WORKING CAPITAL MANAGEMENT

CASH AND MARKETABLE SECURITIES MANAGEMENT

Cash management is one of the key areas of working capital management. Apart
from the fact that it is the most liquid current asset, cash is the common denominator
to which all current assets can be reduced because the other major liquid assets,
which are receivables and inventory, get eventually converted into cash.

Motives/Reasons for Holding Cash

Transaction Motives - refers to the holding of cash to meet routine cash requirements
to finance the transactions which affirm carries on in the ordinary course of business

Precautionary Motives - motive of holding cash implies the need to hold cash to meet
the unpredictable obligations.

Speculative Motives - refers to the desire of a firm to take advantage of opportunities

which present themselves at unexpected moments and which are typically outside the
normal course of business.

Compensating/Contractual Motives - another motive to hold cash balances is to

compensate banks for providing certain services and loans.

Objectives of Cash Management

a. To meet the cash disbursement needs (payment schedule)

b. To minimize funds committed to cash balances

Meeting Payments Schedule

Firms have to make payments of cash on a continuous and regular basis to suppliers
of goods, employees and so on. A basic objective of cash management is to meet the
payment schedule, that is, to have sufficient cash to meet the cash disbursement need
of the firm.

The importance of sufficient cash is to meet the payment schedule can hardly be
overemphasized. The advantages of adequate cash are
a. It prevents insolvency or bankruptcy arising out of the inability of a firm to meets
its obligations
b. The relationship with the bank is not strained

c. It helps in fostering goods relations with trade creditors and suppliers of raw
materials, as prompt payment may help their own cash management

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 d. A cash discount can be availed of if payment is made within the due date

e. It leads to a strong credit rating which enables the firm to purchase goods on
favorable terms and to maintain its line of credit with banks and other sources
of credit

f. To take advantage of favorable business opportunities that may be available

periodically

g. The firm can meet unanticipated cash expenditure with a minimum strain during
emergencies

Minimizing Funds Committed to Cash Balances

In minimizing cash balances, two conflicting aspects have to be reconciled. A high
level of cash balances will ensure prompt payment together with all the advantages.
But it also implies that large funds may remain idle, as cash is a non-coming asset and
the firm will have to forego profits. A low level of cash balances, on the other hand may
mean failure to meet the payment schedule. The aim of cash management therefore
should have an optimal amount of cash balances.

Managing Cash Inflow

Reducing Float can Speed Up Cash Receipts
a. Mail Float: length of time from the moment a customer mails a check until the
firm begins to process it.

b. Processing Float: the time required by a firm to process a check before it can
be deposited in a bank.

c. Transit float: time required for a check to clear through the banking system
and become usable funds.

d. Disbursing float: occurs because funds are available in a firm’s bank account
until its payment check has cleared through the banking system.

Lockbox System
Instead of mailing checks to the firm, customers mail checks to a nearby Post Office
Box. A commercial bank collects and deposits the checks. This reduces mail float,
processing float and transit float.
a. Traditional Lockbox: A post office box maintained by a firm’s bank that is used
as a receiving point for customer remittances.

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 b. Electronic Lockbox: A collection service provided by a firm’s bank that receives
electronic payments and accompanying remittance data and communicates
this information to the company in a specified format.

Preauthorized Checks (PACS)

Arrangement that allows firms to create checks to collect payments directly from
customer accounts. This reduces mail float and processing float.

Depository Transfer Checks (DTCS)

Moves cash from local banks to concentration bank accounts. Firms avoid having idle
cash in multiple banks in different regions of the country.

Wire Transfers
Moves cash quickly between banks. Eliminates transit float.

Managing Cash Outflow

Zero Balance Accounts (ZBAS)
Different divisions of a firm may write checks from their own ZBA. Division accounts
then have negative balances. Cash is transferred daily from the firm’s master account
to restore the zero balance. Allows more control over cash outflows.

