Financial Management ( e.g.

payback period and accounting rate

Module 1 of return.)
Financial Management is more concerned 2. Financing decision
with raising, allocating and controlling the The Financial manager find ways to
firm’s funds. In times of financial trouble, provide money for the activities of the firm.
the finance manager must find ways to get He or she must know where to outsource its
its financial position in order. Should the funds. Short-term or Long-term debt or
firm borrow money? Is it a short term or equity financing has to be considered. The
long- term need? Did the firm generate manager assesses the best possible
enough funds to sustain its activities? financing mix or capital structure for the
Should they issue additional shares of company in order to meet the expected
stocks and would these be preferred or return on an investment.
common? These are the kinds of questions The main idea in financing decision is
that one has to answer when dealing with to look for resources that will give the
financing. company the lowest weighted average cost
If the firm has enough money, the of capital.
finance manager again has to know how to 3. Dividend policy decision.
allocate in order to generate wealth for the It is equally important to know what
stockholders. Should the firm invest it in sound dividend policy is a good financial
short-term marketable securities or long- signal to the market that continually
term investments, pay their debts, or pay assesses the company. Firm with a good
dividends to their stockholders? history of dividend payments have better
A dividend policy decision is another potential in luring investors. Dividend
aspect of financial management that has to declaration reflects a profitable status of
be addressed. One must be able to suggest the company. On the other hand companies
what dividend policy the firm should adopt. with earning retention have more funds for
Dividend policy plays a significant role in investment; hence, it indicate the growth
enticing investors. Thus the policy chosen potential of the company. To pay or not to
by the firm determined the kind if investors pay dividends relies basically on the
the firm will have and the kind of a decision made by the board of directors
company it will be in the future. through the advice given by the finance
The Role of Financial Managers. manager.
The financial manager of the firms plays a In a large -scale industry, the
crucial role in the company goals, policies, aforementioned financial responsibilities
and success. The responsibilities of the are carried out by the treasurer, controller
financial manger include the following: and chief financial officer (CFO). The
1. Investment Decision treasurer is responsible for managing
This entails an outflow of resources with corporate assets and liabilities, planning
the expectation of a benefit in the form of the finances, budgeting the capital,
cash inflow in the near future. The financing the business, formulating a credit
investment decision is the most important policy, and managing the investment
of the three decisions when it comes to portfolio. The Treasurer basically handles
value creation. Investment becomes the external financing matters. The controller is
firm’s life support system in continuing its tasked with internal matters, most of which
existence., the allocation of funds must be are financial and cost accounting, taxes,
prudently done. Since the future benefits budgeting, and control functions. The chief
are not known with certainty, investment financial officers oversees the entire
proposal must recognize the existence of financial activity and serves as the adviser
risk. Investments have to be evaluated in in finance matter to the board of directors.
terms of their expected returns and The common function of the controller
corresponding risk that could effect the includes accounting and financial reporting,
firm’s valuation in the market. internal audit, cost accounting, tax
In accepting or rejecting an investment accounting, planning for control, evaluating
proposal, a firm may use capital budgeting and consulting, government reporting,
technique that considers the time value of protection of assets and economic
money ( e.g. discounted payback period, appraisal.
internal rate of return, net present value, The treasurer’s common function are
and profitability index) or one that does not cash management, banking relationship,
finding sources of financing, financial
planning, investment planning, capital
budgeting, risk management, investor take necessary actions to improve
relations, and credit and collection. performance.

Financial Decisions and Risk – Return trade- Users of the financial statement analysis
off
It is significant to note that an increase in Investors- forecasting the future of the
return is coupled by a corresponding firms is what financial statement analysis is
increase in risk . It cannot be expected that all about.
whatever financial decision is made will Management – that financial statement
immediately favor the firm. The finance analysis is an important tool in determining
manager obligation is to ascertain that such future conditions and serves as a starting
risk present is tolerable. Risk is common point for undertaking actions to improve
and ubiquitous. It could be credit, financial , the firm future performance.
political, interest, and social. The firm must Creditors – the outcomes of such analysis of
recognize the risk and include this in the firm financial position and operating
whatever financial decision it will make. result will have an impact of the firms
The aphorism “ the higher the return, the standing.
higher the risk” must always be kept in
mind.
OBJECTIVES OF FINANCIAL STATEMENT
The primary goal in financial ANALYSIS
management is maximize the stockholder
wealth. This is done by increasing the Analysis of financial statements are set to
market price of the stock. How it is done? answer a wider-range of questions of users.
The firm must be able to increase its value These users have common requirements
by creating a good name in terms of where the very objective of financial
profitability, liquidity, effectiveness of statements analysis originate.
management, and sustainability of the The analysis done aims to probe the
operations. The firm must be able to play a company’s
major role in the economy and in the ● Profitability – this pertains to the
industry to where it belong. In this way , the ability of the firm to yield a sufficient
market forces will favor them and create amount of return on company sales assets
value by increasing the demands for their and invested capital.
shares, As the demands for their shares ● Liquidity and stability – Liquidity is
increases, and with limited authorized also referred to as working capital position
capital stocks to issue, the price of the or short-term financial position. It is the
stock goes higher. ability of the firm to meet or pay its current
or short-term maturing obligations.
FINANCIAL STATEMENT ANALYSIS ● Asset utilization or Activity – this
pertains to how efficient the company is in
Financial Statement analysis is an managing its resources. It also refers to the
evaluation of the past and current firm’s speed or pace in turning over
performance of the firm and its forecast in accounts receivable, inventory and long-
the future (Palepu et all ., 1996) . It allows term assets. This reveals the frequency of
comparison of one company with another, the firm in selling its products or in
Since financial statement analysis looks at collecting its receivable. In so far as fixed or
relationship inside and outside the firm. A long-term assets are concern, it reveals
firm of one size can be directly compared how the company uses their fixed assets to
with similar firms or with industry averages yield revenue.
or norms to determine how the company is ● Debt-utilization or leverage – This
fairing vis-a- vis its competitors (Gitman et pertains to the overall debt status of the
al ., 2003) company. it measures the degree of how
the firm is financed. The debt is evaluated
Financial statement analysis involves using other variables like assets, equity and
calculation. Firms compute by combining earning power.
accounts coming from an income statement
to the balance sheet or vice-versa or by
simply relating an account within the LIMITATIONS OF FINANCIAL STATEMENT
statement. These calculation help the ANAYSIS
management assess the deficiencies and
The primary purpose of financial statement or modifying the industry requirements
analysis is to examine the present, as well may also be considered. Knowledge of
as past, financial position and the results of average price, or market values of
operations of the firm in order to determine commodities, share of stocks and debts
the best suitable estimate and predict the instruments in the industry may be
future state and performance of the considered.
company. 3. Get to know the firm you are analyzing.
The main objective used for the analysis is Know the mission and vision. It may prove
also subject to limitations. These to have a bearing on your financial
limitations, if not carefully considered, can analysis. Know their strategic plans Know
ultimately bring about wrong decisions. The where the company wishes to be. Know
inherent limitations of the financial their current status in the industry. know
statement among other thing may stem the company financial projections. Know all
from: things about the firm which you consider
[Link] failure reconsider changes in the relevant and may have a bearing on your
purchasing power, inconsistencies as well analysis.
as dissimilarities in the accounting 4. ASSESS/ANALYZE the financial
principle, policies and procedures used by statement. The analysis should cover the
the firms in the industry. salient areas namely, the profitability,
2. the age of the financial statement is a liquidity or solvency, stability and
limitation. The older it gets, the less reliable operational efficiency of the firm. Using the
it becomes thus, considered as a risk tools and techniques in analyzing the
management tool. financial statement.
[Link] to read and understand the 5. After finishing the analyzing the financial
information in the Notes to the financial statement interpret the results of the
statements may obscure managers in computations and ratios.
evaluating the degree of the risk. 6. Draw Conclusion from the interpretations
4. Financial statements that have not made in step five. The conclusions must
undergone external auditing procedure may take into consideration the objective you
or may not conform with the Generally have set up in step number 1.
Accepted Accounting Principle (GAAP) and
standard thus usage of these statements TOOLS AND TECHNIQUES IN FINANCIAL
may lead to erroneous analysis and ANALYSIS
ultimately erroneous decisions. The common tools and techniques used In
5. Financial statements that have not financial analysis are as follows:
undergone external auditing procedure may [Link] Analysis
prove to be inaccurate or worse, fraudulent This is used to evaluate the trend in the
hence do not fairly present the company accounts over the years. It is usually shown
financial condition. Financial measurements in comparative financial statements.
from the analysis of these companies are a. Comparative statements Compared
not dependable and not conclusive. are financial data of two years showing the
6 . Audited statements do not guarantee increase or decrease in the account
accuracy. balances with their corresponding
percentages.
PRACTICAL STEPS PROPOSED IN ANALYZING It used to evaluate the changes or behavior
FINANCIAL STATEMENTS patterns of the different accounts in the
[Link] the objective, Is it to evaluate financial statements for two or more years.
the profitability, liquidity, asset activity, or In doing the comparison, the earlier year
debt utilization.? serve as the base year so that the
[Link] analysis done may cover not only the percentage increase or decrease is
subject firm but could involve other firms determined by dividing the difference of the
belonging to the same industry. It would be base year figure from the latter year figure
wise to learn about the retrospective, by the base year figure.
current, as well as the prospective Later year- Base year
conditions of the industry. Other external Base year
variable that may have a bearing or X 100%
significant effect on the industry may also
be considered. This may include socio-
economic and political variables. New laws Illustrative Example:
or mandates, financial in nature, changing
b. Trend Ratio – A firm’s present ratio is
compared with its past and expected future
ratio to determine whether the company’s
financial conditions is improving or
deteriorating over time. It is similar to
comparative statements except that
several consecutive years were used
showing the behavior of financial data
In computing the trend, the base period
(oldest year) amount are written as 100%.
The percentage relationship of each
account in the statements is then
computed by dividing each amount by the
base year figure.
For the year after the base year, it would be
Year 1
Base year x 100 %
Two years after the base year, it would be: Xeron Corporation
Year 2
Base year X 100%

