1

4.1Principles of Working
Capital Management

4.2 Cash and Marketable

Securities Management
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Contents 4.1 Principles of Working Capital

Management
4.1.1 Appropriate level of working
capital
4.1.2 Cash Conversion Cycle
4.2 Cash and Marketable Securities
Management
4.2.1 Objectives of cash management
4.2.2 Motives for holding cash
4.2.3 Cash Conversion Model (Baumol
Model)
4.2.4 Marketable Securities
Working Capital Management
3

also called short-term financial management, is the

management of current assets and current liabilities

Affects firm’s liquidity (current ratio and net working

capital)

addresses the following questions:

How much liquidity should the firm have?
Who should credit be extended to?
How much inventory should a firm carry?
Should inventories be bought on credit or cash?
If credit is used, when should payment be made?
Working Capital Management
4

Goal: to achieve a balance between

profitability and risk that contributes
positively to the firm’s value.

Profitability: reduced financing costs by

decreasing funds tied-up with WC
investment

Liquidity Risk: probability that firm will be

unable to pay its bills as they come due
Profitability-Risk Trade-off
5

Principle #2: There is a risk-return trade-off

Current assets earn low returns,

but help reduce the liquidity risk.

Current liabilities are less expensive,

but increase the liquidity risk.

For example, a firm can enhance its profitability by

reducing its investments in low-yielding money
market securities, but this may mean lack of
access to liquid funds and higher risk of default
Profitability-Risk Trade-off
6

Basic approach: minimize investment in low-or-non-

earning assets (receivables and inventories) AND
maximize use of “free” credit (accounts payable and
accruals)
Working Capital Policy
7

Also known as short-term financial management

policy, involves deciding on an investment strategy
for financing the firm s working capital
1. Current Assets Investment Policy – policies
regarding the size of Current Asset holdings
(relative to Operating revenue)
2. Current Assets Financing Policy- use of
spontaneous, short-term or long-term financing
including financing options for short-term
deficiencies
Current Assets Investment Policies
8

Relaxed Investment Policy- relatively large amount of

cash, marketable securities, and inventories are
carried, and a liberal credit policy results in a high level
of receivables

Restricted (or tight or “lean-and-mean”) Investment

Policy- Holdings of cash, marketable securities,
inventories, and receivables are constrained/
minimized

Moderate Investment Policy- in between relaxed and

restricted policies
Current Assets Investment Policy
9
Types of Asset Investment or funding 10

requirement

Temporary asset investment or Seasonal funding requirement

are those that fluctuate with seasonal or cyclical variations in
sales. These will be liquidated and not replaced within the year
such as increase in accounts receivable during busy season

Permanent asset investment or permanent funding

requirement are those that a firm must carry even the at the
low point of its business cycle. These are expected to be
maintained for a period of longer than one year such as fixed
assets or minimum level of current assets like inventories.
Current Assets Financing Policy
11

Investment in current assets must be financed by a

combination of the following:
1. Spontaneous financing- arise spontaneously out of the
day-to-day operations of the business and consist of
trade credit and other forms of accounts payable (such
as wages payable)
2. Short-term (temporary) discretionary financing- - arise
out of managerial discretion/ decision with maturity of
less than one year such as notes payable
3. Long-term (permanent) discretionary financing- arise
out of managerial discretion/ decision that is available
for a longer period of time such as long-term debt,
bonds, preferred stock and common equity
Current Assets Financing Policy
12

1. Moderate financing policy aka Maturity Matching or Self-

liquidating approach- financing policy that matches maturity
of the source of financing with the length of time that the
financing is needed
Current Assets Financing Policy
13

2. Aggressive financing policy - financing policy wherein a

portion (or all) of its permanent current assets (and even
some fixed assets) will be funded by short-term debt
Current Assets Financing Policy
14

3. Conservative financing policy - financing policy wherein the

firm funds all permanent current assets and a portion of its
temporary current assets with long-term financing; only
peak requirements are financed by short-term debt
Working Capital Cycle 15

Cash

Collect from Purchase

customers materials/
inventory

Sale of goods or Produce goods/

service Stock on hand

Pay supplier
Cash Conversion Cycle
16

Cash Conversion Cycle (CCC)- also known as Working

Capital Cycle, Net Operating Cycle or Cash Cycle, is the
length of time for a company to convert cash invested in its
operations to cash received as a result of its operations. It is
period between paying for working capital and collecting
cash from the sale of the working capital. It can be
calculated as follows:

Inventory Average AP
conversion
period
collection
period
Deferral
Period
CCC
Operating Cycle 17

Operating Cycle -is the time period from the beginning of

the (materials) inventory purchased to collection of cash
from sale of product. It can be calculated as follows:

Inventory Average
Operating
conversion collection
Cycle
period period

Both operating cycle and cash conversion cycle determine

how effectively a firm has managed its working capital. The
shorter the cycles, the more efficient is the firm’s working
capital management
Cash Conversion and Operating 18

Cycle

Cash conversion cycle is shorter than the operating cycle as the

firm does not have to pay for the items in its inventory for a period
equal to the length of the account payable deferral period.
Interpreting CCC
19

Positive CCC means the firm require “x” days worth of

working capital. At any given point, the firm will require
enough cash to support “x” days of operations, if it
doesn’t have the cash itself, it will always need access
to a revolving line of credit that can make sure the
business runs.

Negative CCC means the firm receives cash very

quickly, turns over its inventory quickly and takes much
longer to pay its suppliers. So, the business is practically
throwing off cash. Negative CCCs work well for
growing businesses.
Cash Conversion and Operating 20

Cycle
ACYFMG’s 20xy ratios were as follows:

Days sales outstanding– 40.08 days

Days inventory outstanding- 114.18 days
Days payables outstanding- 88.69 days

Therefore, ACYFMG’s CCC and operating cycle are:

Operating cycle= 114.18 + 40.08 = 154.26 days

Cash conversion cycle = 154.26 – 88.69 = 65.57 days
Illustrative Problem: Cash 21

Conversion and Operating Cycle

If QLY Inc. were to have an average collection

period of 22.3 days, an inventory conversion
period of 37.1 days and accounts payable
deferral period of 83 days, what would its
operating and cash conversion cycles be?
Strategies for managing cash conversion 22

cycle
The goal is to minimize the length of CCC in order reduces the
working capital requirements (or financing costs).
1. Inventory management- Turn over inventory as quickly as
possible without stockouts that result in lost sales
2. AR management- Collect accounts receivable as quickly as
possible without losing sales from high-pressure collection
techniques
3. Cash and Marketable securities management- manage
mail, processing and clearing time to reduce them when
collecting from customers and to increase them when
paying suppliers
4. AP management- Pay accounts payable as slowly as
possible without damaging the firm’s credit rating or its
relationships with suppliers
4.2 Cash and Marketable Securities 23

Management

4.2.1 Objectives of cash management

4.2.2 Motives for holding cash
4.2.3 Cash Conversion Model (Baumol
Model)
4.2.4 Marketable Securities
 Motives for holding cash
24

Cash maintained by a firm is affected by: a) nature of its business

and b) ability to borrow on short notice

(1) Transactions demand

the need to hold cash to satisfy normal disbursement and collection
activities associated with a firm’s ongoing operations.
(2) Precautionary demand
the need to hold cash as a safety margin to act as a financial reserve.
(3) Speculative demand
the need to hold cash to take advantage of additional investment
opportunities, such as bargain purchases.
(4) Compensating balances
cash balances kept at commercial banks to compensate for banking
services the firm receives.
 Cash and Marketable 25

Securities Management
is the efficient collection, handling, disbursement, and investment
of cash in an organization while maintaining the company's
liquidity.

Objective: Strike an acceptable balance between holding too

much cash and holding too little cash.
1. On-hand cash must be sufficient to meet disbursal
needs.
2. Idle cash balances must be reduced to a minimum

The risk-return trade-off principle: cash minimizes

illiquidity/insolvency but penalizes profitability
Cash and MS Management Decisions
26

1. How much liquidity (cash plus marketable securities)

should the firm have?
2. What should be the relative proportions of cash and
marketable securities?
3. When do we pay our bills? How do we slow down cash
outflows?
4. When do we collect our receivables? How do we speed
up cash collections?
5. What is the optimal amount and composition of
marketable securities?
 Cash Management Techniques
27

