Money available to a company for day-to-day operations.

It is a common measure of a company’s liquidity, efficiency, and overall health.

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A measure of both a company's efficiency and its short-term financial health.

The working capital ratio (Current Assets/Current Liabilities) indicates whether a company has enough short term assets to cover its short term debt. Anything below 1 indicates negative W/C (working capital). While anything over 2 means that the company is not investing excess assets. Most believe that a ratio between 1.2 and 2.0 is sufficient. Also known as "net working capital".

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Working capital refers to that part of the capital of the company which is continually circulating. It is circulating in the sense that the initial cash funds of the firm are converted into inventories, which in turn are converted into cash or accounts receivable and ultimately into cash again.

Working capital may be described in two ways:◦ Gross working capital, which is the total

amount of the firm’s current assets; and

◦ Working capital, which is the total amount of current assets minus current liabilities.

The gross working capital of the firm is usually composed of the following:◦ Cash in the firm’s safe;◦ Checks to be cashed;◦ Balances in the bank accounts;◦ Marketable securities (not including stocks in

subsidiaries);◦ Notes and accounts receivable;◦ Supplies;◦ Inventories;◦ Prepaid expenses; and◦ Deferred items

Replenishment of Inventory◦ A sufficient stock of inventory is required to

support the sales target of the firm. This requirement, however, will depend on the availability of resources. An unserved portion of demand may mean lost revenues for the firm.

Provision for Operating Expenses◦ To maintain the operations of the firm on a day-

to-day basis, a working capital is required. This will be needed to take care of salaries and wages, advertising, taxes and licenses, insurance premium, and interest payments.

Support for Credit Sales◦ At times, conditions require that credit sales be

extended to the firm’s clients. This will need sufficient working capital to enable the firm to maintain its operations until receivables are converted into cash.

Provision of Safety Margin◦ The firm should have sufficient amount of capital

to provide for unexpected expenditures, delays in the expected inflow of cash, and possible decline in revenue.

The amount of cash needed depends upon the following:◦ The amount of the firm’s purchases and cash

sales;◦ The time period for which the firm receives and

grants credit;◦ The time period from the dates of purchases of

raw materials and payment of wages to the dates of cash receipts from sales;

◦ The amount of cash to be used for investment in inventories; and

◦ The amount of cash needed for other purposes such as cash dividends.

Since liquidity is a primary concern of sound business finance, firms prefer cash sales over credit sales. Many companies, however, cannot avoid the extension of credit to customers for various reasons. Credit is used to sustain and to promote production, distribution, and consumption of goods and services.

The unpaid portion of credit sales is represented by accounts receivable in the firm’s records. The collection of accounts receivable from customers contribute to cash inflow requirements of the firm.

Credit terms vary according to the degree of competition within individual industries, the availability of bank credit, and pressures for increased sales in periods of increasing plant capacities.

The production of large stocks of inventory generate savings as a result of lower production cost. It will also provide the firm with large quantity of stocks to meet increasing or unusually large orders from customers. The maintenance of large stocks of inventory, however, may unnecessarily tie up funds which could have been made available for other uses. Outside financing may even be required. In addition, storage and warehousing costs may also increase.

The ideal set-up is for the firm to make sales as soon as finished products come out of the production line, or to acquire raw materials and supplies as soon as they are needed. Since these are not possible, economists have devised a method of knowing the inventory level that will optimize results considering both of the above-mentioned requirements.

Working capital must always be able to cover fund requirements of the company as they are needed. There are times when unusual pressures on working capital makes the job of the financial manger very difficult.

To overcome this, a system should be adapted considering the following objectives:◦ Working capital must be adequate to cover all

current financial requirements. It must be allocated among various needs in sufficient amounts. The quantity of inventory stocks to be carried and the maximum allowable amount of receivables must be decided in advance.

To overcome this, a system should be adapted considering the following objectives:◦ The working capital structure must be liquid

enough to meet current obligations as they fall due. Salaries and wages must be paid on time. Raw materials and supplies must be acquired on days they are needed.

To overcome this, a system should be adapted considering the following objectives:◦ Working capital must be conserved through

proper allocation and economical use. It must be protected against losses arising out of natural calamities, malversation, or pilferage.