Illustrative Example:

Ratio Analysis
Trend Analysis 1. Financial Ratio -Ratio present
Statements of Financial Position relationship between two variables.
Financial ratios, therefore, refer to the
relationship between financial statement
items or accounts expressed in
mathematical fashion.

Ratio analysis can reveal much about a

company and its operations. However,
[Link] Analysis there are several points to keep in mind
It uses a significant item on the financial about ratio. First., financial ratios indicate
statement as a base value. All other areas of strength or weakness. One or
financial items on the statements are several ratios might be misleading, but
compared with it. when combined with other knowledge of a
a. Common Size statement - Each company’s management and economy
account in the financial statements is circumstances, ratio analysis can tell much
expressed by dividing them to a common about a corporation. Second there is no
base account ( total assets, liabilities and single correct value for a ratio. The
equity, sales or net sales) observation that the value of a particular
ratio is too high, too low, or just right
Illustrative Example: depend on the perspective of the analyst
and on the company competitive strategy.
Third, a financial ratio is meaningful only
when it is compared with some standard,
such as an industry trend, a ratio trend for
the specific company being analyzed or a
stated management objective.

Financial ratios provide two type of

comparisons:

1. Industry Comparison
Financial ratios are computed and
compared with the industry average.
Through industry comparison, the
company may be able to compare their
performance against their competitors’ and
how they fare with them.

2. Trend Analysis
The firm’s financial ratios are
computed and compared with their past
performance. By the trends, the company
will know if their financial performance is
improving or not over the years. It is a very
powerful tool in deciding the actions that a
company should take in the future.

FINANCIAL RATIO CLASSIFIED INTO

FIVE GROUPS:

a. Liquidity ratio – is a company ability

to meet its maturing short-term obligations.
A company with poor liquidity may have a
poor credit risk, perhaps because it is
unable to make timely interest and
principal payments.
b. Activity or asset utilization ratio- is
used to determine how quickly various
accounts are converted into sales or cash
c. Leverage ratio (solvency) – is the
company’s ability to meet its long term-
obligations as they become due
d. Profitability ratio – shows the
profitability of the operations of the
company. It highlight the firm’s
effectiveness in handling its operations.
Investors will be reluctant to invest in the
company that has poor earning capacity.
e. Market value ratio -relates the firms
stock price to its earnings.

Summary of Financial Ratio

 efficiency report in 1912. A DuPont analysis
is used to evaluate the component parts of
a company's return on equity or the ROE.
This allows an investor to determine what
financial activities are contributing the most
to the changes in ROE. An investor can use
analysis like this to compare the
operational efficiency of two similar firms. It
helps a company understand its strong
factors and helps analyze the reasons
behind this growth so that a healthy
performance can be retained. It also helps
identify the weak performance indicators,
thus helping the company understand and
improve those.

Sample problem
1. An investor has been watching two
similar companies, SuperCo. And Gear Inc.,
that have recently been improving their
Du Pont Analysis return on equity compared to the rest of
What is DuPont Analysis? their peer group. This could be a good thing
The name comes from the DuPont company if the two companies are making better use
that began using this formula in the 1920s. of assets or improving profit margins.
the DuPont analysis is a financial To decide which company is a better
performance framework which aim is to opportunity, the investor decides to use
breakdown the different financial metrics DuPont analysis to determine what each
that affect the return on equity or simply company is doing to improve its ROE and
called ROE to understand what is driving it. whether that improvement is sustainable.
It allows having a better understanding of
the primary drivers of the return on equity
by looking at three financial ratios.

