MANAGEMENT CONSULTANCY OPERATING CYCLE

(WORKING CAPITAL MANAGEMENT)

INTRODUCTION

There are two critical decisions every financial manager is facing: (a) profitability and (b)
liquidity. These decisions will impact organization’s investments in fixed assets or fixed capital
and level of working capital or current assets. Fixed assets pertain to company’s investments
on permanent assets such as land, building and machinery, while, working capital is
investments on assets that can be converted into cash for a short period of time like cash
equivalents, receivables and inventories.

Level of focus on these two-different assets will affect the company in different light. Investing
on fixed capital emphases on profitability as assets-in-place decreases cost of production thus
boosting company’s income. On the other hand, higher level of working capital ensures that
the organization will be able to meet its current and maturing obligation, therefore,
concentrating on liquidity.

Higher Fixed Capital  Higher Profitability  Low Liquidity

Higher Working Capital  Higher Liquidity  Low Profitability Source: http://wps.prenhall.com/wps/media/objects/13070/13384693/Chapter18.pdf

Therefore, every finance manager has to balance the level of fixed and working capital to Inventory Conversion Period
minimize the organization’s risk and maximize the return.
The average time required to convert raw materials to finished goods and sell them
COMPONENTS OF WORKING CAPITAL eventually. Other term for Inventory Conversion Period is Days Inventory Outstanding (DIO).

 Cash Management 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

 Receivables Management 𝐷𝐼𝑂 = =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑
[ ]
 Inventory Management 360
 Payable Management or Working Capital Financing
or
WORKING CAPITAL CYCLE
360 360
𝐷𝐼𝑂 = =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
[ 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 ]
FINISHED
CASH INVENTORY WIP RECEIVABLES CASH
GOODS
Average Collection Period Operating Cycle (OC)

The average length of time required to convert the company’s receivables into cash. Other Average period of time required for a business to make an initial outlay of cash to produce
term for Average Collection Period is Days Sales Outstanding (DSO). goods, sell the goods and receive cash from customers in exchange for the goods.

𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑂𝐶 = 𝐷𝐼𝑂 + 𝐷𝑆𝑂

𝐷𝑆𝑂 = =
𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠
[ 360 ]
Illustrative Problem:

or The following information was extracted from ABC Company’s financial statement ending
20x8.
360 360
𝐷𝑆𝑂 = =
𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠
[ 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 ] 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 Sales Php 15,000,000.00
Cost of Goods Sold 80% of Sales
Inventory 2,000,000.00
Payables Deferral Period
Receivables 3,000,000.00
Average length of time between the purchase of materials in credit and the payment of cash. Payables 1,000,000.00
Other term for Payment Deferral Period is Days Payable Outstanding
𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 Required:
𝐷𝑆𝑂 = =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑
[ 360 ] a. Determine the company’s Days Inventory Outstanding, Days Receivables Outstanding
and Days Payable Outstanding.
or b. Determine the Cash Conversion Cycle and Operating Cycle.

360 360 Solution:

𝐷𝑆𝑂 = =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
[ 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 ] 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 2,000,000.00
𝐷𝐼𝑂 = =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 (15,000,000.00 𝑥 80%)
360 [ 360 ]
Cash Conversion Cycle (CCC)

The average time funds (cash) are tied up in the working capital. 2,000,000.00 2,000,000.00
𝐷𝐼𝑂 = =
12,000,000.00 33,333.33
[ 360 ]
𝐶𝐶𝐶 = 𝐷𝑆𝑂 + 𝐷𝐼𝑂 − 𝐷𝑃𝑂

Note: Cash conversion cycle is a measure of how efficient the organization is managing its 𝑫𝑰𝑶 = 𝟔𝟎 𝒅𝒂𝒚𝒔
working capital. Therefore, the higher the cash conversion cycle means that company’s
resources are tied longer in the business operation.
 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 3,000,000.00 MANAGEMENT CONSULTANCY
𝐷𝑆𝑂 = =
𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 15,000,000.00 (CASH MANAGEMENT)
360 [ 360 ]
Cash management is striking a balance between maintaining enough funds to cover the
3,000,000.00 3,000,000.00
𝐷𝑆𝑂 = = business operations (liquidity) and the cost of holding too much cash (opportunity cost).
15,000,000.00 41,666.67 Higher level of cash ensures that day-to-day operation of the business are being financed and
[ 360 ]
able to settle its maturing obligation, however, holding too much idle cash can cost the
𝑫𝑺𝑶 = 𝟕𝟐 𝒅𝒂𝒚𝒔 company due to non-earning state of these liquid assets. On the other hand, low level of cash
can increase the company risk because it may not be able to finance its day-to-day operation,
but, investing those cash on financial institutions can earn interest.
𝑃𝑎𝑦𝑎𝑏𝑙𝑒 1,000,000.00
𝐷𝐼𝑂 = =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 (15,000,000.00 𝑥 80%)
360 [ 360 ] INVESTMENT OF
SURPLUS CASH
Excess Cash
1,000,000.00 1,000,000.00
𝐷𝐼𝑂 = =
12,000,000.00 33,333.33
[ 360 ]
CASH
FIRM Collection CASH RECEIPTS Payment
DISBURSEMENT
𝑫𝑰𝑶 = 𝟑𝟎 𝒅𝒂𝒚𝒔

