Working Capital and Cash Management

Learning Objectives
1. Understand the concept of working capital management, net working capital and the related trade-off between
profitability and risk.
2. Describe the cash conversion cycle, its funding requirements and the key strategies for managing it.
3. Know some basic motives for holding cash balances, transactions motive, precautionary motive and speculative motive.
4. Understand the management of receipts and disbursements, including float, speeding up collections, slowing down
payments, cash concentration, zero-balance accounts and investing in marketable securities.

Introduction
- A company requires financing whether from creditors or from owners to acquire assets to generate sales or revenues.
- Sources of financing could be both short-term and long-term.
- Short-term financing or working capital management is the focus of this chapter.

Setting working capital policy involves answering two basic questions:

1. How much should we invest in current assets (cash, accounts receivable, inventory or temporary investments)?
2. How should we finance such investment?

Short-Term Financial Management

- It is primarily concerned with the commitments of funds to various activities within the business and with the best
possible combination of types of financing.
- It participates in planning, organizing, administration and control of company activities geared towards profit goals.

Financial management attempts to answer the following questions:

1. How much cash should be maintained in the current, checking, or savings account?
2. How many inventories must be maintained?
3. How long would be the credit terms to old and new customers?
4. Should the company pay dividend this year or not?
5. Should we borrow or issue equity shares?

Managers must have the basic understanding on some investment terms and principles for the effective management of
working capital:
1. Hedging principle (Rule of self-liquidating debt)
- Provides the basis for firm’s working-capital decisions
- Involves that those assets needed by the firm not to be financed by spontaneous sources such as payables and accruals
should be financed by applying the rules below
- Permanent asset investments are financed with permanent sources
- Temporary asset investments are financed with temporary sources

2. Permanent investment in an asset

- One which the firm expects to hold for a period of more than one year
- This may involve current or fixed assets

3. Temporary investment in an asset

- Includes the firm’s investment in current assets that will be liquidated and not to be replaced during the year

4. Spontaneous sources of financing

- All those sources that is available upon demand such as trade credits or account payable or those that arise naturally as a
part of doing business such as wages, interests and taxes payables

5. Temporary sources of financing

- All forms of current or short-term financing not categorized as spontaneous, such as bank loans, commercial papers, and
financing company loans

6. Permanent sources of financing

- Include all long-term sources such as debt having a maturity of more than one year, such as preferred stock, common
stock or long-term bonds
Working Capital Management (Short-term Financial Management)
- The administration and control of the more liquid resources to make sure that they are sufficient to cover day to day
business operations including anticipated contingencies.
- It generally deals with managerial decisions regarding current assets and how they are financed.

Current assets include:

1. Cash
2. Accounts receivable
3. Marketable securities
4. Inventory

Current liabilities include:

1. Accounts payable
2. Notes payable
3. Accruals

The following conditions should be attained:

1. Cash – should be enough to support firm’s operation
2. Accounts Receivable – should not be too lax nor too strict in granting credits
3. Inventories – should be enough to support market demand
4. Current Liabilities – to be prudent in making use of the time before it finally pays off its obligations

Working Capital
- The difference of total current assets and total current liabilities
- It is analyzed as the ability to meet current obligations as they come due using current ratio analysis.
- Effective management of working capital will improve the firm’s overall return on investment performance.
- The firm’s goal is to minimize net working capital by:
1. Having faster collection of cash from sales or service revenues
2. Increasing inventory turnovers
3. Slowing down disbursements to suppliers or securing longer credit terms

Uses and Importance of Working Capital Management

- Working capital investments are made to support day-to-day operations and sales activities
1. The amount of cash on hand and in bank to be maintained
2. The amount of credit to be extended to customers
3. The number of days extended to credit customers
4. The amount and type of inventories on stock to be maintained
5. The amount of securities or temporary investments to be made

Working Capital Management is an Important Topic for Several Reasons:

1. Surveys indicate that the largest portion of most financial managers’ time is devoted to the day-to-day internal
operations of the firm.
2. Current assets represent a large proportion of total assets in most companies.
3. Working capital management is particularly important for small firms.
4. The relationship between sales growth and the need to invest in current assets is close and direct.

Objectives of Working Capital Management

1. To generate additional income for the business
2. To reduce the amount of investment needed to support sales and production

These objectives will be generally affected by the following factors:

1. The general nature of the business
2. The cost and length of the operating process
3. Product or service competitive conditions and seasonal variations
4. Government regulations
5. Self-imposed internal policies and commitments
6. Operational efficiencies
Advantages of Adequate Working Capital
1. Solvency of the business
2. Goodwill
3. Easy loans
4. Cash discounts
5. Regular supply of raw material
6. Regular payment of salaries, wages and other day to day commitments
7. Ability to face crisis
8. Quick and regular return on investments
9. Exploitation of favorable market conditions
10. High morale

Disadvantages of Excessive Working Capital

1. Idle funds which earn no profits for business and hence business cannot earn a proper rate of return
2. It may lead to unnecessary purchasing and accumulation of inventories causing more chances of theft, waste and losses
3. It may result into overall inefficiency in organization
4. Due to low rate of return on investments, the value of shares may also fall
5. The redundant working capital gives rise to speculative transaction
6. Relations with banks and other financial institutions may not be maintained

Disadvantages of Inadequate Working Capital

1. Inability to pay its short-term liabilities in time. It will lose its reputation and will not be able to get good credit
facilities.
2. It cannot buy its requirements in bulk and cannot avail of discounts.
3. It becomes difficult for firm to exploit favorable market conditions and undertake profitable projects due to lack of
working capital.
4. The rate of return on investments also falls with shortage of working capital.
5. The firm cannot pay day-to-day expenses of its operations and it created inefficiencies, increases costs and reduces the
profits of business.

