decision about the management of CA and CL

Strategy in managing WC that will maximize the firm’s value

Investment level in How far the firm How to finance the
CA the firm should should invest in CA CA

maintain

8

WORKING CAPITAL MANAGEMENT

▰ Working capital management hence, covers (but is not limited to) several basic

relationships:

▻ Sales impact  must determine the appropriate levels of receivables and

inventories to maintain

▻ Liquidity  must choose the levels of cash and marketable securities to

maintain

▻ Relations with stakeholders  customers are concerned with price, availability,

quality and service, goodwill and reputation of a firm. On the opposite end, the
firms would also have similar concerns about its suppliers

▻ Firm’s reputation depends on its ability to efficiently manage its current assets

and current liabilities

9

MISMANAGEMENT OF WC

▰ Mismanagement of working capital is a common
cause of business failure, e.g.:
a) inability to meet bills as they fall due
b) overtrading during periods of growth
c) overstocking

10

RISK-RETURN TRADE-OFF IN WC MGT

Related to a Increase Example : However this The Finance
trade-off investment in • Increase in may not result in Manager has to
between the WC by an increase in determine a
firm’s liquidity increasing inventory & the firm’s balance between
& profitability. investment in cash would returns, if profits liquidity &
CA  make the remain profitability that
increases the firm more unchanged. would contribute
firm’s liquidity. liquid & less positively to the
likely face a firm’s value.
stock out &
be able to 11
pay bills on
time.

RISK-RETURN TRADE-OFF IN WC MGT

▰ The use of current vs long term ▰ The use of CL to finance the firm’s
funds involves a risk-return trade-off. assets provides flexibility because

▰ The greater the use of long term maturity period is shorter.

funds, the lower the risk of ▰ The cost of short term funding
insolvency & the lower the return. lower than long term funding but

▰ The greater the use of short term greater uncertainty due to the

funds, the higher the risk on fluctuation of interest rates.

insolvency & the higher the return.

12

CLASSIFICATION OF ASSETS

ASSETS

PERMANENT TEMPORARY

Investment in assets which are expected to be held for more than 1 year Current assets that will be liquidated &
replaced within the current year
CURRENT ASSETS NON CURRENT ASSETS
Therefore, some of the firm’s
Current assets on hand as at its lowest level in a year. All Non Current Assets of firms current assets are temporary
Ex  min cash or bank balance, min level of
The rest are permanent
inventories (safety @ buffer stocks) maintained by the
firm over the year

13

CLASSIFICATION OF SOURCES OF
FINANCING

PERMANENT TEMPORARY SPONTANEOUS

Financing with maturity Short term financing Consist of trade credit & other
periods of more than comprising current Accounts Payable that arise
spontaneously in the firm’s day
one year. liabilities
Medium-term loans, Short term notes payable, to day operations.

common stock, unsecured bank loans, Other AP include wages &
preferred stock, commercial paper & loans salaries payable, accrued
long term debt secured by AR & inventories interest & accrued taxes

14

2

WORKING CAPITAL
PRINCIPLES

15

RM HEDGING  SELF LIQUIDATING @ MATURITY-
MATCHING APPROACH
Total Short-term +
temporary spontaneous  Moderate policy that matches assets &
assets sources of liabilities to maturities.
financing
Total  Permanent assets are financed by
permanent Long-term debt permanent sources, temporary assets
assets + Equity + financed by temporary sources.
spontaneous
sources of  Temporary financing including
financing spontaneous sources finances only
TEMPORARY CURRENT ASSETS.

 Permanent & spontaneous financing
finance PERMANENT CURRENT
ASSETS & NON CURRENT ASSETS.

 There are no excess funds.

Non Current Assets

TIME PERIOD 16

AGGRESSIVE  The firm wishes to take high risk. The
firm finances all of its TEMPORARY
RM ASSETS & some of its PERMANENT
CURRENT ASSETS & NON CURRENT
ASSETS with short term financing
which includes spontaneous sources.

 The other PERMANENT CURRENT

ASSETS NON CURRENT ASSETS are

financed by permanent sources, which

Short-term + also include spontaneous sources.

Total spontaneous  The firm is going for higher returns at
temporary sources of the risk of possible liquidity problems.
assets financing
 Could lead the firm to a dangerous
Total
permanent Long-term debt position of rising interest rates as well
assets
+ Equity + as loan renewal problems.
spontaneous
Non Current Assets sources of  However short term debt is cheaper
financing than long term debt.

