Chapter 16 Working Capital

Topic Outline

• Cash Management• Inventory Management• Accounts Receivable Management

Management of Cash and Marketable Securities

Cash doesn’t earn a profit, so why should the firm hold it?

1. Transactions – must have some cash to operate.

2. Precaution – “safety stock”. Reduced by line of credit and marketable securities.

3. Compensating balances – for loans and/or services provided.

4. Speculation – to take advantage of bargains and to take discounts. Reduced by credit lines and marketable securities.

• cash is needed to satisfy the transactionsmotive

• Another reason to hold cash is for compensating balances.

• it would not be correct for a firm to add the amount of cash required to satisfy its transaction needs to the amount of cash needed to satisfy its compensatory balances to produce a target cash balance.

The goal of cash management

• To meet the above objectives, especially to have cash for transactions, yet not have any excess cash.

• To minimize transactions balances in particular, and also needs for cash to meet other objectives.

Minimizing cash holdings

• Use a lockbox• Insist on wire transfers from

customers• Synchronize inflows and outflows• Use a remote disbursement account• Reduce need for “safety stock” of

cash– Increase forecast accuracy– Hold marketable securities– Negotiate a line of credit

Cash budget• Forecasts cash inflows, outflows, and ending

cash balances. • Used to plan loans needed or funds available

to invest.• Can be daily, weekly, or monthly, forecasts. – Monthly for annual planning and daily for actual

cash management.

Managing Receipts and Disbursements

• Receipts– Cash must be deposited to the bank

account at the shortest time with the minimum cost

– Internal controls– Efficient reporting system that allows real

time updating• Disbursements– Centralization of payments– Playing the float– Cross checking of all payments

Determining Optimum Cash Balance

• Baumol Model– Expenditures occur evenly throughout

the period.– Holding cost for cash is the income

foregone on the cash held or the cost of financing the cash balance.

– Short term investments are alternatives to cash

Baumol Model

Baumol Model

• Aubrey Company has a daily demand for cash of $4,000, or $1,460,000 annually. Short-term investments earn 5% annually. The interest rate on Aubrey’s line of credit is 8%, while the cost to convert marketable securities to cash is $50 per transaction. The optimal value of C for each cash management cycle is:

Illustration

• UP Foundation pays honorarium to 500 faculty members at P30,000 per year per faculty. Investments in short term securities earn 13% and cost per transfer is estimated at P500.

a.How much should be the optimal size of cash transfer?

b.How much is the total cost of cash transfer?

Disadvantages of Baumol Model

• Assumes stable and predictable cash flows

• Does not take into account seasonal fluctuations

• Most firms don’t use their cash flows uniformly and also cannot predict their daily cash inflows and outflows. Mille-Orr Model helps them by allowing daily cash flow variation.

Miller-Orr ModelThe distribution of the daily cash changes is at least

approximately normal.The transfer cost between cash and the portfolio is

at a given fixed costThe transfer between cash and the portfolio can be

implemented instantaneouslyThe minimum cash balance is determined outside

the model and depends on the ability of the firm to source funds externally as required.

Determining Optimum Cash Balance

Miller-Orr Model Does not set a single valued target cash but rather a

range within which the cash balance is to be maintained.

Seeks to minimize the expected cost of holding cash by making sure that cash balance does not exceed the upper limit nor fall below the lower limit.

Cash Return Point is the level to which cash is to be adjusted whenever cash holdings falls below the lower limit or exceeds the upper limit.

• The lower limit is set by the firm based on its desired minimum “safety stock” of cash in hand The firm should also determine the following factors:

• 1. An interest rate for marketable securities, (i)• 2. A fixed transaction cost for buying and selling

marketable securities, (c)• 3. The standard deviation if its daily cash flows,

(s)

Miller-Orr Model

Miller-Orr Model

• UL = 3z + LL• Illustration– The company has found the standard

deviation of its daily cash flow to be P30,983.87. The company’s transfer cost from investment to cash and vice versa is P500 per transfer. The current interest rate on short term investments is 13%. The financing company has set a lower limit at P50,000.

• To use the Miller–Orr model, the manager must do four things:

• 1 Set the lower control limit for the cash balance. This lower limit can be related to a minimum safety margin decided on by management.

• 2 Estimate the standard deviation of daily cash flows. • 3 Determine the interest rate. • 4 Estimate the trading costs of buying and selling

marketable securities

• These four steps allow the upper limit and return point to be computed. Miller and Orr tested their model using nine months of data for cash balances for a large industrial firm. The model was able to produce average daily cash balances much lower than the averages actually obtained by the firm.

Inventory Management

Inventory Management Techniques• ABC Inventory System– Inventory management technique that

divides inventory into three groups— A, B, and C, in descending order of importance and level of monitoring, on the basis of the dollar investment in each.

• EOQ Model– Inventory management technique for

determining an item’s optimal order size, which is the size that minimizes the total of its order costs and carrying costs.

Inventory Management Techniques

• JIT System (Just in Time)– Inventory management technique that

minimizes inventory investment by having materials arrive at exactly the time they are needed for production

• Computerized Systems for Resource Control

EOQ Model

Where: S = usage in Units per periodO = order cost per orderC = Carrying Cost per unit per

periodQ = Order quantity in units

At EOQ, Carrying Cost = Ordering CostCarrying cost = C x (Q / 2)Order Cost = O x (S / Q)Total Cost = Carrying Cost + Order Cost

Accounts Receivable Management

Elements of credit policy1. Credit Period – How long to pay? Shorter

period reduces DSO and average A/R, but it may discourage sales.

2. Cash Discounts – Lowers price. Attracts new customers and reduces DSO.

3. Credit Standards – Tighter standards tend to reduce sales, but reduce bad debt expense. Fewer bad debts reduce DSO.

4. Collection Policy – How tough? Tougher policy will reduce DSO but may damage customer relationships.

Does SKI face any risk if it tightens its credit policy?

• Yes, a tighter credit policy may discourage sales. – Some customers may choose to go elsewhere

if they are pressured to pay their bills sooner.– SKI must balance the benefits of fewer bad

debts with the cost of possible lost sales.

If SKI reduces its DSO without adversely affecting sales, how would this affect its cash

position?

• Short run: If customers pay sooner, this increases cash holdings.

• Long run: Over time, the company would hopefully invest the cash in more productive assets, or pay it out to shareholders. Both of these actions would increase EVA.