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CPAR CPA REVIEW SCHOOL OF THE PHILIPPINES Manila

MAS 8708

MANAGEMENT ADVISORY SERVICES

WORKING CAPITAL MANAGEMENT AND FINANCIAL STATEMENTS ANALYSIS WORKING CAPITAL MANAGEMENT – refers to the administration and control of current assets and current liabilities to maximize the firm’s value by achieving a balance between profitability and risk WORKING CAPITAL FINANCING POLICIES 1.

Matching Policy (also called self-liquidating policy or hedging policy) – matching the maturity of a • •

2.

financing source with an asset’s useful life short-term assets are financed with short-term liabilities. long-term assets are funded by long-term financing sources

Conservative (Relaxed) Policy – operations are conducted with too much working capital; involves financing almost all asset investments with long-term capital

3.

Aggressive (Restricted) Policy – operations are conducted on a minimum amount of working capital; uses short-term liabilities to finance, not only temporary, but also part or all of the permanent current asset requirement

4. Balanced Policy – balances the trade-off between risk and profitability in a manner consistent with its attitude toward bearing risk. WAYS OF MINIMIZING WORKING CAPITAL REQUIREMENT 1. Managing cash and raw materials efficiently. 2. Having efficiency in making collections and in the manufacturing operations. 3. Implementing effective credit and collection policies. 4. Reducing the time lag between completion and delivery of finished good s. 5. Seeking favorable terms from suppliers and other creditors. FORECASTING FINANCIAL STATEMENT VARIABLES ASSUMPTIONS: 1. All variables are tied directly with sales 2. The current levels of most balance sheet items are optimal for the current sales level. STEPS: 1. Identify assets and liabilities that vary spontaneously with sales 2. Estimate the amount of net income that will be retained. 3. Compute the amount of External Financing Needed (EFN) by subtracting increase in spontaneous liabilities and income retained from increase in total financing required (increase in assets due to increase in sales). EFN = ΔS x (SA/S0) – ΔS x (SL/S0) – ( x ) Where: SA/S0 = percentage relationship of spontaneous assets (variable assets) to sales at period 0. SL/S0 = percentage relationship of spontaneous liabilities (variable liabilities) to sales at period 0.

CASH MANAGEMENT CASH MANAGEMENT – involves the maintenance of the appropriate level of cash and investment in marketable securities to meet the firm’s cash requirements and to maximize income on idle funds.

MAS 8708

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REASONS FOR HOLDING CASH

1. Transaction Purposes – firms maintain cash balances that they can use to conduct the ordinary business transactions; cash balances are needed to meet cash outflow requirements for operational or financial obligations.

2. Compensating Balance Requirements – a certain amount of cash that a firm must leave in its checking account at all times as part of a loan agreement. These balances give banks additional compensation because they can be relent or used to satisfy reserve requirements.

3. Precautionary Reserves – firms hold cash balance in order to handle unexpected problems or contingencies due to the uncertain pattern of cash inflows and outflows.

4. Potential Investment Opportunities – excess cash reserved are allowed to build up in anticipation of a future investment opportunity such as a major capital expenditure project.

5. Speculation – firms delay purchases and store up cash for use later to take advantage of possible changes in prices of materials, equipment, and securities, as well as changes in currency exchange rates. THE CONCEPT OF FLOAT IN CASH MANAGEMENT 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: 1. Mail Float – peso amount of customers’ payments that have been mailed by a customer but not yet received by the seller. 2. Processing Float – peso amount of customers’ payments that have been received by the seller but not yet deposited. 3. Clearing Float - peso amount of customers’ checks that have been deposited but not yet cleared. CASH MANAGEMENT STRATEGIES 1. accelerate cash collections – reduce negative (mail and processing) float 2. control (slow down) disbursements 3. reduce the need for precautionary cash balance Operating Cycle – The amount of time that elapses from the point when the firm inputs materials and labor into the production process to the point when cash is collected from the sale of the finished goods. Its two components are: average age of inventories and average collection period of receivables. When the average age of accounts payable is subtracted fro the operating cycle, the result is called cash conversion cycle. Economic Conversion Quantity (Optimal Transaction Size) – the amount of marketable securities that must be converted to cash (or vice versa), considering the conversion costs and opportunity costs involved. ECQ = √

2 x conversion cost x annual demand for cash Opportunity Cost

Conversion Cost – the cost of converting marketable securities to cash Opportunity Cost – the cost of holding cash rather than marketable securities (rate of interest that can be earned on marketable securities).

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MARKETABLE SECURITIES MARKETABLE SECURITIES – short-term money market instruments that can easily be converted to cash REASONS FOR HOLDING MARKETABLE SECURITIES (MS): 1. MS serve as substitute for cash (transactions, precautionary, and speculative) balances. 2. MS serve as a temporary investment that yields return while funds are idle. 3. Cash is invested in MS to meet known financial obligations such as tax payments and loan amortizations.