Formula
The DuPont analysis is an expanded return
on equity formula, calculated by multiplying
the net profit margin by the asset turnover
by the equity multiplier.
Return on Equity = Net Profit Margin x
Asset Turnover x Equity Multiplier
● Net Profit Margin - is a measure of 2. Both A and B company are into the
profitability. It is calculated by finding the electronics industry and have the same
net profit as a percentage of the revenue. ROE of 45%. The ratio of the company are
● Asset Turnover - is a financial ratio as follows:
that measures the efficiency of a
company's use of its assets in generating
sales revenue or sales income to the
company.
● Equity Multiplier - The equity
multiplier is a risk indicator that measures
the portion of a company's assets that is Even though both companies have the
financed by stockholder's equity rather same ROE, however, the operations of the
than by debt. It is calculated by dividing a companies are totally different.
company's total asset value by its total Company A is able to generate higher sales
shareholders' equity. while maintaining a lower cost of goods
which can be seen from its high-profit
margin.
Significance of the formula On the other hand, B company is selling its
DuPont explosives salesman Donaldson product at a lower margin but having very
Brown invented the formula in an internal
high Asset Turnover Ratio indicating that Reader of financial statements often assess
the company is making large number of liquidity by using the current cash debt
sales. Moreover, B company seems less coverage ratio. It indicate whether the
risky since financial leverage is very low. company can pay off its current liabilities
from it operations in a given year. The
Module 2 formula for this ratio is:
USEFULNESS OF THE STATEMENT OF CASH
FLOWS
The higher the current cash debt coverage
The primary purpose of a cash flow
ratio, the less likely a company will have
statement is to provide relevant
liquidity problem. For Example a ratio near
information about a company’s cash
1:11 is good, it indicate that the company
receipts and cash payment during an
can meet all of its current obligations from
accounting period that is useful in
internally generated cash flow.
evaluating the preceding items. The PAS 7
states that the information in a statement
FINANCIAL FLEXIBILITY
of cash flows if used with information in the
The cash debt coverage ratio provides
other financial statement should help users
information on financial flexibility. It
to assess and evaluate:
indicate a company ability to repay its
1.A company’s ability to generate positive
liabilities from net cash provided by
future net cash flows
operating activities. Without having to
2.A company’s ability to meet its
liquidate the assets employed in its
obligations and pay dividends,
operations. Notice its similarity to the
3.A company’s need for external financing,
current cash debt coverage ratio. However
4. the reasons for differences between a
because it uses average total liabilities in
company’s net income and associated cash
place of average current liabilities, it takes
receipts and payment and
a somewhat longer -range view. The
[Link] the cash and noncash aspects of a
formula for this ratio is :
company’s financing and investing
transaction during the accounting period.
The Higher this ratio, the less likely the
The following information may also be company will experience difficulty in
obtained from the cash flow statement: meeting its obligations as they come due. It
[Link] changes in net assets of an enterprise signals whether the company can pay its
of and its ability to affect the amounts and debts and survive if external sources of
timing of cash flows in order to adopt to funds become limited or too expensive.
changing circumstances and opportunities,
2. the ability to the enterprises to generate FREE CASH FLOW
cash and cash equivalents and enables the A more sophisticated way to examine a
users to develop models to assess and company financial flexibility is to develop a
compare the present value of the future free cash flow analysis. Free cash flow is
cash flows of different enterprises and the amount of discretionary cash flow a
3. it enhances the comparability of the company has. It can use this cash flow to
reporting of operating performance by purchase additional investments, retire its
different enterprises because it eliminates debt. Purchases treasury shares, or simply
the effects of using different accounting add to its liquidity. Free Cash flow
treatments for the same transactions and computation:
events.

In addition, the statement of cash flows

provide the means of measuring a business
firms’s
Financial liquidity – which refers to If the free cash flow is positive, the
the measure of cash of asset and liabilities. business Firm could have satisfactory
Financial flexibility – which refers to a financial flexibility. Companies that have
company’s ability to respond and adapt to strong financial flexibility can
financial adversity and unexpected needs
and opportunities. [Link] advantage of profitable investment
even in tough terms, and
FINANCIAL LIQUIDITY
2. be free from worry about survival in poor Payments for taxes unless identified
economic terms with financial and investing activities.
THE BASIC APPROACH TO A CASH FLOW INVESTING ACTIVITIES
STATEMENT The separate disclosure of cash flows
arising from investing activities is important
DEFINITION OF CASH because the cash flows represent the
extent to which expenditures have been
In preparing a statement of cash flows, the made for resources intended to generate
term cash is broadly defined to include both future income and cash flows.
cash and cash equivalents.
Cash equivalent consist of short term, Investing activities includes acquiring and
highly liquid investment such as treasury selling or otherwise disposing of (a)
bill, SEC registered commercial papers and securities that are not cash equivalents and
money market funds. Such investment are (b) productive assets that are expected to
made solely for the purpose of generating a benefit the firm for long period of time; and
return on funds that are temporarily idle. lending money and collecting on loans.
Instead of simply holding cash most Examples are:
companies invest their excess cash INFLOWS
reserves in these types of interest bearing Sales of long-lived assets such as
assets that can be easily converted into property, plant and equipment, intangible
cash. and other long-term
CLASSIFICATION OF CASH FLOW ACTIVITIES Asset
Sales of debt or equity securities of
Operating Activities other entities
Collection of loans (principal) to
The amount of cash flows arising from other (other than advances and loans made
operating activities is a key indicator of the by financial insti-
extent to which the operations of the Tution)
enterprises have generated sufficient cash Outflows
flow to repay loan, maintain the operating Acquisition of long live assets
capability of the enterprises, pay dividend such as property, plant and equipment,
and make new investments without intangibles and other Long term assets.
recourse to external source of financing. Purchases of debt or equity
Information about specific components of securities of other entities
historical operating cash flow is useful in Loans(principal) to others
conjunction with other information, in (other than advances and loans made by a
forecasting future operating cash flows. financial institution)
FINANCING ACTIVITIES
Operating activities include delivering or The separates disclosure of cash flows
producing goods for sale and providing arising from financing activities is important
services and the cash effects of transaction because it is useful in predicting claims on
and other events that enter into the future cash flows by providers of capital to
determination of income. Example are: the enterprise
INFLOWS
Sales of goods Financing activities include borrowing from
Revenue of services creditors and repaying the principal:
Return on interest earnings assets obtaining resources from owners and
(interest) providing them with a return on the
Return on equity securities (dividend) investments. Example are:
Receipts from contracts held for INFLOWS
dealing and trading purposes Proceeds from Borrowing
Tax refunds unless identified with (short-term and long-term)
financing and investing activities Proceeds from issuing the
Outflows firm’s own equity securities
Payment for purchases of inventories Outflows:
Payments for operating expenses Repayment of debt principal
(Salaries, rent, Insurance, etc) Repurchases of a firm’s own
Payments for purchases from shares
suppliers other than inventory Payment of dividends
Payments for lenders(interest)
 Acquisition of the enterprise’s ADJUSTMENTS TO CONVERT INCOME
own shares STATEMENT AMOUNTS TO OPERATING CASH
CONTENT AND FORM OF THE STATEMENT FLOWS
OF CASH FLOWS INDIRECT METHOD
A statement of cash flows for a period shall
report the following
Net Cash
[Link] or used by operating activities
2. Provided or used by investing activities
3. Provided or used by financing activities
B. Net effect of those flows on cash and
cash equivalent during the period in a
manner that reconciles the beginning and
ending cash and cash equivalent.
Noncash investing and financing
activities affecting the financial position
shall be excluded from a cash flow
statement . such transaction should be in
the financial statement (e.g. notes to
financial statements).
Calculating Cash Flow from operating
activities
Direct method
In reporting the cash flow for operating
activities enterprises are encouraged to
report major classes of gross cash receipts
and gross cash payments and the net cash ADJUSTMENTS TO CONVERT INCOME
flow from operating activities. At minimum STATEMENT AMOUNTS TO OPERATING CASH
the following classes of operating cash FLOWS
receipts and payments should be DIRECT METHOD
separately reported:
[Link] collected from customers, including
lessees, licensees and the like
2. Interest , fees, royalties and dividends
received
3. other operating cash receipts if any
4. cash paid to employees and other
suppliers of goods or services
5. Interest paid
6. Income tax paid
7. Other operating payment, if any
8. Contracts held for dealing or trading
purposes
INDIRECT METHOD

