FINANCIAL MANAGEMENT

CHAPTER 3: WORKING CAPITAL AND CASH MANAGEMENT

ILLUSTRATIVE SCENARIO

Mr. Chan, President of Dynamics , Inc. was shocked to learn that one of
the company’s principal supplier had just informed the company that it
would no longer supply the firm with parts needed in their products. The
reason is simply the company’s inability to pay its obligation on its due
dates for quite sometime now including other suppliers, and the reason
for slow payment was shortage for cash. Mr. Chan cannot believed and
cannot understand how that happen, were in fact the company’s sales
were terrific, and the profits break its records in the past.
ILLUSTRATIVE SCENARIO

The financial officers response was short and simple: There’s a big
difference between profits and cash. We’re making profits, but because
of the amazing growth we are experiencing, we had to acquire more new
assets than we could finance with retained earnings. We have lots of
inventory, receivables, and fixed assets, but not so much in terms of
cash. We really need to change our operating policies or else, we will go
bankrupt.
ILLUSTRATIVE SCENARIO

Setting working capital policy involves 2 basic questions:

1. How much should we invest in current assets?
2. How should we finance such investment?
To correctly answer the questions above, understanding the following
topics are inevitable
SHORT-TERM FINANCIAL MANAGEMENT

Financial management main concerns are where to get cash and how
such cash be used for the benefit of the company, thus, 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?
SHORT-TERM FINANCIAL MANAGEMENT

Determining the appropriate or optimal level of working capital,

pragmatically, is impossible to achieve. Such would require estimation of
the potential costs of illiquidity which, until now have not yet been
precisely measured.
Managers must have the basic understanding on some investment terms
and principles for him/her to effectively manage the working capital.
SHORT-TERM FINANCIAL MANAGEMENT

1. Hedging principles (rule of self-liquidating debt) provides the basis for

firm’s working capital decisions. It involves that those assets needed by
the firm not to be financed by spontaneous sources, such as payables
and accruals, should be financed in general, applying the following rule:
Permanent asset investments are finance with permanent sources and
temporary investment are finance with temporary source.
2. Permanent investment in an asset is one which the firm expects to
hold for a period of more than 1 year. This may involve current or fixed
assets
3. Temporary investment in an assets includes the firm’s investment in
current assets that will be liquidated and not to be replaced during the
year.
SHORT-TERM FINANCIAL MANAGEMENT

4. Spontaneous sources of financing include all those sources that are

available upon demand, such as trade credits or accounts payable, or
those that arise naturally as a part of doing business, such as wages,
interest, taxes payables.
5. Temporary sources of financing include all forms or 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 long-term bonds
and when it comes to distribution of dividends for preference and
common stocks as well.
WORKING CAPITAL MANAGEMENT

It generally deals with managerial decisions regarding current assets and

how they are financed.
The following condition 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 the market demand.
4. Current liabilities – to be prudent in making use of the time before it
finally pays off its obligations.
WORKING CAPITAL

A good current ratio may only imply liquidity position, but this may not be
absolutely true. Careful and deeper analysis of the composition of the current
assets must be made. Example would be the inclusion of the old receivable and
non-moving inventories
Effective management of working capital will improve the firms overall return on
investment performance. Usually, the firm’s goal is to minimize net working
capital. This could be achieved by:
1. Having faster collection of receivable from sales or service revenues
2. Increasing inventory turnovers
3. Slowing down disbursement to suppliers or securing longer credit terms
USED AND IMPORTANCE OF WORKING CAPITAL
MANAGEMENT

Working capital investment are made to support day-to-day operations

and sales activities. These includes:
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 to be 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.
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 materials.
6. Regular payment of salaries, wages and other day to day commitments.
7. Ability to face crisis.
8. Quick and regular return on investment.
9. Exploitation of favorable market condition.
10. High morale.
DISADVANTAGES OF EXCESSIVE WORKING CAPITAL