Payable-Through Drafts (PTDS)

Allows the firm to examine checks written by the firm’s regional units. Checks are
passed on to the firm, which can stop payment if necessary.

Remote Disbursing
Firm writes checks on a bank in a distant town. This extends disbursing float.

Determining Cash Needs

Baumol Model
The optimal amount of short-term securities sold to raise cash will be higher when
annual cash outflows are higher and when the cost per sale of securities is higher.
Conversely, the initial cash balance falls when the interest is higher.

The purpose of this model is to determine the minimum cost amount of cash that a
financial manager can be obtain by converting securities to cash, considering the cost
of conversion and the counter balancing cost of keeping idle cash balances which
otherwise could have been invested in marketable securities. The total cost of
associated with cash management, according to this model has 2 elements (i) cost of
converting marketable securities into cash (ii) the lost opportunity cost. The conversion
costs are incurred each time marketable securities are converted into cash.

2 x annual cash outflows x cost per sale of securities

Initial cash balance =
interest rate

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 Cash Budget
Cash budget is a device to help a firm to plan and control the use of cash. It is a
statement showing the estimated cash inflows and outflows over the planning horizon.
The net cash position of a firm as it moves from one budgeting sub period to another
is highlighted by the cash budget.
Marketable securities are highly liquid, shot-term, interest-earning government, and
nongovernment money market instruments. They can be easily converted to cash.

Reasons for Holding Marketable Securities

a. They serve as a substitute for cash balances.

b. They are held as a temporary investment where a return is earned while funds
are temporary idle.

c. They are built up to meet known financial requirements such as tax payments,
maturing bond issue and so on.

Factors Influencing the Choice of Marketable Securities

1. Risks such as financial risk (uncertainty of expected returns due to changes in
issuer’s ability to pay) and interest rate risk (uncertainty of expected returns
due to changes in interest rates).

2. Maturity.

3. Yield or returns on securities.

4. Marketability/liquidity risk (ability to transform securities into cash).

Types
a. Treasury Bills - short term securities issued by the government.

b. Bankers Acceptances - short term securities used in international trade, sold

on discount basis. Short-term promissory trade notes for which a bank (by
having “accepted” them) promises to pay the holder the face amount at
maturity.

c. Negotiable Certificates of Deposits (CDs) - short-term securities issued by

banks. A large-denomination investment in a negotiable time deposit at a
commercial bank or savings institution paying a fixed or variable rate of interest
for a specified period of time.

d. Commercial Paper - short-term unsecured “IOUs” sold by large reputable firms

to raise cash.

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 e. Repurchase Agreements - an investor acquires short-term securities subject to
a commitment from a bank to repurchase the securities on a specific date.

f. Money Market Mutual Funds - a pool of money market securities, divided into
shares, which are sold to investors.

ACCOUNTS RECEIVABLE MANAGEMENT

Accounts receivables are generated when a firm offers credit to its customers. The
first thing that needs to be addressed when establishing a credit policy is to set the
standards by which a firm is judged in determining whether or not credit will be
extended.

Factors to Consider for Accounts Receivable Policy

1. Credit Standards
Character - customers’ willingness to pay
Capacity - customers’ ability to generate cash flows
Capital - customers’ financial sources
Conditions - current economic or business conditions
Collateral - customers’ asset pledged to secure debt

2. Credit Terms
This defines the credit period and discount offered for customers prompt payment. The
following costs associated with the credit terms must be considered: cash discounts,
credit analysis and collections costs, bad debts losses and financing cost.

3. Collection Program
Shortening the average collection period may preclude too much investment in
receivable (low opportunity cost) and too much loss due to delinquency and defaults.
The same could also result to loss of customers if harshly implemented.

Credit Management
Credit management strategically defines the quality of accounts receivable collections.
Credit and collection have a direct relationship. If credit standards are high, the rate of
collection is expected to be high, and vice-versa. Credit processes precede collection
activities. Generally, it is a choice of offering and implementing a set of stiff credit
criteria to have a high collection rate or a set of lax credit criteria coupled with high
collection costs. However, creative managers can still develop a mix model in
managing their receivables and collection to optimize sales and collections. There are
several variables of credit management such as discount rate, discount time, credit
period, credit cap (limit), credit class, and credit assessment.