 HIGHER RISK, HIGHER RETURN

TIME PERIOD 17

CONSERVATIVE  Conservative because the firm prefers
to have more cash on hand, especially
RM Short-term + in hard times.
spontaneous
sources of  Uses permanent sources including
financing spontaneous to finance all
PERMANENT ASSETS (CA & NCA) &
some TEMPORARY ASSETS (CA)

 Temporary sources including
spontaneous are used to finance some
of the TEMPORARY ASSETS.

Total  Very safe WC financing policy.
temporary
assets However, the permanent sources are

Total Long-term debt more expensive.
permanent
assets + Equity +  LOWER RISK, LOWER RETURN
spontaneous
sources of  Instead of having idle cash on hand
financing with no returns, the firm should invest
the excess cash in marketable

Non Current Assets securities & earn a return.

TIME PERIOD 18

TEST YOUR UNDERSTANDING

Marea Bhd’s summarized SOFP for the year is as follows :

Assets RM Liabilities RM
Non current assets 100,000,000 Equity 55,000,000
Current assets 20,000,000 Long term debt 40,000,000
Current liabilities 25,000,000
120,000,000 120,000,000

The company’s return on capital employed (ROCE) for the year is 40%. 19
Required :
a) Calculate Marea Bhd’s current ratio and total debt to total assets for the year.
b) What is the working capital policy applied by Marea Bhd currently?
c) What would Marea Bhd have to do to apply the hedging principle?

3

WORKING CAPITAL
MANAGEMENT CYCLE

20

OPERATING CYCLE

 The operating cycle is the time required for a company's cash to be put into its operations and then 21

return to the company's cash account.

 The average period of time required for a business to make an initial outlay of cash to produce goods,

sell the goods, and receive cash from customers in exchange for the goods.

 For instance a retailer’s operating cycle would be the time between buying merchandise inventory

and selling the same inventory. A manufacturer’s operating cycle might start when the company
spends money on raw manufacturing materials to make a product. The operating cycle wouldn’t end
until the products are produced and sold to retailers or wholesalers.

 Most companies try to keep their operating cycles at a year or less. This means that it would take a

retailer an entire year to sell its inventory.

 Operating cycles are important because they determine cash flow. If a company is able to keep a

short operating cycle, its cash flow will consistent and the company won’t have problems paying
current liabilities.

CASH CONVERSION CYCLE (CCC)

 CCC is the length of time from the beginning of the
production process to the point when cash is
collected from the sale of finished products less
the average payment period.

 Represents the amount of time the firm’s
resources are tied up.

22

CASH CONVERSION CYCLE (CCC) MODEL AN ILLUSTRATION

Vincenzo Bhd is going to introduce a new product. The effect of this new product on the working capital 23
position :

 VB will order and then receive the materials it needs to produce this new product. As purchase are
usually on credit, this transaction will create an accounts payable.

 Labour will be used to convert the materials into finished goods. However, wages will not be fully paid
at the time the work is done, resulting in accrued wages.

 The finished goods will be sold usually on credit creating receivables and not immediate cash inflows.

 At some point during the cycle, VB must pay off its accounts payable & accrued wages. As these
payments will be made before VB has collected cash from its receivables, a nest cash outflow will
occur, and this outflow must be financed.

 The cycle will be completed when VB’s receivables have been collected. At that time, VB will be in
position to pay off the credit that is used to finance the manufacturing of the product, and it then
repeats the cycle.

CASH CONVERSION CYCLE (CCC)

 Formula CCC :

 Inventory Conversion Period (ICP)  average length of time required to convert materials into finished goods &
then to sell them (average time between purchasing stocks and selling the goods)

ICP = (Inventory / COGS) x 365 days

 Debtors Collection Period (DCP) @ Receivables CP @ Day Sales Outstanding  average length of time required to
convert the firm’s receivables into cash (number of days for debtors to pay from time of sale)

DCP = (Receivables / Credit Sales) x 365 days

 Payables Credit Period (PCP) @ Payables Deferral Period  average length of time between the purchase of
materials & labour and the payment of cash for them (number of days from the time of purchase of materials and
labour for goods and the time of payment)

PCP = (Payables / COGS) x 365 days 24

CASH CONVERSION CYCLE (CCC)

 Example :

Jess Industries, a manufacturer of electrical appliances, has an annual sales of RM10 million. Cost
of goods sold is 70% of sales. The average inventory is RM1.25 million, average receivables is
RM1.11 million and the average payables is RM0.5 million.