RECEIVABLE MANAGEMENT ACCOUNTS RECEIVABLE MANAGEMENT – formulation and administration of plans and policies related to sales on account and ensuring the maintenance of receivables at a predetermined level and their collectibility as planned. WAYS OF ACCELERATING COLLECTION OF RECEIVABLES 1. 2. 3. 4.

Shorten credit terms. Offer special discounts to customers who pay their accounts within a specified period. Speed up the mailing time of payments from customers to the firm. Minimize float, that is, reduce the time during which payments received by the firm remain uncollected funds.

AIDS IN ANALYZING RECEIVABLES 1. Ratio of receivables to net credit sales 2. Receivable turnover

3. Average collection period 4. Aging of accounts

INVENTORY MANAGEMENT INVENTORY MANAGEMENT – formulation and administration of plans and policies to efficiently and satisfactorily meet production and merchandising requirements and minimize costs relative to inventories. INVENTORY MODELS A basic INVENTORY MODEL exists to assist in two inventory questions: 1. How many units should be ordered? 2. When should the units be ordered?

Economic Order Quantity – the quantity to be ordered, which minimizes the sum of the ordering and carrying costs. •

Economic Order Quantity may be computed as follows: EOQ =

2aD k

where: a – cost of placing one order (or ordering cost) D – annual demand in units k – annual costs of carrying one unit in inventory for one year

Assumptions of the EOQ Model 1. 2. 3. 4.

Demand occurs at a constant rate throughout the year. Lead time on the receipt of the orders is constant. The entire quantity ordered is received at one time. The unit costs of the items ordered are constant; thus, there can be no quantity discounts. 5. There are no limitations on the size of the inventory. ➢

When applied to manufacturing operations, the EOQ formula may be used to compute the Economic Lot Size (ELS)

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where: a – set-up cost D – annual production ELS = requirement k – annual costs of carrying one unitinventory in inventory for one year When the EOQ figure is available, the average is computed as follows: EOQ Average Inventory = 2 2aD k

➢

➢

When to Reorder: When to reorder is a stock-out problem. i.e., the objective is to order at a point in time so as not to run out of stock before receiving the inventory ordered but not so early that an excessive quantity of safety stock is maintained

Lead time – period between the time the order is placed and received Normal time usage = Normal lead time x Average usage Safety stock = (Maximum lead time – Normal lead time) x Average usage Reorder point if there is NO safety stock required = Normal lead time usage Safety stock + Normal lead time usage

Reorder point if there is safety stock required

or Maximum lead time x Average usage

SHORT TERM FINANCING 1. ACCOUNTS PAYABLE – the major source of unsecured short-term financing. a. Credit terms: credit period, cash discount, cash discount period b. Analysis of credit terms: • Taking the cash discount – If cash discount is to be taken, a firm should pay on the last day of the discount period. • Giving up cash discount – If the firm has to give up the cash discount, it should pay on the last day of the credit period. • Cost of giving up cash discount = [CD/(100% - CD)] x (360/N) Where: CD = cash discount percentage N = number of days payment can be delayed by giving up the cash discount The above formula assumes that a firm gives up only one discount during the year. If a firm continually gives up the discount during the year, the annualized cost is calculated as follows: Annualized cost of giving up cash discount = [1 + (CD/(100% - CD)]360/N – 1] c.

Stretching Accounts Payable: A firm should pay the bills as late as possible without damaging its credit rating. When a firm can stretch the payment of accounts payable, the cost of foregoing the discount is reduced.

2. Bank Loans a. Single-payment notes – If the interest is payable upon maturity, the effective interest rate is equal to the nominal rate. b. Discounted Note – The effective interest rate is higher than the nominal rate. Effective interest rate =

Interest

Principal amount−Discounted Interest

If the term is less than a year, the interest rate is annualized.

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WORKING CAPITAL MANAGEMENT AND FINANCIAL STATEMENTS ANALYSIS

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Compensating Balance - an arrangement whereby a borrower is required to maintain a certain percentage of amount borrowed as compensating balance in the current account of the borrower.