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 Collection Management
Operationally, collection management starts from the date the merchandise is sold to
credit customers. Complete and reliable records and corroborating documents should
be maintained to ensure an efficient basis of collection. Billings and collection policies
are interrelated processes to complete a collection cycle.

Receivable Portfolio Analysis

Receivable portfolio (i.e., “receivable spread) refers to the strategy of spreading
investments in receivables over a customer base. It gives an impression of whether
the management is strict or lax in imposing its receivable policies and whether the
management is conservative and aggressive in its receivable investment. Receivable
should also be tracked down – per customer, customer group, customer receivable
age, and customer balances. This is done in relation with the goal of speeding up the
collection of receivables.

Aging of Accounts Receivable

Aging of accounts receivables classifies the accounts to their number of days
outstanding. It has the following advantages:
• It tracks down receivable balances.

• It serves as an analysis sheet to study receivable balances according to their

“age” as either current account or past due account.

• It gives an idea of which accounts are “moving” and which are “not moving” by
doing a supplemental analysis of the long past due accounts.

• It is a reasonable technique of estimated doubtful accounts expense.

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 INVENTORY MANAGEMENT

Inventory management is directly linked to the operating goal of giving the best
service to customers. When a customer calls for a sales order, delivery must be done
at the fastest possible time at the lowest possible costs. Traditionally, companies
maintain a large stock of inventories to meet the challenge of serving customers on
time.

Objectives
a. Reduce inventories while maintaining customer service levels and quality. The
firm can free needed cash to finance both internal and external growth.

b. To establish production and inventory control.

Inventory Planning and Control

Inventories provide a cushion to smooth out the differences in the time and location of
demand and supply for a product. The purpose of inventory planning and control is to
determine the optimum level of inventory necessary to minimize costs.

The EOQ Model

The economic order quantity (EOQ) refers to the units of materials that should be
purchased to minimize total relevant inventory costs. Total relevant inventory costs
include the sum of ordering and carrying costs. Total relevant inventory costs do not
include the purchase price in the analysis because the unit purchase price remains
the same regardless of the order quantity the business places.

Ordering costs include those spent in placing an order, waiting for an order,
inspection and receiving costs, setup costs, and quantity discounts lost.

Cost per order = Total ordering costs / No. of orders

Total ordering costs = Cost per order x No. of orders
No. of orders = Annual demand / order size

Annual demand represents the annual need or requirements of the business. Order
size refers to the number of units or amount purchased per order batch.

Carrying costs are those spent in holding, maintaining, or warehousing inventories

such as warehouse and storage costs, handling and clerical costs, property taxes and
insurance, deterioration and shrinkage of stocks, obsolescence of stocks, interest, and
return on investment (e.g., lost return on investment tied up in inventory).

Carrying cost per unit = Total carrying costs / Average inventory

Total carrying costs = Carrying cost per unit x Average inventory
Average inventory = Order size / 2

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 also,
Carrying cost per unit = Unit cost x Carrying cost ratio
Carrying cost ratio = Carrying cost per unit / Unit cost

Economic order quantity is the point where the total ordering costs equal the total
carrying cost. Also, at this point the total inventory cost is at its minimum.

______________
EOQ = √ 2 x D x O ÷ C

D = demand annually for the product; O = Order cost per order placed;
C = carrying cost annually per unit of the product in inventory.

Reorder point refers to the inventory level where a purchase order should be placed.

Lead time refers to the waiting time from the date the order is placed until the date the
delivery is received. Lead time quantity represents the normal usage during the lead
time period. Normal usage means the average usage of inventory during a period (i.e.,
annual demand / working days in a year).