What is the CCC for Jess Industries?

Solution : 25
CCC = ICP + DCP – PCP

= [(RM1.25m/0.7 x RM10m) x 365] + [(RM1.11m/RM10m) x 365] – [(RM0.5m/RM7m) x 365]
= 65 days + 41 days – 26 days
= 80 days

CCC MODEL

▰ The shorter the CCC, the
more profitable it is for
the firm.

▰ The length of time
between paying for
materials & labour, and
collection of receivables
is shorter.

26

HOW TO REDUCE CCC

1) REDUCING ICP
 It involves increasing inventory turnover as quickly as possible by efficient management
of inventories ; better production planning, scheduling & control ; effective sales
forecasting ; and synchronize the production & demand.

2) REDUCING THE DCP
 It involves speeding up collection of accounts receivables as soon as possible (ASAP)
without losing potential sales. The uses of proper techniques such as changes in credit
policies & collection policies that will improve collection period will benefits the firm.

3) INCREASING THE PDP
 It involves delaying payments on accounts payable as late as possible (ALAP) without
damaging the firm’s credit rating. Favourable cash discount should not be ignored as the
opportunity cost is high if not taken.

27

4

CASH

28

WHAT IS CASH?

$ The currency and coin the firm has on hand in petty cash drawers, in cash registers,
or in checking accounts (demand deposit accounts) at various commercial banks.

$ Maintain liquidity, minimize risk of insolvency

$ More cash  strong liquidity, but foregone investment in other securities.

$ Investment in Marketable Securities – return on unused funds

$ Little cash  increase profit, but risk of illiquidity

29

MOTIVES FOR HOLDING CASH According to economist,
John Maynard Keynes
TRANSACTION PRECAUTIONARY
MOTIVE MOTIVE SPECULATION
MOTIVE
• Balances held for transaction purpose • Towards uncertainty
allow the firm to meet its cash needs condition • Cash is held for speculative
that arise in the ordinary course of purposes in order to take
doing business. • Precautionary balances advantage on potential
serve as a buffer  profit-making situation
• The relative amount of cash needed to maintenance of balances
satisfy transaction requirements is used to satisfy possible, but • Ex : purchase materials in
affected by a number of factors, as yet unknown, needs. bulk  low cost per unit,
including the industry in which the firm thus leads to higher profit
operates & certainty of cash flow • The cash flow predictability
predictions of the firm has a material • Least important component
influence on this motive. of a firm’s preference for
• Outflow – payments of wages, utilities, liquidity.
inventories, fixed assets, supplier
30
• Ex : pharmacy vs computer software

5

MARKETABLE
SECURITIES

31

WHAT IS MARKETABLE SECURITIES?

▰ MS  Security investments (financial assets) that the firm
can quickly convert into cash balances.

▰ Near cash or near cash assets that can be quickly converted
to cash.

▰ Very short maturity periods (less than 1 year)
▰ Lower return

32

RATIONALE FOR HOLDING MS 33

▰ Substitute for cash
▻ Speedy conversion to cash
▻ Outflow > inflow  sell MS to obtain cash

▰ Temporary investment
▻ Inventories & receivables low – seasonality in sales
▻ Meeting the known financial requirements

TYPES & FEATURES OF MALAYSIAN MS

(1) GOVERNMENT DEBT SECURITIES 34
▰ Malaysian Government raises short-term financing through the

issue of marketable debt instruments.
▰ Forms of Government securities that are available in Malaysia are:

a) Malaysian Government Securities (MGS)
b) Malaysian Treasury Bills (MTB)
c) Government Investment Issues (GII)
d) Malaysian Islamic Treasury Bills (MITB)

TYPES & FEATURES OF MALAYSIAN MS

(2) REPURCHASE AGREEMENTS (REPO)

▰ In a Repo, the bank sells market instruments approved by BNM to an
investor, with the understanding that the bank would buy back the said
instrument at an agreed price (defined as interest rate) on a specific
future date.

▰ Firm can invest in these securities for short periods, ranging from 1 day to
1 year and firms can retire the transaction earlier (known as Reserve
Repo), subject to rate adjustment, should firm requires funds prior to
maturity of the Repo.