𝐶𝐶𝐶 = 𝐷𝐼𝑂 + 𝐷𝑆𝑂 − 𝐷𝑃𝑂 = 60 + 72 − 30 Cash Deficit

SHORT- and
LONG-TERM
𝑪𝑪𝑪 = 𝟏𝟎𝟐 𝒅𝒂𝒚𝒔 FINANCING

𝑂𝐶 = 𝐷𝐼𝑂 + 𝐷𝑆𝑂 = 60 + 72
MOTIVES OF HOLDING CASH
𝑶𝑪 = 𝟏𝟑𝟐 𝒅𝒂𝒚𝒔
 Transaction Motive – Allows the firm to finance the ordinary course of the business.
 Speculative Motive – Taking advantage of possible income generating activities in the
future.
 Precautionary Motive – Buffer cash balance for unexpected demand for cash.
 Potential Investment Opportunities – Excess cash reserve is allowed to build up on
anticipation of future investment opportunity such as a major capital expenditure project.

FLOAT

Difference between the bank's balance for a firm's account and the balance that the firm
shows on its own books.
TYPES OF FLOAT b. Use of Account Sweeping Facility - an automated funds transfer service. It is capable of
maintaining the target balance in your subsidiary accounts by automatically transferring
Negative Float - cash book balance exceeds the bank balance (incoming checks) funds FROM and TO a parent account.
a. Mail Float - peso amount of customer's payments that have been mailed by a customer c. Play the float - increase positive float
but not yet received by the seller.
b. Processing Float - peso amount of customer's payments that have been received but by 3. REDUCE THE NEED FOR PRECAUTIONARY CASH BALANCE
the seller but not yet deposited. a. More accurate cash budgeting
c. Clearing Float - peso amount of customer's payments that have been deposited but not b. Maximize the use of credit lines
yet credited to the seller's bank account (deposit in transit). c. Invest idle cash in highly liquid, short term investments instead of holding idle
precautionary cash balances.
*negative float must be minimized, if not eliminated
DETERMINING THE OPTIMUM CASH BALANCE
Positive Float (Disbursement Float) - The firm's bank balance exceeds its book balance. (e.g.
checks written / issued by the firm that have not yet cleared) There are two-factors in determining the optimum cash balance of the company:

*positive float must be maximized  Transfer Cost – This is the cost associated to the number of times the organization
withdrew its cash from the bank.
CONTROL OF CASH
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐷𝑒𝑚𝑎𝑛𝑑
𝑇𝑟𝑎𝑛𝑠𝑓𝑒𝑟 𝐶𝑜𝑠𝑡 = 𝑥 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑇𝑟𝑎𝑛𝑠𝑓𝑒𝑟
 Ensure that at the end of the day, all cash receipts are properly deposited to minimize the 𝐴𝑚𝑜𝑢𝑛𝑡 𝑝𝑒𝑟 𝑇𝑟𝑎𝑛𝑠𝑓𝑒𝑟
susceptibility of theft and pilferage.
 Search of short-term investment to make excess or idle cash productive. Low Amount of Transfer  High No. of Transfer in a Year  High Transfer Cost
 Increase cash float.
 Effective billing and collection system and policy. High Amount of Transfer  Low No. of Transfer in a Year  Low Transfer Cost

CASH MANAGEMENT STRATEGIES  Carrying Cost – Cost associated of holding too much cash instead of investing those cash
in an interest-earning facility.
ACCELERATE CASH COLLECTION - reduce negative float
a. Bill customer promptly 𝐴𝑚𝑜𝑢𝑛𝑡 𝑝𝑒𝑟 𝑇𝑟𝑎𝑛𝑠𝑓𝑒𝑟
𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 = 𝑥 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐶𝑜𝑠𝑡
b. Offer cash discounts for prompt payment 2
c. Use of lockbox system - customers mail their payments to a P.O. box in a specific city.
The local bank collects the checks from this box and deposits them in the firm's account. Low Amount of Transfer  Low Level of Cash  Low Carrying Cost
d. Establish local collection office
e. Request customer to make direct payment to the firm's depository bank. High Amount of Transfer  High Level of Cash  High Carrying Cost
f. Use of Electronic Fund Transfer