Safety stock is set to serve as a margin in case of variations in normal usage and
normal lead time. Hence, there is a safety stock for variation in usage and a safety
stock for variations in time.

Reorder point = Lead time quantity + Safety stock quantity

where:
Lead time quantity = normal usage x normal lead time
Safety stock = safety stock (in usage) + safety stock (in time)
Safety stock (in usage) = (Maximum usage – Normal usage) x Normal lead
time
Safety stock (in time) = (Maximum lead time – Normal lead time) x
Normal usage
and;
Maximum inventory level = Safety stock quantity + Order size

Stock-out (Shortage) Costs include those costs incurred when an item is out of
stock. These include the lost contribution margin on sales plus lost customer goodwill.

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 SHORT-TERM FINANCING

Short term finance refers to financing needs for a small period normally less than a
year. In businesses, it is also known as working capital financing. This type of financing
is normally needed because of uneven flow of cash into the business, the seasonal
pattern of business, etc. In most cases, it is used to finance all types of inventories,
accounts receivables etc. At times, only specific one-time orders of business are
financed.

Why Do Firms Need Short-Term Financing?

• Cash flow from operations may not be sufficient to keep up with growth-related
financing needs.

• Firms may prefer to borrow now for their inventory or other short-term asset
needs rather than wait until they have saved enough.

• Firms prefer short-term financing instead of long-term sources of financing due

to:

- easier availability

- usually has lower cost (remember yield curve)

- matches need for short term assets, like inventory

Types/Sources
As we understood, why we need short-term financing, there are various sources of
short-term financing for a business. Each type of short-term finance has different
characteristics and can be used in different situations. Some of those are explained
below:

Trade Credit
It is the credit extended by the account’s payables. We would classify this credit into
2 types – free trade credit and paid trade credit. After a particular no. of days as per
payment terms, the supplier charges interest on the delay of payment. So, the period
before this is free trade credit and after that is paid trade credit.

It’s quite obvious that the free trade credit should be as much as possible because it
is free of cost. How much is free trade credit extended to a customer? It depends upon
the creditworthiness of the buyer, discipline maintained in payment commitments, the
bulk of the business, etc. Higher you rate on these factors, higher would be the free
trade credit available to your business.

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 Paid trade credit is definitely a type of short-term financing but on the priority list, it
would be quite below. In short, it should be selected only when another financing is
not available. The reason for not opting for it is its high-interest cost.

Short-Term Loans
Short term loans can be availed from banks and other financial institutions. Banks
extend these loans after careful study of the business, its working capital cycle, past
track record etc. Once availed, these loans are repaid either in small installments or
may be paid in full at the end of the period. This depends on the terms of the loan. It
is advisable to use these loans for financing permanent working capital needs. There
are other alternatives to fund the temporary working capital needs. For more refer
Working Capital Loans.

Business Line of Credit

A business line of credit, a type of short-term financing, is most appropriate for
temporary working capital needs. In this type of financing, an amount is approved by
the issuing bank or financial institution. Within the limit of this amount, the business
can make payment and keep depositing once payment from customers is received. It
works like a revolving credit and best part of this is the interest is charged on the
utilized amount only and not on the approved amount. The business has the flexibility
to deposit unused amount to save on interest cost. This way it becomes a very cost-
effective financing option.

Invoice Discounting
Invoice discounting is another source of short-term finance where the receivable
invoices can be discounted with the financial institutes or banks or any third party.
Discounting invoices means the bank will pay you the money at the time of discounting
and collects the money from your customer when the bill becomes due.

Factoring
Factoring is also a similar arrangement like invoice discounting where the accounts
receivables of a business are sold to a third party at a price which is lower to the
realizable value of the accounts receivable. This purchasing party is commonly known
as a factor. These factoring services are provided by both banks and other financial
institutions. There are many types of factoring like with recourse or without recourse
etc.

