All Rights Reserved Ch. 5: 1 Financial Management © Oxford Fajar Sdn. Bhd. (008974-T) 2010 Chapter 5 Cash and Working Capital Management
Jan 15, 2016
All Rights Reserved
Ch. 5: 1
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Chapter 5
Cash and WorkingCapital Management
All Rights Reserved
Ch. 5: 2
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Learning Objectives
At the end of this chapter, you should be able to: Explain working capital and the cash conversion
cycle Describe motives for holding cash Describe and analyse the different mechanisms for
managing the firm’s cash collection and disbursement procedures
Identify and compute inventory management costs Apply inventory management models to optimize the
firm’s inventory
All Rights Reserved
Ch. 5: 3
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Explain the reasons for granting credit Evaluate credit granting decisions Describe important accounts receivable
management tools Describe the mechanics of different types of short-
term borrowings and evaluate their costs
Learning Objectives (cont.)
All Rights Reserved
Ch. 5: 4
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Introduction
Working capital comprises of current assets minus its current liabilities
Current assets comprise….. Current liabilities……..
WC=CA - CL
All Rights Reserved
Ch. 5: 5
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Working capital management involves all aspects of the administration of current assets and current liabilities.
Working capital management, hence, covers (but is not limited to) several basic relationships:• Sales impact—must determine the appropriate levels
of receivables and inventories to maintain• Liquidity—must choose the levels of cash and
marketable securities to maintain
Introduction (cont.)
All Rights Reserved
Ch. 5: 6
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
• Relations with stakeholders—customers are concerned with price, availability, quality and service, goodwill and reputation of a firm. On the opposite end, the firms would also have similar concerns about its suppliers
• Firm’s reputation depends on its ability to efficiently manage its current assets and current liabilities
Introduction (cont.)
All Rights Reserved
Ch. 5: 7
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Guiding Principles about Working Capital Finance
Risk return trade-off
All Rights Reserved
Ch. 5: 8
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Financing Working Capital
Three (3) approaches may be adopted:
i) Maturity-matching approach
ii) Conservative approach
iii) Aggressive approach
All Rights Reserved
Ch. 5: 9
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Maturity-matching Approach
Hedge risk by matching the maturities of assets and liabilities.
Permanent current assets are financed with long-term financing, while temporary current assets are financed with short-termfinancing.
There are no excessfunds.
All Rights Reserved
Ch. 5: 10
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Temporary current asset: A subset of a company's current assets that changes according to seasonal fluctuations. For example, a retail store's current inventory may include holiday decorations around Christmas. These decorations would be temporary assets with respect to the remainder of the store's inventory.
Permanent current asset: The current assets a firm needs in order to continue operations. Examples depreciating assets such as computers. These assets are current because they do not remain assets for longer than a year, but they are permanent because they must be replaced with similar assets.
All Rights Reserved
Ch. 5: 11
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Conservative Approach
Long-term funds are used to finance both permanent as well as some temporary short-term assets.
When there areexcess funds,they are investedin marketablesecurities.
All Rights Reserved
Ch. 5: 12
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Aggressive Approach
Use less long-term and more short-term financing than the conservative approach.
All Rights Reserved
Ch. 5: 13
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Cash Management Cycle
Overall measure of effectiveness in managing net working capital.
Main objective is to minimize working capital subject to the constraint that there should be adequate working capital to support the firm’s operations
All Rights Reserved
Ch. 5: 14
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Cash Conversion Cycle
All Rights Reserved
Ch. 5: 15
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Inventory conversion period is the average time between purchasing inventories and selling the goods:
Cash Conversion Cycle (cont.)
365 daysInventory conversion period X=Cost of goods sold
Inventory
Debtors’/ac receivables collection period is the number of days for debtors to pay from time of sale:
365 daysDebtors' collection period X=Sales
Receivables
All Rights Reserved
Ch. 5: 16
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Cash Conversion Cycle
Creditors’/ac payables credit period is the number of days from the time of purchase of materials and labour for goods and the time of payment:
Refer to Example 5.1 of textbook for illustration.