Enterprises that choose not to provide the

major classes of operating cash receipts
and payments by the direct method shall
determine and report the same amount of
net cash flow from operating activities
indirectly by adjusting net income to
reconcile it to net cash flow from operating
activities.

Regardless of whether the direct and

indirect method of reporting net cash flow
from operating activities is used, the Working Capital Management
reconciliation of net income to net cash Working Capital
flow from operating activities shall be Working capital is the difference between
presented. the firm current asset and current liabilities.
It is used as a measure to check the prevent paying for more interest. The
liquidity of the firm. If the firm current management must fully aware that having
assets are greater than the current excess cash does not contribute to the
liabilities, it is capable of paying its current firm’s profitability because of the
liabilities, if the current assets are less than opportunity income attributable to cash.
the current liabilities , then the firm cannot
pay its current obligations and has to resort Working Capital Policies
to borrowings. Current assets comprise The working capital policies are
cash, accounts receivable, marketable guidelines on the amount of capital the
securities, inventory and prepaid asset. The company should maintain. It is concern with
current liabilities are the short-term the level and financing of each component
obligations that are expected to mature of the current assets.
within one year. Managing the movement
of working capital ensure the continuity of Matching policy – the policy works in
company operation. an arrangement where the current assets of
Working Capital Management the business are used to perfectly match
Working capital management is the current liabilities. Under this policy , all
concerned with the efficient and effective faced assets plus the permanent current
utilization of working capital to attain the assets are financed by long-term liabilities
predetermined objective of the company or equity. Meanwhile , temporary current
relative to profitability of operations, asset brought by seasonal needs are
liquidity of financial resources, and financed by short –term liabilities. Inventory
minimization of risk and company costs. It needs with seasonal fluctuation are
is also pertinent to the administration and financed by a 30-day bank loan. Equipment
control of working capital to ensure that it , machinery, or other non-current assets
is adequate and effectively utilized. expected to last for more than a year are
Working capital management regulates financed by long-term loan or equity
various types of current assets and current financing. This type of working capital
liabilities. It requires decision on how the policy provides moderate risk and
current assets will be financed and utilized. moderate return to the company.
Managing current liabilities, on the other Aggressive policy – This type of
hand, implies maximizing the company policy has a high risk and often, high return
holding period before the firm finally pays to the company. The company keeps a low
off its obligations. number of currents assets to support the
The top management determines how operations. For this type of policy, the
much investment should be made in company is financing its temporary current
current assets. The investment may change assets and some of its permanent current
from time to time and requires close assets with short-term liabilities. It puts the
monitoring of the account’s balances. company at risk for financing a portion of
Current assets are not properly managed if the permanent current assets. The purpose
funds are tied up in one or several assets of adapting an aggressive policy is to take
that do not provide any return when its fact the opportunity of having a lower interest
, it could be more productive and beneficial charge for short term liabilities instead of
to the firm if placed somewhere else (shim long-term liabilities. This type of strategy is
& Siegel, 2006). quite risky due to the fact that interest
The goal of management is to maintain rates fluctuate in a shorter period of time.
a cash level at a minimum without putting The firm may also be at risk in terms of
the company at risk, maintaining a level of loan renewal and increasing interest rate.
cash that is enough to support the firm’s Conservative policy- the conservative
operations. Maintaining too much policy has the lowest risk and lowest return.
Cash is hazardous to the company. As the In this type of policy, the company matches
most liquid among assets, cash is a portion of the temporary current assets,
susceptible to theft. A good finance and the entire permanent assets and fixed
manager would not allow such as asset with long –term liabilities or equity
occurrence because of the risk involved. issuances. The remaining portion of the
Any excess cash should be placed in other temporary current asses not financed by
investment opportunities likes time deposit, long-term financing is funded by short term
mutual fund, bonds, and capital liabilities.
investments. Paying off the company
obligation would be another option to
Working Capital Management and Risk- internal control of inventories prevents
Return Trade-off unauthorized releasing of goods from the
Managing working capital requires warehouse and proper internal control of
consideration of the risk-return trade-off. By receivable disallowed the non-recording of
Managing cash, receivable, inventory and cash collection. The different units of the
accounts payables. A firm can maximize its organization should take part in the control
rate of return and minimize its liquidity and process. Each unit should have its own
business risk. Holding a high amount of control measures to curb any irregularities
current assets decrease the firm’s liquidity that could affect the working capital of the
risk more than holding more fixed assets. firm .
However more current assets on hand Changing company policies . Policies
means less risk and less return to the firm. serve as a guideline in executing the
More current assets also result in greater transactions and activities of the company.
flexibility as its components can easily If the existing policy does not contribute to
change as the demand for the firm’s the general welfare of the fire.
product also changes. On the other Preparing the budget. Doing the
hand ,fixed asset generates more return budget for the entire year is a good tool to
than current assets but also entail higher help the company manage its working
risk due to the capital involved. capital. Through this budget , the firm can
The firm’s needs for financing differ clearly identify the time when additional
accordingly. A firm whose sales are faced working capital is required or when it has
by seasonality uses short-term financing, an excess working capital.
and not long-term financing. A short-term
loan gives the firm elbow room to meets it Tracing Cash and Net working Capital
obligation with seasonal needs. On the To trace cash movement through the firm’s
contrary, the capital assets should be operation , we must measure the operating
financed with long-term debt such as bonds cycle as well as the firm’s cash conversion
or equity. Since those assets have longer cycle.
life, the long-term obligation can also be Understanding the following time periods is
allocated over a longer period of time. necessary in monitoring the working capital
movement.
How is working capital Managed? Operating cycle - The length of time
Managing working capital is done in in which the firm purchases or produce
numerous ways, listed below are some of inventory, sell it and receive cash
the possible ways that could help improve Cash conversion Cycle – The length
the firm’s management: of time funds are ties up in working capital
or the length of time between paying for
Looking at the financial ratios. working capital and collecting cash from
Financial ratio plays a crucial role in the sale of inventory.
managing working capital . it draws
important information that the firm may Inventory conversion period. The Average
use in order to improve in working capital. time required to purchase merchandise or
If a firm with a high current ratio but a low to produce raw materials and convert them
quick ratio gives high investment in into finished goods and then sell them
inventories. High investment in inventories
does not necessarily have a bad impact on Average Collection Period – the average
the firm’s profitability if such investment length of time required to convert the firm’s
has a high turnover. However, if the firm receivable into cash, that is to collect cash
has a high level of inventories but low following a sale.
turnover, it signifies that the firm is not
creating sales. Thus, a high and slow- Payable Deferral Period. The Average length
moving inventory will result in spoilages of time between the purchase of materials
and high cost of maintenance and labor or merchandise and the payment
Putting up proper internal control. of cash for them.
Internal control has an important part in The operating cycle
securing the working capital of the firm.
With proper internal control, irregularities The operating cycle of a company consist
could be avoided if not totally eliminated. of the time period between the
Proper internal control of cash avoid theft, procurement of inventory of raw material
mishandling or misappropriation; proper and turn them into finished goods ( for
manufacturing concern), sell them and
receive payment for them. To measure the
firm operating cycle , the following formula
can be used:

Operating cycle = Inventory Conversion

Period + Average Collection Period

Or

Discussion:
Illustration 1 Mantrade buys merchandise and expects
Suppose that Mantrade Industries has to sell the goods and thus convert them to
annual sales of P1 million , cost of goods accounts receivable in 65 days, it should
sold of P650,000, average inventories of take 55 days to collect the receivable ,
P116,000 , and average accounts making a total of 120 days between
receivable of P150,000. Assuming that all receiving merchandise and collecting cash ,
Mantrade Industries sales are on Credit . Mantrade is able to defer its own payments
What will be the Firm operating cycle? for only 67 days.
The operating cycle will be equal to:
Although Mantrade must pay its supplier
after 67 days, it will not receive any cash
until 120 days into the cycle, therefore it
may have to borrow from its bank on day
67 and it will not be able to repay the loan
until it collects from customers on Day 120.
For 53 days which is the cash conversion
cycle (CCC) , it will owe the bank and will
be paying interest on this debt. The shorter
So, it will take Mantrade industries almost the cash conversion cycle the better
120 days from the time they receive raw because that will lower interest charges
material to produce market, sell and collect
the cash for their finished goods. Therefor if Mantrade could (a) sell the good
The Cash Conversion Cycle faster, (b) collect receivable faster or (c)
The Firm cash conversion cycle is defer its payables longer without hurting
determined by subtracting the average sales or increasing operating costs, its
payment period from the operating cycle. conversion cycle would decline, its interest
charges would be reduced and its profits
and stock price would be improved.
How can operating cycle be reduced?

The aim of every management should be to

Illustration 2 reduce the length of operating cycle or the
Using the data from the previous examples number of operating cycles in a year in
Mantrade industries and assuming that the order to reduce the need for working
average accounts payable balance is capital. It is therefore necessary that the
P120,000, What will be the firm’s cash financial managers be able to identify the
conversion cycle? reasons for prolonged operation cycle and
how it could be reduced.