1. Excessive working capital means idle funds which earn no profits for business
and hence business cannot earn a proper rate of return.
2. When there is a redundant working capital, 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 investment, the value of shares may also fall.
5. The redundant working capital gives to speculative transaction.
6. When there is excessive working capital, relations with banks and other
financial institution may not be maintained
OPERATING CYCLE AND CASH CONVERSION
CYCLE

• OC = ASP + ACP
OC – OPERATING CYCLE
ASP – AVERAGE SELLING PERIOD
ACP – AVERAGE COLLECTION PERIOD
• CCC = OC – APP or CCC = ASP + ACP – APP
CCC – CASH CONVERSION CYCLE
APP – AVERAGE PAYMENT PERIOD
CASH CONVERSION CYCLE – FUNDING
REQUIREMENT AND STRATEGIES

Permanent funding requirement is a constant investment in operating assets

resulting from constant sales over time. A seasonal funding requirement is an
investment in operating assets that varies overtime as a result of cyclic sales.
• Aggressive funding strategy (opposite of Conservative funding
strategy) is a funding strategy under which the firm funds its seasonal
requirements with short-term debt and its permanent requirements with long-
term debt. This approach seeks to increase profit by using as much of the less
expensive short-term financing as possible but increase risk because the firm
operates with minimum working capital, which could become negative.
CASH CONVERSION CYCLE – FUNDING
REQUIREMENT AND STRATEGIES

Illustration given information:

Permanent funding in operating assets = P135,000
Seasonal funding requirements: P0 – P990,000 and P101,250 average
amount
Short-term rate = 6.25%
Long-term rate = 8%
Earning rate on investment for surplus balance = 5%
CASH CONVERSION CYCLE – FUNDING
REQUIREMENT AND STRATEGIES

Aggressive strategy:
Cost of short term financing = 0.0625 x P101,250 = P6,328.13
Cost of long term financing = 0.0800 x P135,000 = P10,800.00
Earnings on surplus balance = 0.0500 x P0 =( P0)
Total cost of aggressive strategy P17,128.13
CASH CONVERSION CYCLE – FUNDING
REQUIREMENT AND STRATEGIES

Conservative strategy:
Cost of short term financing = 0.0625 x P0 = P0
Cost of long term financing = 0.0800 x P1,125,000 = P90,000.00
Earnings on surplus balance = 0.0500 x P888,750 = (P44,437.50)
Total cost of conservative strategy P45,562.50
CASH CONVERSION CYCLE – FUNDING
REQUIREMENT AND STRATEGIES

Conservative strategy:
Cost of short term financing = 0.0625 x P0 = P0
Cost of long term financing = 0.0800 x P1,125,000 = P90,000.00
Earnings on surplus balance = 0.0500 x P888,750 = (P44,437.50)
Total cost of conservative strategy P45,562.50
BREAKTIME !
MANAGEMENT OF CASH
Motives of holding cash balance
1. Transaction motive
2. Precautionary motive
3. Speculative motive
MANAGEMENT OF CASH
Possible placements of Cash
1. Savings or Current accounts
2. Time deposits
3. Stocks
4. Treasury bills
5. Commercial papers
MANAGEMENT OF CASH
Management responsibilities relating to Cash
1. To prevent losses from fraud or theft
2. To provide accurate accounting of cash receipts, payments and
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
banks which no revenue
MANAGEMENT TECHNIQUES IN
CONTROLLING CASH FLOWS

Float Management
• Float
• Collection float/Disbursement float
• Negative float/Positive float
• Mail float/Processing float/Clearing float
MANAGEMENT TECHNIQUES IN
CONTROLLING CASH FLOWS

Speed-up collections
• Bills customer promptly
• Offer cash discount for prompt payment
• Use lockbox system
• Establish local collection office
• Request customer to make direct payment to the firm’s depository
bank
• Use of automatic fund transfer or electronic fund transfer
MANAGEMENT TECHNIQUES IN
CONTROLLING CASH FLOWS