Profitability
- The relationship between revenues and costs generated by using the firm’s assets, both current and fixed, in productive
activities

Risk (of insolvency)

- The probability that a firm will be unable to pay its bills as they come due

Operating Cycle
- The time from the beginning of the production process to collection of cash from the sale of the finished product

Cash Conversion Cycle

- The length of time required for a company to convert cash invested in its operations to cash received as a result of its
operations

Permanent Funding Requirement

- A constant investment in operating assets resulting from constant sales over time

Seasonal Funding Requirement

- An investment in operating assets that varies over time as a result of cyclic sales

Aggressive Funding Strategy

- Firm funds its seasonal requirements with short-term debt
- Permanent requirements are funded with long-term debt
- This approach seeks to increase profit by using as much of the less expensive short-term financing as possible but
increases risk because the firm operates with minimum net working capital, which could become negative.

Conservative Funding Strategy

- Funding strategy under which the firm funds both its seasonal and its permanent requirements with long-term debt.
- This strategy results in relatively lower profits because the firm uses more of the expensive long-term financing and may
pay interest on unneeded funds.
Management of Cash
- The most effective way of handling cash or its equivalent in a manner intended to result in its most efficient use
- Focused on the cash flow process and the reasons why a firm holds cash balances

Cash Management Issues

1. Cash is the most important and challenging resources to manage.
2. The optimal cash level is influenced by a subjective factor.
3. Effective management of the cash collection cycle can both reduce the demand for cash and increase its supply.
4. The normal operating cycle is a cash-to-cash cycle.
5. Sound cash management techniques are based on a thorough understanding of the cash flow process.
6. Trying to have an acceptable balance between holding too much cash and holding too little cash
7. That a large cash investment minimizes insolvency but sacrifices profitability

Motives of Holding Cash Balances

1. Transaction motive
- Allow the firm to make payments that arise in the ordinary course of doing business

2. Precautionary motive
- Provide a buffer stock of liquid assets that can be drawn if there are unexpected demands for cash

3. Speculative motive
- Permit the economic unit to take advantage of future income producing activities

Possible Placements of Cash

1. Savings and/or current accounts
2. Time deposits
3. Stocks
4. Treasury bills
5. Commercial papers

Management Responsibilities Relating to Cash

1. To prevent losses from fraud or theft
2. To provide accurate accounting of cash receipts, cash payments and cash balances
3. To maintain enough cash at all times to make necessary payments plus reasonable balances for emergencies
4. To prevent unnecessary large amounts of cash from being held idle in bank accounts which produce no revenue

Management Techniques in Controlling Cash Flows

- The techniques in controlling cash flows include managing cash floats on payments and collections, extending cash
payment, availing of cash discount and establishing the optimum transaction size

Float Management
- This involves controlling the collection and disbursement of cash
- The objective in cash collection is to reduce the lag between the time customers pay their bills and the time the checks
are collected

Float
- A delay between when funds are sent by a payer to a payee
- Funds that have been dispatched by a payer but not yet in form that can be spent by the payee
- It includes the time it takes a company to process its checks internally and the time consumed in clearing the check
through the banking systems

Collection float
- The time between when a payer sends payment and the funds are credited to the payee’s bank account

Disbursement float
- The time lag between when a payer sends payment and when the funds are deducted from the payer’s bank account

Negative float
- Exists when book balance exceeds the bank balance which means, that there is more cash tied up in a collection cycle
and it earns a 0% rate of return
Positive float
- Happens when the firm’s bank balance exceeds its book balance

Mail float
- The delay between the time when payer places payment in the mail and when it is received by the payee

Processing float
- The delay between the receipts of a check by the payee and the deposit of it in the firm’s account

Clearing float
- The delay between the deposit of a check by the payee and the actual availability of funds

Speed-up Collections
- This is a variety of techniques available for speeding up the collection process and thereby reducing the collection float
1. Bill customers promptly
2. Offer cash discounts for prompt payment
3. Use lockbox system
- Customers mail their payments to a post office in a specific city
- The local bank collects the checks from this box and deposits them in the firm’s account
4. Establish local collection office
5. Request customers to make direct payment to the firm’s depository bank
6. Use of automatic fund transfer or electronic fund transfer

Concentration Banking
- This is a collection procedure in which payments are made to regionally dispersed collection centers and then deposited
in local banks for quick clearing, thus reducing collection float by shortening mail and clearing float

Lockboxes
- It refers to a collection procedure in which payers sends their payments to a nearby post office box that is emptied by the
firm’s bank several times daily

Direct Sends
- This is a collection procedure in which the payee presents payment checks directly to the banks in which they are drawn,
thus reducing clearing float

Slowing Down Disbursements

Controlled disbursing is the strategy use mailing points and bank account to lengthen mail float and clearing float
respectively by:
1. Stretching payables by paying as late as possible within a credit period
2. Maintaining zero-balance accounts
3. Less frequently payroll and scheduled issuance of checks to suppliers

Reduce the need for precautionary cash balance with the following techniques:
1. More accurate cash budgeting
2. Have ready lines of credit
3. Invest idle cash in highly liquid short-term investments instead of holding idle precautionary cash balances

Playing the float

- A method of consciously anticipating the resulting float associated with the payment process and using it to keep funds
in an interest-bearing form for as long as possible

Estimating Cash Balances

- Management’s goals are to maintain levels of transactional cash balances and marketable securities investments that
improve the value of the firm.

Baumol Model (by William J. Baumol)

- This model determines the optimum balance of cash based upon carrying and transaction costs of cash
- Involves the computation of economic conversion quantity; the cost-minimizing quantity in which to convert marketable
securities to cash