1. Reduce required or idle cash balance: (a) cash flow

synchronization; (b) cash concentration; (c) zero-balance
account (ZBA);
2. Speed up receipts and the incoming check clearing process (a)
Reduce collection float; (b) Use other collection mode like
direct deposit to the company’s bank account, wire Transfers,
credit/debit cards, and pre-authorized checks (PACs)
3. Stretch payments and the outgoing check-clearing process: (a)
Negotiate credit terms with suppliers; (b) Scheduling check
preparation or issuance; (c) Increase disbursement float; (d) use
of payable-through-drafts in place of check
4. Prepare for emergency cash requirement: (a) Negotiate a line
of credit; (b) Hold marketable securities rather than demand
deposits to provide liquidity
 Minimizing idle cash
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1. Cash flow Synchronization: time cash

receipts to coincide with cash requirements
to reduce required cash balance
1. Cash Concentration: the process used by
the firm to bring lockbox and other deposits
together into one bank, often called
concentration bank. This set-up reduces idle
cash tied-in compensating balances. The
single pool of funds will be used for making
short-term investment reducing transaction
costs. This may be implemented through a
depository transfer check (DTC) or
automated clearinghouse (ACH) transfer.
Depository Transfer Check 29

(DTC)
an unsigned check drawn on one of a firm’s
bank accounts and deposited in another.

Automated clearinghouse (ACH)

transfer
Preauthorized electronic withdrawal from the
payer’s account and deposit into the payee’s
account via settlement among banks by the
ACH which clears in 1 day.
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3. A waiver that states “I/We allow the electronic clearing of

this check and hereby waive the presentation for payment of
this original to Bank of the Philippine Islands”
 Zero-balance account (ZBA)
31

A disbursement account that

always has an end-of-day balance
of zero

The firm deposits money (or

transfer funds) to cover checks
drawn on the account only as they
are presented for payment each
day

Used by companies for their

payroll and petty cash account to
reduce excess/idle cash on
balances
 Float Management
32

Float are funds that have been sent by the payer but are not yet usable
funds to the payee. It is the difference between cash balance recorded
in the company’s cash account and the cash balance recorded at the
bank.

Float management, aka “playing the float” is the process of accelerating

deposits and slowing down payment by taking advantage of the “float”.
Its objective is to generate more float by reducing collection float and
increasing disbursement float resulting to a higher net float.
Collection float - Total time between the mailing of the check by the
customer and the availability of cash to the receiving firm.
Disbursement float - Total time between issuance of the check
by the company to its supplier and the time the amount is
deducted (debited) from its account by the bank
Net float – the difference between collection float and disbursement
float
 33

Elements of Float

Processing Float: Transit/Clearing Float:

Mail Float: Time Time it takes a Time consumed in
the check is in company clearing
the mail. to process the check the check through the
internally. banking system.

Customer Firm’s bank

Firm Firm
mails check account credited
receives check deposits check

Firm Supplier Supplier Firm’s bank

mails check receives check deposits check Account debited
Net Float
34

Calculated as follows:

=Disbursement float less Collection float

If Disbursement float > Collection float, then Net float is
positive. The available bank balance exceeds the book
balance.

If Disbursement float < Collection float, then Net float is

negative. The available bank balance will be lower than the
book balance.
Calculating Float
35

A recent analysis of ACYFMG’s collections indicated that customers'

payments were in the mail for an average of 4 days. Once received, the
payments are processed in one and a half days. After payments are
deposited, it takes an average of two and a half days for these receipts
to clear the banking system.

On the other hand, an analysis of its payment to suppliers revealed that

it takes 5 days on average for supplier to received the checks issued by
the company. Furthermore, the disbursement checks are outstanding
for 3 days before it is deposited to a bank.

Collection: 4 + 1.5 + 2.5 = 8 days

Disbursement: 5 + 3 + 2.5 = 10.5 days
Net float: 10.5 – 8 = 2.5 days
Measuring Float
36

Using the definition of the float, it can be calculated as:

Float = Firm’s Bank Balance – Firm’s Book Balance

The value of the float depends on the check amount

and float time. Alternatively, Float can be calculated as
follows:

Collection Float = Ave. daily cash receipts x

collection float time
Disbursement Float = Ave. daily cash
disbursements x disbursement float time
The cost of collection float- is the opportunity cost of not
having that money in cash
The benefit of disbursement float- is the additional
interest earned on the payment amount
 Measuring Float
37

On an average day, ACYFMG writes checks totaling P165,000

and receives checks totaling P220,000.