The following could be the reasons for

longer operating cycle period:
The cash conversion cycle (CCC) may also Defective purchasing policy and
be calculated as follows: practices that could lead to
CCC = Inventory + Average -purchase of raw material or merchandise
- Payables in excess/short of requirements
Conversion Period collection -Buying inferior, defective materials thus
period Deferral Period lengthening the production time
-failure to get credit from suppliers
-failure to get trade/cash discount and
-inability to purchase goods due to seasonal entrants of new competitors, government
swing fiscal and monetary policies, price
Lack of proper production planning , fluctuations, etc. To be able to anticipate
coordination and control that could result to and minimize any adverse impact of the
protracted manufacturing cycle. changes to the company.
Defective inventory policy
Use of outdated machinery, Module 3
technology as well , poor maintenance and Lecture Guide 2:- Cash Management
upkeep of plant, equipment and Objective of cash Management
infrastructure facilities The basic objective in cash management is
Defective credit policy and to keep the investment in cash as low as
receivable collection procedure possible while still keeping the firm
Lack of proper monitoring of external operating efficiency and effectively
environment A Financial officer can use the following
Remedies that may be adopted to reduce strategies in monitoring cash balances:
the length of operating cycle period are as o Accelerate cash inflows by
follows; optimizing mechanisms for
Production Management collecting cash
There should be proper production o Monitor the cash disbursement
planning and coordination at all levels of needs or payments schedule
activity. Also, a continuing assessment of o Minimize the amount of idle
the manufacturing cycle, proper
cash or funds committed to
maintenance of plant, equipment and
transaction and precautionary
infrastructure facilities and improvement of
balances and
manufacturing system, technology would
o Avoid misappropriation and
help shorten manufacturing cycle thus
handling losses in the normal
shortening the operating cycle.
course of business.
Purchasing Management
To achieve the above objectives, proper
The purchasing manager should ensure the
planning of cash flow is needed. Effective
availability of the right type. Quantity and
cash management generally encompasses
quality of materials/merchandise obtained
proper management of cash flows which
at the right price, time and place through
entails among other the following:
proper logistics management . Further
o Improving forecasts of cash
efforts exerted toward lengthening the
flows
credit period of the suppliers, increasing
o Using Floats
the rates of trade discount and cash
discount would certainly bring favorable o Synchronizing cash inflows
outcome to the company’s deferral and outflows
payment period. o Accelerating collections
Marketing Management o Controlling disbursement
The sale and production policies should be o Obtaining additional funds
synchronized. Production of quality when and where they are
products at lower cost enhances their needed.
marketability and salability. Storage cost DETERMINING THE TARGET CASH BALANCE
would likewise be minimized. The 1. The Target cash balance may be
marketing people should stive to derived with the use of the following
continually develop effective approaches namely:
advertisement, sales promotion activities , a. Cash Budget
effective salesmanship and appropriate b. Cash Break-even chart
distribution channels. c. Optimal Cash Balance using
Credit and collection Policies the
Sound credit and collection will enable the i. Baumol Model
finance manager to minimize investment in ii. Miller-Orr Model
working capital particularly on inventory CASH BUDGET
and receivables The cash budget is the tool used to
External Environment present the expected cash inflows and cash
The length of operating cycle is equally outflow.
influenced by external environment. The CASH BREAK EVEN POINT (MATHEMATICAL
financial manager should be aware and APPROACH)
sensitive to fluctuations in demand ,
XYZ company manufacture plastic which it
sells to other industrial users. The monthly
production capacity is 1,200,000 kilos.
Selling price is P2 per kilo
Its cash requirements have been
Where:
determined as follows:
C = amount of
a. Fixed monthly payment amounting to
cash raised by selling marketable securities
P250,000 while
or by borrowing
b. Variable cash payment are 50% of
C/2 = average
sales
cash balance
Required:
C* = optimal
Determine the Cash Break-even
amount of cash to be raised by selling
point (Mathematical approach)
marketable securities or by
Solution:
borrowing
C*/2 = optimal
average cash balance
F = Fixed costs of
making a securities trade or of obtaining a
loan
T = Total amount
of net cash needed for transactions during
Optimal Cash Balance the period ( usually a A year.
The Baumol Model K = opportunity
In most medium or large-sized cost of holding cash, net equal to the rate
corporation, liquidity management has of return foregone on marketable
assumed a greater role over the past securities or the cost of borrowing to hold
decade. Since cash is needed for both cash
transactions and precautionary needs in all The minimum cost of cash balance
companies, it must be available in some are achieved when C is set equal to C*, the
form (cash, marketable securities, optimal cash transfer or optimal cash
borrowing capacity) all of the time. The replenishment level. The formula to find C*
liquidity managers must utilize some formal is as follows:
models or techniques to maintain the
optimal amount at each moment in time
because too much liquidity brings down the
rate of return on total assets employed and
too little liquidity jeopardizes the very
existence of the firm itself. In managing the Illustrative Case 1: Determination of
level of cash ( currency plus demand Optimal Average Cash Balance for Baumol
deposits) for transaction purposes versus Model
near cash (marketable securities) the To illustrate consider a business with total
following costs must be considered: payments of P10 million for one year cost
Fixed and variable brokerage fees per transaction of P100 and the interest
and rate on marketable securities is 8 percent.
Opportunity cost such as interest The optimal cash balance is calculated as
foregone by holding cash instead of near follows:
cash C* = √((2(10M)
One of the models that can be used to help (100))/(8%))
determine the optimal cash balance is the = P158,114
“Baumol model”. This model balances the Optimal average cash balance =
opportunity cost of holding cash against the P158,114/2
transactions costs associated with =
replenishing the cash account by selling off P79,057
marketable securities or by borrowing. The Miller – Orr Model
The optimal cash balance can be found by The Miller -Orr Model takes a different
using the following variable and equations: approach to calculate the optimal cash
The total costs of cash balances management strategy. It assumes that the
consist of a holding ( or opportunity cost distribution of daily net cash flows is
plus a transaction costs: normally distributed and allows for both
cash inflows and outflows. This model = 378,305.16 - 200,000
bases its computation where: = P178,305.16
L = The lower control limit As shown in the above computation. The
F = the trading costs for firm will reduce cash to P126,101.72 by
marketable securities per transaction buying marketable securities when the cash
σ = the standard deviation in net balance gets up to P178,305.16 and it will
daily cash flows increase cash to P126,101.72 by selling
i day = the daily interest rate on marketable securities when the cash
marketable securities balance get down to P100,000.
Z* = optimal cash return point
H* = upper control limit for cash Module 4
balances Unit 3 – Accounts Receivable Management
To compute for Z* the following formula is Lecture Guide
applied: Receivable represent the amount of money
Z* =∛((3Fσ^2)/(4i day)) +L to be collected from individuals or firm. It
arises from sales of merchandise or the
performance of services or the performance
of services, and granting of loans to
To compute for H*, the following formula is officers, employees, and stockholders
used:
H* = 3Z*- 2L General classes of receivable
Note that the firm determines L and the 1. Trade receivable arising from sale of
firm can set to a non-zero number to merchandise or service in the ordinary
recognize the use of safety stock. The course of business operations. The usual
optimal cash return point Z* is comparable types of receivables are accounts
to the replenishment level C* in Baumol’s receivable and notes receivables. Accounts
model but with one key difference. receivable are open accounts not supported
Since Baumol’s model only allowed to cash by promissory notes. Other names for
disbursement, C* was always replenished accounts receivable are customer’s
to” From a level of xero. accounts, trade debtor, and trade accounts
The Miller-Orr model Z* will be receivable. Notes receivable are those
replenishment level to which cash is supported by formal promises to pay in the
replenished when the cash level hits L. But form of notes. Trades receivable which are
it will also be the return level that cash is expected to be realized in cash within the
brought back down to when cash hits H*. normal operating cycle or in one year,
Illustrative Case II: Calculation of Optimal whichever is longer, are classified as
Return Point and Upper Limit for Miller -Orr current assets.
Model 2. Non-trade receivables claim arising
Suppose that ABC Inc. would like to from sources other than the sale of
maintain its Cash account at a minimum merchandise or services in the ordinary
level of P100,000. But expects the standard course of business. Ex., advances to
deviation in net daily cash flows to be officers, employees, affiliates, and others
P5,000; the effective annual rate on outside parties; claims against suppliers
marketable securities will be 8% per year, and insurance companies; and other
and the trading cost per sale or purchase of receivables arising from non- recurring
marketable securities will be P200 per transactions such as calls for subscriptions
transaction. What will be the ABC”s optimal and disposal of property. None trade
cash return point and upper limit? receivables which are expected to be
realized in cash within one year, the length
Solution: of the operating cycle are classified as
The daily interest rate on marketable current assets. If collectible beyond one
securities will equal to: year, non-trade receivables are classified as
i day = (8%)/(365 days) = .00021 non-current assets.