▰ In Malaysia, firms can have a choice of conventional or Islamic Repo.

35

TYPES & FEATURES OF MALAYSIAN MS

(3) BANKERS’ ACCEPTANCES

 Negotiable instruments drawn on and accepted by a bank.
 Also a money market instrument  a short term discount instrument that

usually arises in the course of international trade.
 A bankers’ acceptance starts as an order to a bank by a bank’s customer to pay

a sum of money at a future date, typically within 6 months.
 At this stage, it is like a postdated cheque  when the bank endorses the order

for payment as “accepted”, it assumes responsibility for ultimate payment to the
holder of the acceptance

36

TYPES & FEATURES OF MALAYSIAN MS

(4) PROMISSORY NOTE

▰ An unconditional promise to pay a specific amount to bearer or to the
order of a named person, on demand, or on a specified date.

▰ It is a written promise by the maker to pay money to the payee  a
promise to pay a sum of money.

▰ The one who makes the promise and signs the instrument is called the
maker and the party to whom the promise is made or the instrument is
payable is called the payee.

37

TYPES & FEATURES OF MALAYSIAN MS

(5) BILL OF EXCHANGE

 BoE or draft is written order by the drawer to the drawee to pay money to the payee.
A common type of BoE is the cheque.

 It is essentially an order made by one person to another to pay money to a 3rd
person. The person who draws the bill is called the drawer. He gives the order to pay
money to a 3rd party.

 The party upon whom the bill is drawn is called the drawee. He is the person to
whom the bill is addressed and who is ordered to pay. He becomes an acceptor
when he indicates his willingness to pay the bill.

 The party in whose favour the bill is drawn or is payable is called the payee.

38

TYPES & FEATURES OF MALAYSIAN MS

(6) CERTIFICATE OF DEPOSIT

 A CoD is a time deposit, a financial product commonly offered to consumers by
a bank  similar to saving accounts in that they are insured and thus virtually
risk-free.

 They are different from savings accounts in that the CoD has a specific, fixed
term (often 3 months, 6 months, or one year), and usually a fixed interest rate.

 It is intended that the CoD be held until maturity at which time the money may
be withdrawn together with the accrued interest.

 Fixed rates are common, but some institutions offer CoDs with various forms of
variable rates.
39

6

CASH BUDGET

40

WHAT IS CASH BUDGET?

▰ Detailed plan of a firm’s future cash flows. 41

▰ An estimation of the cash inflows and outflows of a firm for a specific
period of time in the future.

▰ Assess whether it has sufficient cash to fulfil its cash flow requirements in
the future and whether excess cash that exists ought to be put into more
productive use.

▰ Three main components necessary for creating a cash budget:

(i) Time period

(ii) Desired cash position

(iii) Estimated sales and expenses

CASH BUDGET GENERAL FORMAT

Cash Budget for period ended XX / XX / XXXX

42

CASH BUDGET PREPARATION

 Example :

Awani Co. wishes to arrange overdraft facilities with its bankers during the period April to June, 2021 when it will
be manufacturing mostly for stock. Prepare a cash budget for the above period from the following data, indicating
the extent of the bank facilities the company will require at the end of each month:
a) R

2021 SALES (RM) PURCHASES (RM) WAGES (RM)

February 180,000 124,800 12,000

March 192,000 144,000 14,000

April 108,000 243,000 11,000

May 174,000 246,000 10,000

June 126,000 268,000 15,000

b) 50% of credit sales are realized in the month following the sales and remaining 50% in the second month 43
following. Creditors are paid in the month following the month of purchase.

c) Workers are paid on 1st of the following month.
d) Cash at Bank on 1.4.2021 (estimated) RM25,000.

CASH BUDGET PREPARATION SOLUTION

Cash Budget for Three Months from April to June 2021 44

April (RM) May (RM) June (RM)

RECEIPTS (CASH INFLOWS): (51,000)
54,000
Opening balance 25,000 53,000 87,000
90,000
Collection from Receivables : 90,000 96,000
246,000
96,000 54,000 10,000
256,000
Total Receipts 211,000 203,000 (166,000)

PAYMENTS (CASH OUTFLOWS) :

Purchases 144,000 243,000

Wages 14,000 11,000

Total Payments 158,000 254,000

Closing balance 53,000 (51,000)

Note : Workers are paid on 1st of the following month

THANKS!

Any questions?

45