2. CONTROL (SLOW DOWN) DISBURSEMENT

a. Maximize credit period given by suppliers. Pay on due date and not earlier.
Illustrative Problem: In the illustration above, based on the cash information of the company, the right amount of
Annual Demand ₱ 250,000,000.00 transfer the organization should do is at P100,000.00. This is where the organization will incur
Cost per Transfer ₱ 2.00 the lowest opportunity cost of P10,000.
Carrying Cost 10.00%
You may notice that the higher the amount of transfer, the transfer cost decreases. It’s
because the higher the amount of transfer, the no. of transfer decreases. On the other hand,
Amount of Cash Total Opportunity the higher the organization withdrew funds, the carrying cost increases because of interest
Transfer Cost Carrying Cost income lost due to holding too much cash.
per Transfer Cost
₱ 20,000.00 ₱ 25,000.00 ₱ 1,000.00 ₱ 26,000.00 Baumol Model
₱ 40,000.00 ₱ 12,500.00 ₱ 2,000.00 ₱ 14,500.00
₱ 60,000.00 ₱ 8,333.33 ₱ 3,000.00 ₱ 11,333.33 Determining the right balance of cash is not an exact science due to speculative nature of
₱ 80,000.00 ₱ 6,250.00 ₱ 4,000.00 ₱ 10,250.00 organization’s cash receipts and disbursement. However, there are certain model that will aid
financial managers to determine the level of cash.
₱ 100,000.00 ₱ 5,000.00 ₱ 5,000.00 ₱ 10,000.00
₱ 120,000.00 ₱ 4,166.67 ₱ 6,000.00 ₱ 10,166.67 Based on the amount of transfer, the total transfer cost is inversely related to the total
₱ 140,000.00 ₱ 3,571.43 ₱ 7,000.00 ₱ 10,571.43 carrying cost. In this model, the lowest total opportunity cost in relation to cash. Therefore,
₱ 160,000.00 ₱ 3,125.00 ₱ 8,000.00 ₱ 11,125.00 to achieve the lowest total opportunity cost, transfer cost should be equal with carrying cost.
₱ 180,000.00 ₱ 2,777.78 ₱ 9,000.00 ₱ 11,777.78
₱ 200,000.00 ₱ 2,500.00 ₱ 10,000.00 ₱ 12,500.00 Let:

OCB = Optimum Cash Balance

AD = Annual Demand
CB = Cash Balance / Transfer
CPT = Cost per Transfer
CC = Carrying Cost

𝐴𝐷 𝐶𝐵 2𝐴𝐷 𝑥 𝐶𝑃𝑇
𝑥 𝐶𝑃𝑇 = 𝑥 𝐶𝐶  2𝐴𝐷 𝑥 𝐶𝑃𝑇 = 𝐶𝐵2 𝑥 𝐶𝐶 ∴ 𝑂𝐶𝐵 = √
𝐶𝐵 2 𝐶𝐶

Using the Same Illustration

Annual Demand P250,000,000
Cost per Transfer P2
Carrying Cost 10%

𝑃250𝑀 𝑥 2 𝑠 𝑃2 𝑃1𝐵
𝑂𝐶𝐵 = √  𝑂𝐶𝐵 = √  𝑂𝐶𝐵 = √𝑃10𝐵
10% 10%
𝑶𝑪𝑩 = 𝑷𝟏𝟎𝟎, 𝟎𝟎𝟎. 𝟎𝟎
 CREDIT EFFECTS
MANAGEMENT CONSULTANCY MANAGEMENT CREDIT POLICY RECEIVABLE RECEIVABLE COLLECTION
(RECEIVABLES MANAGEMENT) VARIABLES COLLECTION
BALANCE BALANCE PERIOD
Receivables management is concern with credit policies, billing and collection systems, the STRICT FASTER DECREASE INCREASE SHORTER
CREDIT CLASS
magnitude of funds tied up in the trade receivables and receivable financing. The trade off in LAX SLOWER INCREASE DECREASE LONGER
accounts receivables occurs when there are less creditworthy customers, thus, higher
probability of bad debts even there was an increase in sales or revenues.
FIVE C’s OF CREDIT
CREDIT POLICY
Investment in accounts receivables is essentially financing company’s customers and as a
Capacity
result companies with high level of receivables are expose to financial risk (i.e. non-payment
of receivables). To ensure the risk exposure of companies will be minimized credit policies are
This is the ability of the credit applicant to repay the account when it comes due. This may be
established that requires assessment of customers before approving their requested level of
measured by looking into the financial records of the applicant, with special emphasis on
receivables.
projected cash flows. There will, of course, be a tendency for very optimistic numbers to be
presented. Hence, credit officer involved must possess a good level of skepticism in
Elements of Credit Policy
interpreting financial records.
 Credit Period – the length of time buyers as before they must pay their purchases
 Cash Discount – the reduction in price to encourage prompt payment Character
 Credit Standard – the minimum financial strength of acceptable credit customers
 Collection Policy – toughness or laxity in following up on slow moving or slow paying This is the overall impression the credit officer gets from the applicant’s credit history,
accounts. business track record, past dealings with other supplier and banks, including the culture
cultivated within the organization by its top management.
Note: When you combine Credit Period and Cash Discount it is now called Credit Terms Capital