*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. The bank deposits the payment check in the firms account and reduces
collection float by shortening processing float as well as mail and clearing float
MANAGEMENT TECHNIQUES IN
CONTROLLING CASH FLOWS

*Lockboxes
Illustration 1:
Average cash receipt per day = P200,000; Time it takes to be available =
5 days
Average cash receipt per day P200,000
Number of days tied up x 5 Days
Amount of cash tied up P1,000,000
MANAGEMENT TECHNIQUES IN
CONTROLLING CASH FLOWS

*Lockboxes
Illustration 2:
• 7 days to receive and deposit collection from customer
Float time reduced to 5 days
Monthly charge for lockbox system = P5,750
Requirements:
1. Should the service be avail?
2. How much is the advantage or disadvantage if the daily collection is
P500,000 and the rate of return is 12%
MANAGEMENT TECHNIQUES IN
CONTROLLING CASH FLOWS

Solution:
Amount of cash freed per day P500,000
No. of days cash is freed x 2
Amt. of cash freed up P1,000,000
Rate of return x 12%
Expected return (benefit) P120,000
Cost of lockbox system - 69,000
Net advantage P51,000
MANAGEMENT TECHNIQUES IN
CONTROLLING CASH FLOWS

• Direct sends
• Slowing down disbursement
*Controlled disbursement
*Reduce the need for precautionary cash balance
*Playing the float
MANAGEMENT TECHNIQUES IN
CONTROLLING CASH FLOWS

• Collecting center or agent

Illustration:
*Base agreement – Bank A will collect P5,000,000 per day to be compensated
by P1,500,000
*Alternative – Split the agreement to Bank A that needs to collect
P3,000,000 per day to be compensated by P1,200,000 & to Bank B that
needs to collect P2,000,000 per day to be compensated by P1,000,000
*In alternative arrangement, the collection period will be reduce by 1 day
*Rate of return = 8%
MANAGEMENT TECHNIQUES IN
CONTROLLING CASH FLOWS

• Collecting center or agent

Solution:
Amount of cash freed per day P5,000,000
No. of days cash is freed x 1
Amt. of cash freed up P5,000,000
Increase in compensating balance ( 700,000)
Increase in Cash flow P4,300,000
Rate of return x 8%
Incremental Income P344,000
MANAGEMENT TECHNIQUES IN
CONTROLLING CASH FLOWS

• Estimating cash balances

*Baumol Model – in relation to Economic Conversion Quantity:

Economic order quantity (EOQ) is the order size which minimizes the sum of carrying
costs and ordering costs of a company’s inventories.
- The two most significant inventory management costs are ordering costs and carrying
costs. Ordering costs are costs incurred on placing and receiving a new shipment of
inventories. These include communication costs, transportation costs, transit insurance
costs, inspection costs, accounting costs, etc. Carrying costs represent costs incurred on
holding inventory in hand. These include opportunity cost of money held-up in
inventories, storage costs such as warehouse rent, insurance, spoilage costs, etc.
MANAGEMENT TECHNIQUES IN
CONTROLLING CASH FLOWS

• Estimating cash balances

*Baumol Model

-Ordering costs and carrying costs are opposite in nature. To minimize its
inventory carrying costs, a company must place small orders. But small order
size means that the company must place more orders which increases its
total ordering costs. Similarly, if a company wants to cut its ordering costs, it
must reduce the number of orders placed which is possible only when order
size is large. But increase in order size means that average inventory balance
on hand will be high which increases total carrying costs for the period.
MANAGEMENT TECHNIQUES IN
CONTROLLING CASH FLOWS

• Estimating cash balances

*Baumol Model
ECQ – Economic Conversion Quantity
CC – Conversion Cost
DC – Demand for Cash
OC – Opportunity Cost (in decimal)
MANAGEMENT TECHNIQUES IN
CONTROLLING CASH FLOWS

• Estimating cash balances: *Miller-Orr Model – bahala ka na jan