To overcome this, a system should be adapted considering the following objectives:◦ Working capital must be used in the

attainment if the profit objectives of the firm. Measures to contribute to increased profits through avoidance of loss must be instituted.

Liquidity refers to the ability of the firm to pay its bills on time or otherwise meet its current obligations. Activities geared towards achieving the liquidity objectives of the firm is called liquidity management.

The objective of management is to acquire sufficient amounts of funds to cover the cash requirements of the firm. The cash inflows of the firm come from various sources which are briefly described as follows:

Cash Sales◦ The percentages of cash derived from sales vary

from company to company and from industry to industry.

Collection of Accounts Receivables◦ The credit policies and the pattern of company

sales determine the frequency and volume of collections from receivables.

Loans◦ Loans from banks and other creditors may be

availed of by management mostly on its own initiative. The timing and amount of cash receipts derived from loans depend largely on the borrowing firm.

Sales of Assets◦ Assets are sometimes sold by the company for

various reasons. Obsolescence is one of those.

Ownership contribution◦ Additional contributions from the owners are

sometimes tapped to improve the liquidity posture of the firm.

Advances from Customers◦ Manufacturers, at times, require cash advances

from customers as soon as an order is made and before production is started. This is not unusual especially if the objects of sales are capital goods like airplanes and ships. The number of years required in the manufacturing process justifies whatever cash advances are required from customers.

Idle cash earns nothing and even if it is kept in a bank, the interest it earns is minimal. If sufficient amounts of profits must be attained, cash should be invested. Sufficient cash must be maintained, however, to cover the firm’s cash expenditures. The activity involved in achieving these two opposite goals is called cash management.

To effectively manage cash, five major approached are suggested. These are as follows:◦ Exploit techniques of money mobilization to

reduce operating requirements for cash;◦ Expend major efforts to increase the precision

and reliability of cash flow forecasting;◦ Use maximum efforts to define and quantify the

liquidity reserve needs of the firm;◦ Develop explicit alternative sources of liquidity;

and◦ Search aggressively for more productive uses of

surplus money assets.

Money Mobilization◦ Some companies maintain branches and agencies

in distant places. Those that serve customers directly may find that they are also serving customers from far-flung areas. These two conditions are characterized by remittances which take several days before they are converted into usable cash balances. Check payments, for instance, are sent through the mail. When these checks are received, they are deposited in the bank.

◦ These checks will only be cleared for the company’s use after several days. Checks issued by customers from distant areas require longer clearing period. This time lag stated briefly, consists of two identifiable periods:

◦ The mail traveling time of the check payment; and

◦ The check clearing time.

Improved Cash Flow Forecasting◦ A cash flow forecast with a high degree of

precision and reliability provides the firm with realistic approaches to planning and budgeting. The disadvantages of cash excess and cash shortages are eliminated if not minimized.

The advantages brought by an improved cash flow forecast are the following:◦ Surplus funds are more fully invested;

◦ Alternative methods of meeting the outflows can be explored; and

◦ The creation of special reserves for major future outlays will be minimized.

Defining and Quantifying the Liquidity Reserve Needs of the Firm◦ Firms are faced with a number of uncertainties

and contingencies which may require cash reserves. To be protected against the worst possibilities, a very large reserve of cash will be needed. The idea is to avoid unnecessary losses or expenditures brought about by liquidity problems. The holding of cash reserves, however, entails cost. The management is left with striking a reasonable balance between the two requirements.

Several steps are necessary to accomplish this objective. These are the following:◦ Identification of contingencies requiring

protection;

◦ Assessment of the probabilities of the contingencies occurring;

◦ Assessment of the probabilities of the contingencies occurring at the same time; and

◦ Assessment of the probable amount of cash required if each of the contingencies happens.

If reserves for certain contingencies will not be provided, the amount of possible losses must be ascertained. If reserves will be provided, the cost of carrying the reserves must also be determined. The expected value of the losses and cost must be computed. This may be arrived at by multiplying the losses or cost with probability estimates of occurrence.

To illustrate, assume that a labor strike happening in the premises of the company will paralyze operations. Borrowing funds to cover the necessary expenditures of the firm will penalize the firm with interest charges amounting to one million pesos. It has also been ascertained that if a reserve fund has to be carried for the contingency, the firm will be penalized with eight thousand pesos in the form of lost income which could have been otherwise earned by the idle cash reserve.