Accounts Receivable as Collateral

A pledge is a promise that the borrowing firm will pay the lender any payments
received from the accounts receivable collateral in the event of default. Since accounts
receivable fluctuate over time, the lender may require certain safeguards to ensure
that the value of the collateral does not go below the balance of the loan. So, normally
a bank will only loan you 70 -75% of the receivable amount. Accounts receivable can
also be sold outright. This is known as factoring.

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 Inventory as Collateral
A major problem with inventory financing is valuing the inventory. For this reason,
lenders will generally make a loan in the amount of only a fraction of the value of the
inventory. The fraction will differ depending on the type of inventory. If inventory is long
lived, i.e. lumber, they (lender or a customer) may loan you up to 75% of the resale
value. If inventory is perishable, i.e., lettuce, you will not get much.

Short-Term versus Long-Term Financing

The most important difference between the two types of financing is the time period,
the purpose and the cost of financing. The time period is simple to understand. Short-
term financing is normally for less than a year and long-term could even be for 10, 15
or even 20 years. The purposes are totally different for both types of financing. Short-
term financing is normally used to support the working capital gap of business whereas
the long term is required to finance big projects, PPE, etc. The third thing is the cost
of financing which is higher in case of short-term and comparatively lower in case of
long-term barring abnormal economic conditions.

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 PROBLEMS

1. The Company turns out 200 calculators a day at a cost of P250 per calculator for
materials and variable conversion cost. It takes the firm 18 days to convert raw
materials into calculator. The usual credit terms extended to its customers is 30
days, and the firm generally pays its suppliers in 20 days.

Required:
a. If the foregoing cycles are constant, what amount of working capital must
Company finance?
b. What is the length of the firm’s cash conversion cycle?

2. You estimate a cash need for P4 million over a one-month period where the cash
account is expected to be disbursed at a constant rate. The opportunity interest
rate is 6 percent per annum, or 0.5 percent for a one-month period. The transaction
cost each time you borrow or withdraw is P100.

Required:
a. What is the Optimum Level of Cash Holding for the company as per the
Baumol Model?
b. What is the number of transactions you should make during the month?

3. The Corporation is preparing its cash budget for August. The budgeted beginning
cash balance is P17,000. Budgeted cash receipts total P187,000 and budgeted
cash disbursements total P177,000. The desired ending cash balance is P40,000.
The company can borrow up to P120,000 at any time from a local bank, with
interest not due until the following month.

Required:
Prepare the company's cash budget for August in good form.

4. The Company sells on terms 3/10, net 30. Total sales for the year are P900,000.
Forty percent of the customers pay on the tenth day and take discounts; the other
60 percent pay, on average, 45 days after their purchases. What is the average
amount of receivables?

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 5. Let us assume ABC Company with the credit terms 2/10, n/30, has the following
aging of accounts receivable:
Account Group Amount
Current account P6,000,000
Past due accounts:
1 – 30 days 1,000,000
31 – 60 days 500,000
61 – 90 days 200,000
More than 90 days 100,000
Total A/R P7,800,000
And further assume that the collectability rates of each group are as follows:
Account Group Collectability Rate
Current account 99%
Past due accounts
1 – 30 days 95%
31 – 60 days 90%
61 – 90 days 80%
More than 90 days 50%

Required:
a. Determine the credit balance needed in a company’s Allowance for Doubtful
Accounts.
b. Compute the net realizable value of accounts receivable.
6. What is the economic order quantity for the following inventory policy: A firm sells
32,000 bags of premium sugar per year. The cost per order is P200 and the firm
experiences a carrying cost of P0.80 per bag.

7. The Company has developed the following data to assist in controlling one of its
inventory items:
Economic order quantity 1000 liters
Average daily use 100 liters
Maximum daily use 120 liters
Working days per year 250 days
Safety stock 140 liters
Cost of carrying inventory P1.00 per liter per year
Lead time 7 working days
Required:
a. Order point
b. Average inventory
c. Maximum inventory assuming normal lead time and usage
d. Cost of placing one order (CO)

8. With credit terms of 3/8, n/30, what is the customer’s payment decision date?

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