=∛((3 (200) 〖(5,000)〗^2)/(4

Factors that affect the size of Receivables
Z* 1. Term credits – The level of accounts
x .00021))+ 100,000 receivable depends on the length of the
term credit. A common expectation is that
= P126,101.72 the longer the term of the sale., the higher
H* = 3 (126,101.72) – 2 (100,000)
the level of the accounts receivable. An P150,000. What is the average accounts
example of a term credit is 2/10, n/30. receivables?
2. Paying practice of the customers.
Firm with customers who prolong payment
are expected to have a higher level of The P25,000 represent the average
receivables. accounts receivable and not the investment
3. Collection policies- Firm with a itself. The computed amount is based on
lenient collection policy have higher levels sales incurred and not on the initial cost
of receivables than firms with a stricter outlay of the firm.
collection policy.
4. Volume of credit sales- Firms that Illustration 2:
mostly grant sales on credit have a higher The cost of a given product is 45% of
level of receivables. the selling price and the carrying cost is
Accounts Receivable Management 10% of the selling price, On Average,
Accounts Receivable management is accounts are paid 60 days subsequent to
the process of determining, handling, and the date of sale. The sale average is
administering accounts receivables related P120,000 per month. What is the
to sales and credit policies (Block et al., investment on receivables?
2006) Accounts receivable
Accounts receivable, used as a test for
liquidity, is only correct as long as the
company’s collectible are normal. Careful
planning and analysis are crucial task to
undertake to have an effective and efficient
utilization of accounts receivable. thereby
The amount of P132,000 represents the
keeping the firm’s financial structure and
cost of investment made on the accounts
operation healthy.
receivables being the initial cost outlay
made by the firm.
Float on Receivables
Floats exist from the time goods are sold
Illustration 3:
or services are rendered on accounts. Sales
A company has accounts receivables of
on credit have to undergo the process of
P900,000. The average manufacturing cost
sending the billing statement to the
is 45% of the sales price. The before tax
customers. A customer writes the checks
profit margin is 12%. The carrying cost of
and sends it back to the selling company.
inventory is 5% of the selling price. The
The company deposit the check and waits
sales commission is 10%. What is the
for the time the check is cleared. Again if
investment in the accounts receivable?
the company likes to expedite the process
of collection, establishing a system will be
an additional cost. Granting trade credit
prolongs the cash flow cycle. For this
Manufacturing cost
reason, the firm uses financial ratios like
receivable turnover, average collection
period, and operating cycle as a means of
monitoring credit sales.
Trade Credit
The granting of trade credit is a
Illustration 4:
consideration that has to be well studied.
If ABC Company ‘s credit sales are
Firms grant credits in order to increase the
P180,000, the collection period is 90 days,
sales volume. It also means investing or
and the cost is 75% of the sales price, what
increasing the company’s accounts
is the average accounts receivable balance
receivables. Investment in receivables by
and the average investment in accounts
the firm is the variable cost incurred by the
receivable?
accounts receivables and not the amount of
credit sales recognized.
Illustration 1:
ABC Corporation sells on term of
net/30. On the average, its accounts are 30
days past due. Annual credit sales are Purpose of Granting trade credits:
1. To increase the current sales volume Fixed costs do not change as long as they
– it will able to entice old and new customer are within the relevant range.
to buy the products. Illustration 1:
2. To retain the current sales – The main ABC company current sales volume is
purpose of this move is to prevent the 10,000 units . The firm is planning to
company from losing its current customers increase its sales by granting a trade credit.
to the competitors. Once implemented, the firm is expected to
Possible cost to be expected by the increase its sales by 5,000 units. The
company for granting trade credits: normal capacity of the firm is 12,000 units,
1. Bad debt expense – accounts of which the fixed cost is P250,000. Any
receivables with the possibility of none- production in excess of the normal capacity
collection by the firm selling goods or of the firm would result in an additional cost
services. This kind of expense is incurred of P5 per unit. The bad debt expense rate is
when companies grant credit to customers 5% and 9% for sale units of 10,000 and
who do not have a good credit standing, or 15,000 respectively. If the variable cost is
customer who fail to pay their obligation 70%, what is the advantage or
because of a downturn in the economy. It is disadvantage of increasing the sales to
worth noting that being loose in granting 15,000 units?
credit increase both sales and bad debt.
Being too stiff in granting credit means less
customer and less bad debt. The company
firm only has to ascertain that before
granting trade credits, the benefit should
be greater than the cost.
Illustration 1: 3. Cost of Capital - As the level of
accounts receivable rises, the cost of funds
ABC company has a current annual sales invested in the accounts receivable also
of P12,000,000 with bad debt at 5% of increases. The concept of cost of capital in
sales. The owner, desiring to increase the accounts receivable is the same as the
profit, decided to grant trade credit to concept of placing money in a special time
increase the firm’s current sales. The deposit. If P1,000,000 will earn 12% per
expected sales upon implementation is annum. It becomes the benchmark in other
P20,000,000. With the granting of trade investment activities. Less than 12% return
credit the bad debt expense is also is no longer acceptable. Another example is
expected to increase by 5%. If the firm’s when granting trade credit, the accounts
variable cost is 60% of sales, how much is receivable together with inventory will
the advantage or disadvantage of granting increase in order to meet the increase in
trade credits? sales. The firm needs additional financing
with cost of capital equivalent to 15% . For
this increase in accounts receivable and
inventory to be acceptable an incremental
income of 15% is necessary. Like for
example if the combined increase in
accounts receivable and inventory is
equivalent to P100,000, the incremental
income should at least be P15,000.
4. Cash discount – Cash discount is
normally given to entice prompt payment
Based on the analysis, granting of the of payment of obligation. Firm that have
trade credits will increase the net income excess money usually to avail of this cash
by 2,200,000 despite an increase in bad discount. If used by the customers, the net
debts expense by 3% income will decline due to a deduction of
cash discount to a deduction of cash
2. Variable and fixed Costs. As sales discount from the invoice price. The main
increase, variable cost also increase . This idea of granting cash discount is to
is natural as long as these costs are accelerate the cash inflows and reduce the
properly accounted for as variable costs. level of accounts receivables.
Variable costs are costs that vary in direct
proportion to the production, so an increase Ex. ABC Company gave the following data
in sales is also an increase in variable costs. for analysis:
 includes the credit period and the cash
discount.

Credit period is the length of time in which

the credit sales are allowed. Credit period is
offered from 30 days tp 90 days and is
always starts from the date of issuing the
invoice.
ABC company propose to offer a 3/10,
net/30 discount. The company anticipates
Cash discounts are given
25% of its customers will take advantage of
to customers to entice prompt payment. It
the discount. As a result of the discount
is a deduction from the accounts
policy, the collection period will decline to
receivable provided that the customer paid
1.5 months. Should ABC Company offer the
its obligation within the discount period. If
new term?
the customer did not pay within the
Answer:
discount period, the entire amount of the
obligation will be paid at the end of the
credit period.
Relaxing Term Credit
Relaxing term credit
means that from the existing practice of the
Since the cost of the discount company, a more lenient term is
granted is more than the expected return implemented. Like from a current practice
from cash inflow of a reduced accounts of n/30 days, the firm may decide to
receivable, ABC company should not offer change it to n/45 or more days. With this
the proposed term 3/10,n/30. leniency granted by the firm, it is expected
that the existing customers, as well as the
Credit Policy targeted customers, will benefit from
extending the period. They can hold their
The firm credit policy influences its sales, money for longer period of time. It is
cost of sales, and profit (Brigman & expected that expenses together with
Houston, 2011). Firms with relatively lax receivable and inventories will also
credit policy tend to have a higher volume accumulate.
of sales due to a higher baseline of To achieve, its objective
customers. Firm with this kind of credit to increase profitability involving this kind
policy attract all sorts of customers. They of problem. The company should determine
can get both good-paying customers and whether the rate of return on the
not-so-good-paying customers. Because of incremental income against the
an increased customer base, higher cost is incremental capital requirement is greater
also imminent. On the other hand, firms than or equal to the minimum required rate
with a tighter credit policy will have a lower of return. The incremental working capital
baseline because trade credits are given requirement is the difference between the
only to customers with high credit proposed increase and the current working
standard. This kind of firm has less cost and capital requirement.
risk in the process. A firm’s commitment to
invest in accounts receivable involves a risk
and return trade-off between being to
loose or too strict in implementing the
credit policy. Certain benefit will be accrued
and certain costs will be incurred. The real
challenge to the firm is to establish a credit
policy in which it can maximize the return
on the investment made on its receivables. An increase in sales of 25% is expected
if the term credit increased to 45days. Bad
debts expense is expected to increase by
Component of Credit Policy 2% of increase sales. The minimum desired
1. Term Credit - A Firm proposal on how rate of return is 20%. Income tax is 32%.
the goods and services are to be sold . This Inventory is maintained at a level
equivalent to 30 days sales. ABC traders
uses 360 days in a year