If the probability of the strike happening is placed at 50%, the expected values of the options may be computed as follows:

OPTION PENALTY PROBABILITY EXPECTED VALUE

No reserve P1,000,000 50% P500,000

With cash reserve

P800,000 50% P400,000

Development of Alternative Sources of Liquidity◦ Once the liquidity reserve needs of the firm have

been defined and quantified, alternative sources of meeting these should be identified and evaluated.

One possible alternative is the exploitation of the unused borrowing capacity of the firm. Borrowings, oftentimes, provide the funds necessary for liquidity. Not all companies, however, may avail of this option. During recession, when small companies are unable to borrow money from lending institutions, interbusiness financing may provide the answer to liquidity problems. Interbusiness financing refers to credit flowing from a large business to small business.

Search for More Productive Uses of Cash Surplus◦ Cash surplus may be utilized by the firm to earn

higher returns. A gap may exist, however, between the time when cash starts coming in and the same time it is actually made more productive. As various investment opportunities may be available, it is important that sufficient effort is expended in the determination of the best alternative. Planning activities must also be geared towards eliminating the unproductive or less productive gap.

As sales on account cannot be avoided most of the time, management must face the difficulty squarely and make it work to the advantage of the firm. This is important because when accounts receivables are not properly managed, the financial viability of the firm may be impaired.

Objectives◦ One of the goals of business finance is to

maximize profitability. In this regard, all activities of the firm must contribute towards the attainment of this objective.

The purpose of credit extension to clients is to maximize sales. Thus, if more sales is required by the firm, more credit is extended. Increased sales, however, is not an end in itself. Any advantage gained in extending credit to customers may be offset or even surpassed by problems brought about by bad-debt losses and the consequent tie-up of funds in receivables.

The objective of accounts receivable management is to determine the cost and probability of credit sales. There is no point in extending credit to customers if this will cause a lowering of the firm’s return on investment.

The second objective of accounts receivable management is the projection of cash flows from receivables. This will provide an essential input in the preparation of the firm’s financial plan.

The third objective relates to the direction and control of activities involved in the extension of credit to customers.

Elements of the Cost of Credit◦ The cost of credit is composed of three elements:◦ Bad debts cost;◦ Cost of invested funds; and◦ Administrative costs

Bad debts cost refers to accounts receivable uncollected and subsequently written off.

The cost of invested funds refers to the rate at which the firm could borrow funds to finance credit sales. These include form letters, individually written letters, telephone charges, clerical and administrative time spent on an account, and credit and investigation expenses.

Functions of the Credit Department The credit department performs the

following functions:◦ Gathering and organizing of information

necessary for decisions on the granting of credit to particular customers;

◦ Assuring that efforts are made to collect receivables when they become due; and

◦ Determining and carrying out appropriate efforts to collect accounts of customers who cannot or do not intend to pay.

Sources of Credit Information A variety of sources may be used to obtain

credit information concerning customers. The sources most commonly used are the following:◦ Personal interviews;◦ References;◦ Credit bureaus;◦ Credit-reporting agencies; and◦ Banks.

Personal interviews provide basic information concerning an applicant for credit. The applicant is usually required to fill up a credit application blank. The credit application contains the following items:◦ The name of the applicant;◦ Residence and former address;◦ Occupation or business;◦ Business address;◦ Bank where the applicant maintains an account;

and◦ Property owned.

References also provide a valuable source of information. The credit applicant is usually required to furnish names of at least three credit references. These references, in turn, may provide valuable insights into the character and ability of the applicant.

Credit bureaus are institutions organized for the exchange of ledger information among associated creditors. Among the services rendered by credit bureaus are the following:◦ Reports;◦ Bulletins;◦ Credit guides; and◦ Special services.

Credit reporting agencies consist of more specialized form of credit bureaus.

Banks constitute a valuable source of credit information. This is largely due to their involvement in lending activities.

Evaluation of Credit Risk Before credit is granted, the risk involved is

evaluated. This is done after information regarding the credit risk has been gathered. In the evaluation of a credit risk, the basic criteria used refers to the following:◦ Capital; ◦ Capacity; ◦ Character; and◦ Conditions.

Capital refers to the financial resources of the credit applicant. The balance sheet is a very useful tool in determining the resources of the applicant.