365 daysPayables credit period X=Cost of goods sold
Accounts payable
All Rights Reserved
Ch. 5: 17
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Cash Budget
Detailed plan of a firm’s future cash flows An estimation of the cash inflows and outflows for
a firm for a specific period of time in the future Assess whether it has sufficient cash to fulfil its
cash flow requirements in the future and whether excess cash exists
3 main components necessary for creating a cash budget: i) Time period
ii) Desired cash position
iii) Estimated sales and expenses
All Rights Reserved
Ch. 5: 18
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
General Format of Cash Budget
All Rights Reserved
Ch. 5: 19
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Reasons for Holding Cash
Transactions—the need for cash make everyday payments
Precautionary—the need to have cash on hand to meet unexpected needs or unforeseen expenses
Speculative—based on the desire to take advantage of potential profit-making opportunities that require cash
All Rights Reserved
Ch. 5: 20
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Transaction Demand Models
Baumol Model The firm can predict its cash requirements with
certainty Cash disbursements are spread uniformly over the
period Interest rate or opportunity cost of funds (holding
cash) is fixed at all times, represented by ‘K’ Firm pays fixed transaction cost each time it
converts securities to cash, represented by ‘F’
All Rights Reserved
Ch. 5: 21
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Baumol Model
All Rights Reserved
Ch. 5: 22
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Optimal deposit size
Baumol Model (cont.)
All Rights Reserved
Ch. 5: 23
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Miller-Orr Cash Model
All Rights Reserved
Ch. 5: 24
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Inventory Management
Inventory management ensures that firms have sufficient inventory for production and for sale to customers.
Manufacturing firms carry three types of inventories:
i) Raw materials
ii) Work in progress
iii) Finished goods
All Rights Reserved
Ch. 5: 25
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Economic Order Quantity (EOQ)
Total inventory costs = Total carrying costs + Total ordering costs
Average inventory = Q/2
All Rights Reserved
Ch. 5: 26
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Economic Order Quantity (EOQ) (cont.)
All Rights Reserved
Ch. 5: 27
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Reorder Point
Reorder point = Expected lead time + Safety stock
All Rights Reserved
Ch. 5: 28
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Debtors
Sales on credit terms to customers give rise to debtors (accounts receivables)
Level of debtors is determined by the level of sales and credit and collection policies of the firm
Credit Terms Conditions as agreed in the contractual agreement
between the supplier and the customer pertaining to the credit granted to customer
Interpretation of ‘3/10, net 30’
All Rights Reserved
Ch. 5: 29
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Debtors (cont.)
Credit standards The criteria to assess customers and determine the
amount of credit and extent of credit period to be granted to debtors
Sources of credit informationInternal sources include: Credit application, including referees Customer’s past history, especially the payment history Information and input from the firm’s sales and
accounting department staff
All Rights Reserved
Ch. 5: 30
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Sources of credit information
External sources of information include: Recent years’ financial statements (typically the last
three most recent years)—review of customer’s profitability, financial standing, debt obligations and liquidity
Reports from credit rating agencies e.g. Ratings Agency Malaysia
Credit bureau reports—Central Credit Reference Information System (CCRIS)
Debtors (cont.)
All Rights Reserved
Ch. 5: 31
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Five C’s of credit Character—the commitment to meet credit obligations Capacity—the ability to meet credit obligations with
current income Capital—the ability to meet credit obligations from
existing assets if necessary Collateral—refers to the security that underlies assets
if necessary Conditions—includes consideration of general and
industry economic conditions
Debtors (cont.)
All Rights Reserved
Ch. 5: 32
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Credit-scoring Models
Credit-scoring models involve the numerical evaluation of customers using scientific approaches.
Score is a number that lenders use to determine the credit risk.