[Link] Standards:
Credit standard are guidelines followed by
the company in giving credit sales to
customers. It refers to the financial strength
and credit worthiness a customer must
exhibits in order to qualify for credit. If a
customer does not qualify for the regular
term credit, he or she can still purchase
from the firm under a more restrictive term.
Credit Standards: The Five C’s of Credit
In granting loan to prospective
customer, the following condition have to
Rate of return = Incremental net be considered (Miranda, 2002)
income/incremental working capital 1. Character. This refers to the moral
= P375,000/437,499 and ethical quality of the individual who is
=85.71 responsible for the paying the loan. A
person of principle or a company run by
Since the rate of return on the proposed people with high ethical standard is
relaxation of the term credit is 85.71% expected to have a good credit risk,
which is greater than 2. Capacity- it is the applicant’s ability
Minimum required rate of return of 20%, to pay off the credit extended, as judged by
then the proposed relaxation is acceptable the financial statement analysis focusing on
cash flows available to pay debt
Shortening Credit Period with Discount obligations.
offering 3. Capital-it is the level of financial
A firm may considered offering credit to resources available to the company seeking
customers with a higher –than –normal risk the loan. Reviewing capital involves an
rating. Instead of offering a longer credit analysis of debt-to equity and the firm
period, the firm will offer a shortened capital structure.
period compensated by a discount. 4. Conditions- these are the current
Example: general and industry-specific economic
states, and any unique
Situation surrounding a specific transaction.
5. Collateral – It consist of asset
pledged by the customer. It also includes
the economic values of these assets in the
case of default.
ABC corporation proposes to offer a 2/10,
Sources of credit Information
net/30 discount. The corporation
1. Financial statements - Financial
anticipates 20% of its customers will take
statement could provide a good credit
advantages of the discount. As a result of
analysis for firms that intend to get credit.
the discount policy, the collection period
Financial ratios like liquidity ratio, asset
will decline to two months. Should ABC
utilization ratio, and profitability ratio can
Corporation offer the new term?
give an initial impression if the company is
capable of paying its credit.
The discount policy is advantageous as
2. Credit –rating agencies. –these credit
indicate below,
rating agencies sell information to
subscribers containing the credit
performance of many companies from
different industries. In the Philippines a
well- known credit rating agency is the
PhilRating. With an increasing demand for 2. Receivable turnover – This formula
information, foreign firm like standard and tells how fast the accounts receivable are
Poor’s and Merrill Lynch are also present in converted into cash. The higher the
the country. receivable turnover, the faster the
3. Commercial banks- As a form of collection of cash.
service to their clientele, banks give credit 3. Average collection period - it refers
information to their customers. The to the number of days of sales in the
customer only have to make a formal accounts receivable . A component of the
request to the bank concerned. cash conversion cycle, average collection
4. Trade Checking –Suppliers could period is the average length of time
provide first-hand information on their starting from when the merchandise is sold
personal experience with the prospective until the payment becomes usable funds of
customer, particularly how much maximum the firm. If the receipt, processing and
credit has been given, and the customer’s collection time are constant, the average
promptness in making payments. collection period tells the firm , on the
[Link] policy average, when to expect its customers to
Collection policy refers to the pay their accounts. Knowledge of the
guidelines on handling receivables in terms average collection period enables the firm
of monitoring and collection. A well- to determine if there is a problem with its
established collection policy has a crystal accounts receivable.
clear procedure as to the sequence of 4. Aging of accounts Receivable - The
collecting the accounts receivables (keown, aging of the accounts receivable is one way
Martin, & Petty, 2006). The process usually of identifying clients who are paying their
starts by sending a billing statement when obligation within the prescribed credit tem.
the due date is near. When payment is not If there is a significant piling-up of
received on the due date, another letter is receivable beyond the normal credit term, a
sent to inform the debtor that its account is more stringent policy on credit and
not yet paid. Sometimes, telephone call or collection must be made. This monitoring
even personal visit are made to assure technique use a schedule that indicate the
collection of the overdue account. If the percentage of the total accounts receivable
balance is still not paid, a collecting agency balance that have been outstanding for a
is hired by the company to make an specified period of time.
aggressive move to collect the overdue Through the aging schedule, the credit
account. The Collecting agency is normally manager easily identifies risky accounts,
paid a fixed rate plus a certain percent of From there, the credit manager can review
the amount to be collected . the credit and collection policies and make
Changing the collection policy affects possible changes. If there is a build-up in
the sales, the collection period, and the bad receivable beyond normal credit term, cash
debt losses. For the firm to implement a inflow will suffer, and the company should
change in collection policy, a carefully consider implementing more stringent
designed system, should be established. It credit term and collection procedures.
must ensure that the benefits of Illustration l
implementing the system are not Aging schedules of WYX and TGIS
overshadowed by costs. The effectiveness Corporations
of the policy can be partly evaluated by
looking at the level of bad debts expense
against the return generated by a change
in policy.
Evaluating Receivable Management
Factors to be considered in assessing
the receivable of the firm (Shim &Siegel,
2000).
1. Ratio of Accounts receivable to net WYX Corporation and TGIS Corporation are
credit sales – This is used as a determinant in the same line of business. They both
to see if the company is too lenient or too offer the same credit term 2/10, n/30 and
strict in implementing its credit and show the same receivable of P1,000,000.
collection policies. If the ratio is high, it WYX corporation’s aging schedule indicate
means the firm is lenient. If the ratio is low, that all of its customers pay on time -60%
it means the company is strict pay on days 0-10 while the other 40% pay
on days 11-30. TGIS Corporation which is Mr. Cruz
more typical ,shows that many of its 250,000
customers do not honor the term of the Mr. X
sale –some 40% of its receivables are more 100,000
than 30 days past due even though TGIS
Corporation credit terms call for full
payment by day 30. The data indicate the
WYX Corporation has better quality of
accounts receivables than TGIS Corporation
because it has no overdue accounts.

Desired Level of Receivables

If a company desires to maintain a
certain level of accounts receivable, the
formula is (Mejorada, 2000)

Receivable =net credit sales/360 x

Required collection period

Illustration :

ABC company would like to maintain a

balance of P150,000 in its accounts
receivable account. If the company has a
credit sale of P3,500,000 a year, what
would be the required collection period of
ABC company?

Answer:
Receivable = net credit sales/360 x
Required collection period
P150,000 = 3,500,000/360 x Required
collection period
Required collection period = P150,000/
P3,500,000/360 = 15.43 days
If the company wishes to maintain an
accounts receivable balance of P150,000,
the collection period should be 15.43 days
Accounts Receivable Turnover = net Credit
Sales/Average Accounts Receivable
Average collection period =
Average Accounts Receivable/Net Credit
Sales x 360 days or = 360 days /
Accounts Receivable Turnover

Customer Name