Capacity refers to the ability of the applicant to operate successfully. This is indicated in the profit and loss statement of the applicant.

Character refers to the reputation for honesty and fair dealing of the applicant or the owners of the firm applying for credit.

Conditions refers to the environment required for the extension of credit.

Inventory management refers to the activity that keeps track of how many of the procured items needed to create a product or service are on hand, where each item is, and who has responsibility for each item.

Inventory management consists of two aspects:◦ Liquidity; and◦ Profitability

The liquidity aspect is usually measured in terms of inventory turnover.

The probability aspect is measured in terms of inventory level at a given level of sales and profit.

A successful inventory management program’s main objective is to strike a balance among three key elements as follows:◦ Customer services;

◦ Inventory investment (in terms of pesos or dollars); and

◦ Profit.

Customer Service◦ The period between when the order is made and

the date of delivery is very important to the customer. Shorter periods are preferred. If the customers have to wait too long to get the product, they will get them elsewhere. The company with the shortest lead time, i.e., the number of days the customers have to wait, has a better chance of improving its sales.

Inventory Investment◦ Funds tied up in inventory should ideally be kept

to a minimum without sacrificing customer service. investments in inventory eat away company profits. These usually take the form of interests, insurance, taxes, obsolescence, and storage.

Profit◦ The level of inventory carried by the company

most often affects the profitability of the company. The task of management is to determine the level which would bring the highest return on equity.

Functions of Inventory Inventories perform certain functions. These

are the following:◦ They serve to offset errors contained in the

forecast of the demand for the company’s products;

◦ They often permit more economical utilization of equipment, buildings, and manpower when the nature of the business is such that fluctuations in demand exists; and

◦ It permits the company to purchase or manufacture is economic lot sizes.

Forms of Inventory Inventories are composed of three major

forms which are as follows:◦ Raw materials;

◦ Work-in-process; and

◦ Finished goods.

LIQUIDITY MANAGEMENT

Cash ManagementAccounts Receivable

ManagementInventory

Management

Money Mobilization

Effective Cash Flow Forecasting

Liquidity Reserve Definition and Quantification

Productive Use of Surplus Assets

Determine Cost and Probability of Credit Sales

Projection of Cash Flows from

Receivables

Direction and Control of Credit

Extension

Customer Service

Inventory Investment

Profit Aspects

Raw materials consists of all parts, sub-assemblies, and components purchased from other firms but not yet put into the manufacturer’s own production processes. When raw material and labor is added into the basic raw material inputs, they are combined and transformed into work-in-process inventories. They become finished goods when they are completed and stocked.

Methods of Achieving Inventory Goals Inventory goals may be achieved by using

any of the several devices available. These devices are the following:◦ The ABC method;◦ The economic order quantity method;◦ The safety stock; and◦ The anticipation stock.

The ABC method classifies inventory into three categories: A,B, and C management and control purposes. Category A may be classified as those comprising a large proportion of the inventory value, and in which tight control is applied. Category B comprises those accounting for a substantial part of the total inventory value, requiring less tight control. Category C items are those that account only for a small proportion of the total inventory value and as a consequence is the least controlled.

The economic order quantity (EOQ) method is used to determine what quantity to order so as to minimize total inventory costs. The EOQ method involves two major costs:◦ Carrying costs (warehouse storage costs); and◦ Ordering costs (filling in purchase requisitions).

These two costs tend to offset each other. One reason is that ordering in large quantities allows volume discounts, but it also involves higher storage costs. To balance these two factors, an economic order quantity should be determine. The EOQ formula is as follows:

EOQ = the square root of 2 US/CI

Where: EOQ = economic order quantity U = annual usage S = restocking or ordering cost C = cost per unit I = annual carrying cost (expressed as

percentage of inventory value)

Thus, if annual usage is 1,000 units, restocking cost is P1,000, cost per unit is P50,000, and annual carrying cost is 10%, EOQ is:

EOQ = the square root of 2 X 1,000 X P1,000/P50,000 X 10%

= 20

When conditions are uncertain, safety stocks are needed. Safety stocks are that part of inventory used to absorb random fluctuations in purchases, production, and sales.

Anticipated stock refers to that portion of the inventory used for expected seasonal, cyclical, and secular changes in inventory.