ANALYSIS OF FINANCIAL STATEMENTS A. Importance of Statement Analysis. The purpose of financial statement analysis is to assist statement users in predicting the future. Three techniques are commonly used to make comparisons and to detect trends. • Peso and percentage changes in financial statement items. • Common-size statements. • Ratios. B. Statements in Comparative and Common-Size Form. Two basic approaches are often used to compare financial statements between companies or between different years for the same company: horizontal (trend) analysis and vertical (common-size) analysis. 1. Horizontal Analysis; pesos and percentage changes on statements - the financial statements are placed side-by-side. Two types of comparisons can then be made. a. Trend percentages restate a time-series of financial data in terms of a base year. Particularly when plotted against time, this approach allows the analyst to quickly gauge the rate and direction of changes. b. The difference (increase or decrease) between two statements can be shown in separate columns in both peso and percentage forms. Showing changes in peso form helps to zero in on key factors that have materially affected profitability or financial position. Showing changes in percentage form helps to gain a feel of how unusual the changes might be. 2. Vertical Analysis; Common-size Statements. A common-size statement is one that shows each item as a percentage of a total rather than in peso form. These kinds of statements make it much easier to compare firms of different sizes and to track balance sheet and income statement relationships within a company over time as its size changes. a. When preparing common-size statements for the balance sheet, the various items on the balance sheet are typically stated as percentages of total assets. b. When applying common-size techniques to the income statement, all items on the income statement are usually stated as a percentage of total sales pesos.

C. Ratio Analysis

EXERCISES: 1. FORECASTING – Nanaynor Corporation’s sales are expected to increase from P8 million in 2019 to P10.4 million in 2020. Its financial records show the following information as of the end of 2019: Total assets P5,000,000 Current liabilities: Notes payable P200,000 Accounts payable 700,000 Others 100,000 1,000,000 The corporation is at full capacity, so its assets must grow in proportion to projected sales. The projected after tax profit margin is 30% and the forecasted profit retention ratio is 20%.

REQUIRED: What was the capital intensity ratio in 2019? How much is Nanaynor Corporation’s additional funds (AFN) needed for the coming year?

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2. EXTERNAL FINANCING NEEDED. ALZ, Inc. has current sales of P60 million. Sales are expected to grow to P80 million next year. ALZ currently has accounts receivable of P9 million, inventories of P15 million, and net fixed assets of P21 million. These assets are expected to grow at the same rate as sales over the next year. Accounts payable are expected to increase from their current level of P15 million to a new level of P19 million next year. ALZ wants to increase its cash balance at the end of next year by P3 million over its current cash balance. Earnings after tax next year are forecasted to be P12 million. ALZ olans to pay a P2 million dividend. The marginal tax rate is 40%. How much external financing is required by ALZ next year? 3. OPTIMAL TRANSACTION SIZE – Assume that the fixed cost of selling marketable securities is P4 per transaction and the interest rate on marketable securities is 5% per year. The company estimates that it will make cash payments of P20,000 per month. Required: Compute the (a) Optimal transaction size, (b) the average cash balance, (c) the number of times (during the year) the company has to convert marketable securities to cash, (d) the total cost of converting marketable securities to cash, and (e) the total carrying cost of cash 3. OPERATING AND CASH CONVERSION CYCLES – Consider the following data for Cycles Corporation: Sales Cost of goods sold Credit purchases Average accounts receivable Average inventory Average accounts payable

P11,250,000 4,320,000 10,560,000 P450,000 256,000 584,000

P1,550,000 320,000 1,000,000

Cash sales are 20% of total sales, while cash purchases are 10% of the total purchases. The firm spends P12.60 million on operating cycle investments each year, at a constant rate. Assume a 360-day year. a. Calculate the firm’s operating cycle. b. Calculate the firm’s cash conversion cycle. c. Calculate the amount of resources needed to support the firm’s cash conversion cycle. 4. WORKING CAPITAL INVESTMENT – The Alabang Corporation is a leading manufacturer of dolls popularly known as “Alabang Girls”. The corporation turns out 1,500 dolls a day at a cost of P6 per doll for materials and labor. It takes the firm 22 days to convert raw materials into a doll. Alabang allows its customers 40 days in which to pay for the dolls, and the firm generally pays its suppliers in 30 days. a. What is the length of Alabang’s cash conversion cycle? 32 days b. At a steady state in which Alabang produces 1,500 dolls a day, what amount of working capital must it finance? P288,000 c. By what amount could Alabang reduce its working capital financing needs if it was able to stretch its payables deferral period to 35 days? P45,000 d. Alabang’s management is trying to analyze the effect of a proposed new production process on the working capital investment. The new production process would allow Alabang to decrease its inventory conversion period to 20 days and to increase its daily production to 1,800 dolls. However, the new process would cause the cost of materials and labor to increase to P7. Assuming the change does not affect the receivables collection period (40 days) or the payables deferral period (30 days), what will be the length of the cash conversion cycle and the working capital financing requirement if the new production process is implemented? 30; 378,000 5. Wasting Resource Co. has annual sales of P6,250,000, 20% of which is cash sales. Its average collection period is 40 days and bad debts are 6% of credit sales. The credit and collection manager is considering instituting a stricter collection policy, whereby bad debts would be reduced by 4% of credit sales, and the average collection period would fall by 10 days. However, credit sales would also fall by an estimated P500,000 annually. Variable costs are 70% of sales and the cost of carrying receivables is 10%.

REQUIRED: Assuming a tax rate of 30% and 360 days a year,...