CREDIT EFFECTS The most important consideration in credit analysis. It is not a wise decision to offer credit to
MANAGEMENT CREDIT POLICY RECEIVABLE RECEIVABLE COLLECTION an already highly levered business because the risk of default is directly related with the level
VARIABLES COLLECTION of debt.
BALANCE BALANCE PERIOD
HIGH FASTER DECREASE INCREASE SHORTER Collateral
DISCOUNT RATE
LOW SLOWER INCREASE DECREASE LONGER
SHORT (STRICT) FASTER DECREASE INCREASE SHORTER The availability of assets which will serve as additional protection to the creditor in case of
DISCOUNT TIME default. The availability of collateral is only taken into consideration in analyzing prospective
LONG (LAX) SLOWER INCREASE DECREASE LONGER credit customers as a last resort in case of future problems that make it difficult for the
SHORT (STRICT) FASTER DECREASE INCREASE SHORTER customer to pay.
CREDIT PERIOD
LONG (LAX) SLOWER INCREASE DECREASE LONGER
LOW (STRICT) FASTER DECREASE INCREASE SHORTER
CREDIT CAP / LIMIT
HIGH (LAX) SLOWER INCREASE DECREASE LONGER
Conditions Solution:

The creditor takes into account not only the factors inherent to the applicant’s business, but Particulars Present Policy I Policy II Policy III Policy IV
also factors outside the company that may have significant effects on its operations. The Terms 90 75 60 45 30
factors may include macroeconomic variables, the political climate and industry-specific Sales ₱ 1,600,000.00 ₱ 1,550,000.00 ₱ 1,500,000.00 ₱ 1,450,000.00 ₱ 1,400,000.00
conditions. Variable Cost 1,280,000.00 1,240,000.00 1,200,000.00 1,160,000.00 1,120,000.00
Contribution Margin ₱ 320,000.00 ₱ 310,000.00 ₱ 300,000.00 ₱ 290,000.00 ₱ 280,000.00
Illustrative Problem: Fixed Cost 100,000.00 100,000.00 100,000.00 100,000.00 100,000.00
Profit ₱ 220,000.00 ₱ 210,000.00 ₱ 200,000.00 ₱ 190,000.00 ₱ 180,000.00
GHI Company is currently making an annual sale of Php 1,600,000 and offers a credit period
of 90 days. However, the management thinks that the current credit policy is too lax and Average Receivables ₱ 400,000.00 ₱ 322,916.67 ₱ 250,000.00 ₱ 181,250.00 ₱ 116,666.67
Cost of Capital 15.00% 15.00% 15.00% 15.00% 15.00%
wants to consider tightening its policy. Financial managers offer the following changes in the
Opportunity Cost ₱ 60,000.00 ₱ 48,437.50 ₱ 37,500.00 ₱ 27,187.50 ₱ 17,500.00
policy and its effects:
Profit adjusted to
Policy Period Sales Opportunity Cost ₱ 160,000.00 ₱ 161,562.50 ₱ 162,500.00 ₱ 162,812.50 ₱ 162,500.00
I 75 days Php 1,550,000
II 60 days Php 1,500,000
III 45 days Php 1,450,000
Based on profit without considering the opportunity cost due to cash is tied up to receivables,
IV 30 days Php 1,400,000 clearly, GHI company should maintain its current collection policy. However, when the
The firm has variable cost of 80% and a fixed cost of Php 100,000. The company’s cost of company consider the cost that ties up with its receivables, the company should adopt policy
capital is 15% IV as it provides higher profit with the consideration of opportunity cost.
Required:

Evaluate each of the policy and determine which should be implemented