The firm's disbursement float amount, Collection float amount

and Net float amount are:
Collection: 220,000 x 8 = P1,760,000
Disbursement: 165,000 x 10.5 = P1,732,500
Net float = 1,732,500 – 1,760,000 = -P27,500

Thus, on average, ACYFMG bank balance will be P27,500 less

than what is shown on its books.
 Measuring Float
38

If ACYFMG’s can earn 9.5% on marketable securities. Calculate

the annual cost of collection float and annual income of the
disbursement float. What’s the net benefit/cost of the firm’s
float?
Cost of collection: 1,760,000 x 9.5% = 167,200
Benefit of disbursement: 1,732,500 x 9.5% = 164,587.50
Net cost of float: 164,587.50 – 167,200 = -2,612.50
or -27,500 x 9.5% = -2,612.50

Thus, on average, ACYFMG losses P2,612.50 per year due to

the float
 Illustrative: Measuring Float
39

Float Works Inc. (FWI) estimates that it takes around 6.5 days
from the time customers mail in payments until FWI’s bank
account is credited. On the other hand, time lag from FWI mailing
to supplier withdrawal is 8 days. FWI receives an average of
P505,400 daily payments and pays an average of P475,000 to
suppliers per day. FWI has an opportunity cost of 4.8%. Compute
for the following:
a) Net float (in days)
b) Amount of collection float
c) Amount of disbursement float
d) Net benefit (cost) of float
Float Management Tools 40

Increase
disbursement Controlled
Float disbursing

Reduce
Collection Lockbox system
Float
Controlled disbursing 41

Involves strategic use of mailing points and

bank accounts to lengthen mail float and
clearing float, respectively

The firm directs checks to be drawn on a bank that is

geographically remote from its suppliers so as to
maximize check-clearing time.

This may stress supplier

relations and raise ethical
issues.
 Lockbox system 42

A collection procedure in which customers mail payments to a post office box

that is emptied regularly/daily by the firm’s bank, which processes the
payments and deposits them in the firm’s account. The bank then notifies the
firm of the collection made. Lockboxes are geographically dispersed to match
customer’s location. This process eliminates processing float time but would
entail cost.
Illustrative: Implementing
43

Float Management tools

The Player Inc. has daily cash receipts of P80,000. If
the firm's opportunity cost is 5.5%, would it be
economically advisable for the firm to pay an annual
fee of P18,000 to reduce collection float by 2 days?

Decrease in annual cost of collection float: P80,000

x 2 x 5.5% = P8,800

No, because it would cost P18,000 to save P8,800

only, netting the company –P9,200.
 Illustrative: Implementing Float 44

Management tools
Gale Supply estimates that its customers’ payments are in the mail for 3
days, and once received they are processed in 1 days. After the
payments are deposited in the firm’s bank, the funds are made available
to the firm by the bank in 1.5 days. The firm estimates its total annual
collections, received at a constant rate, from credit customers to be
P84,935,500. Its annual opportunity cost of funds is 6.3%. Assume a
365-day year.
1. How many days of collection float does Gale Supply have?
2. What is the current annual peso cost of Gale Supply’s collection
float?
3. If the installation of a new electronic payment system would
result in a 2 days reduction in Gale’s collection float, how much could
the firm earn annually on this float reduction?
4. Based on your findings in part c, should Gale install the new
system if its annual cost is P32,300?
Determining the target cash 45

balance

?
How much Cash should a firm have?
Determining the target cash 46

balance
Opportunity cost: cash does
not pay interest

More: Opportunity
Cost

Trading cost: cash shortage

would require liquidation of
securities resulting to trading
costs
Less:
Trading/Transaction
Cost
The opportunity costs of
holding cash rise and
trading costs fall as the cash
holdings rise.
Determining the target cash 47

balance

Cash Conversion Model – balance the relevant

costs and benefits of holding cash versus investing
in marketable securities to determine the
economically optimum quantity of each.
 Baumol Model
48

Developed by William J. Baumol based on the Economic

Order Quantity (EOQ) of inventory management

States that optimal cash balance is reached at a point where the total
cost is at the minimum. This is found at the point where the opportunity
costs equals the trading costs

Total Costs

Opportunity Costs

Trading costs

C* Size of cash balance

Baumol Model
49

Assumptions of the model:

1. Net cash flow is the same everyday
2. Size and timing of cash flow is known with certainty

To use the model, the firm needs to know the following:

• Tr = the fixed cost of selling securities to raise cash
(trading or transaction cost)
• TC = the total amount of cash needed over the relevant
planning period (for ex., one year)
• O% = the opportunity cost of holding cash (interest rate)
Baumol Model
50

Opportunity costs (interest forgone) is computed as:

= Average Cash Balance x Interest Rate

Trading costs is computed as:

= No. of times the firm sells marketable securities x Cost of
trading

where C - cash balance, O%- opportunity cost, TC- total cash needed and Tr is the
trading cost
Baumol Model
51

The optimal cash balance (C*) can be found where the

opportunity costs equals the trading costs

Computing for C* as follows:

Note: TC and O% should have the same period (annual,

monthly or weeky)
Illustrative: Baumol Model
52

ACYFMG began week 0 with a cash balance (C) of P4,000. Each

week, outflows exceed inflows by P2,000. The cash balance drops
to zero at the end of week 2. At the end of Week 2, the company
replenishes its cash by selling marketable securities. Assuming
ACYFMG’s opportunity cost is 4% and incurs P20 each time it
sells its marketable securities.

Compute for the total cost maintaining a P4,000 cash balance.

Using the Baumol Model, determine the optimal cash balance (C*).
Use 52 weeks per year.
Baumol Model
53

Opportunity costs= (4,000/2) x 4% = P80

Weekly cash requirement is P2,000; hence, total cash

needed in a year is P2,000 x 52 weeks = P104,000.

Trading costs = (104,000/4,000) x 20 = P520

Total Cost of maintaining P4,000 cash balance is

P80 + P520 = P600

Baumol Model
54

ACYFMG’s optimal cash balance using Baumol

Model can be computed as follows:

C* = Squareroot of [(2 x 104,000 x 20) / 4%]

= 10,198.04
We can verify the answer by calculating the various
costs at this balance, as well as a little above and a little
below:
Cash Balance Opportunity Cost Trading Cost Total Cost
4,000 80 520 600
8,000 160 260 420
10,198 204 204 408
12,000 240 173 413
15,000 300 139 439
Exercise: Baumol Model
55

The Brilliant Corp. has cash outflows of P1,850 per day. The
interest rate is 7%, and the fixed cost of replenishing cash
balances is P100 per transaction. What is the optimal cash
balance? What is the total cost? Assume a 365-day year.
Baumol Model
56

Advantage of the Baumol Model: Simple to use

Limitations of the Baumol model:

Unrealistic assumptions assumes steady, certain
cash flows and a constant disbursement rate
ignores cash receipts during the period
does not allow for safety cash reserves
Investing Idle Cash in 57

Marketable Securities
Marketable securities are short-term, interest-
earning, instruments that can be easily converted to
cash.

To be truly marketable, a security must have:

1. Ready market to easily convert it to cash when
needed
2. Safety of Principal- it experience little or no loss
in value over time

Types: government issues and non-government

issues (with slightly higher return than government
issues).
Investing Idle Cash in 58

Marketable Securities
Firms usually go to money market to earn a safe return on
temporary idle cash balances. Money market securities are highly
liquid with little or no risk of capital loss, but earns low return
compared to other securities.
MONEY MARKET INSTRUMENTS
Treasury Bills- short-term obligations issued by the government
Repurchase agreements- agreements involving the sale of securities by one party
to another with a promise by the seller to repurchase the same securities from
the buyer at a specified date and price
Commercial paper- short-term unsecured promissory notes issued by a company
to raise short-term cash
Negotiable certificates of deposit- bank-issued time deposits that specify an
interest rate and maturity date and are negotiable (i.e. can be sold by the holder
to another party)
Banker’s acceptance- time drafts payable to a seller of goods, with payment
guaranteed by a bank
Money market mutual funds- professionally managed portfolios of marketable
securities
 59

Contents 4.1 Principles of Working Capital

Management
4.1.1 Appropriate level of working
capital
4.1.2 Cash Conversion Cycle
4.2 Cash and Marketable Securities
Management
4.2.1 Objectives of cash management
4.2.2 Motives for holding cash
4.2.3 Cash Conversion Model (Baumol
Model)
4.2.4 Marketable Securities
 60

E n d o f 4 .1 & 4 .2
Questions?

Key takeaways