Calculation is based on a mathematical equation that evaluates information in the credit file and compares it to the patterns in millions of other credit files.
All Rights Reserved
Ch. 5: 33
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Credit-scoring Models (cont.)
Multi-discriminant analysis (MDA)
Z-score ≥ 3.0: Firm is safe based on these financial figures only
Z-score between 2.7 and 2.99: On alert—should exercise caution
All Rights Reserved
Ch. 5: 34
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Z-score between 1.8 and 2.7: Good chance of the company going bankrupt within 2 years of operations from the date of financial figures given
Z-score below 1.80: Probability of bankruptcy is very high
Credit-scoring Models (cont.)
All Rights Reserved
Ch. 5: 35
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Other Credit Decisions
Delinquent credit accounts Letter or statement Telephone Personal visits to customers’ premises Collection agencies Legal proceedings
All Rights Reserved
Ch. 5: 36
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Other Credit Decisions (cont.)
Changing credit policy Credit policy changes involves altering the terms,
standards or collection practices Typical way to evaluate the net benefit of changing
a credit policy is via the use of the incremental analysis
Refer to textbook—page 108 & 109
All Rights Reserved
Ch. 5: 37
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Using Accounts Receivable as Collateral
Accounts receivables (debtors) may be used as collateral to raise short-term financing
The accounts receivable is pledged by the firm as collateral to the lender.
The amount of the loan is a percentage of the receivables pledged.
Other Credit Decisions (cont.)
All Rights Reserved
Ch. 5: 38
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Factoring Accounts Receivable Factoring is where a firm sells its debtors at a
discount Involves raising funds against the security of the
firm’s trade debts Basic services are offered:
a) Sales ledger accounting, involving invoicing and collecting debts;
b) Credit insurance, which guarantees against bad debts;
c) Provision of finance
Other Credit Decisions (cont.)
All Rights Reserved
Ch. 5: 39
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Factoring Accounts Receivable (cont.) 2 types of factoring service—Non-recourse factoring
and Recourse factoring Non-recourse factoring is where the factoring company
purchases the debts without recourse to the firm selling its accounts receivable.
Recourse factoring, on the other hand, is where the business takes the bad debt risk.
Factoring also provides additional services such as:a) Administration of a firm’s invoicingb) Accounts maintenancec) Debt collections service
Other Credit Decisions (cont.)
All Rights Reserved
Ch. 5: 40
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Marketable Securities
Malaysian Government raises short-term financing through the issue of marketable debt instruments.
Forms of Government securities that are available in Malaysia are:a) Malaysian Government Securities (MGS)
b) Malaysian Treasury Bills (MTB)
c) Government Investment Issues (GII)
d) Malaysian Islamic Treasury Bills (MITB)
All Rights Reserved
Ch. 5: 41
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Repurchase Agreements- Banks sell market instruments to investors and buy
back those instruments later- Firms can invest in these securities for short periods,
ranging from one day to one year
Negotiable Certificate of Deposits- Receipts certifying that monies have been deposited in
a bank issuing the certificate- Represent high quality financial asset; fetches higher
yield than the comparable time deposit and treasury bills
Marketable Securities (cont.)
All Rights Reserved
Ch. 5: 42
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Banker’s Acceptance- Short-term credit investments created by other
firms and guaranteed by a bank Commercial Paper- Short-term unsecured debts issued by firms
Marketable Securities (cont.)
All Rights Reserved
Ch. 5: 43
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Trade Creditors
Management of trade creditors involves: Attempting to obtain satisfactory credit from
suppliers/creditors Attempting to extend credit during periods of cash
shortage Maintaining good relations with regular and important
suppliers
All Rights Reserved
Ch. 5: 44
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Trade Creditors (cont.)
Source of Short-term Finance Represents another source of short-term finance as
firms make use of short-term trade credit offered by supplier
Trade credit will have a cost Firms may be offered discount for early payment Finance managers therefore face whether to
accept the suppliers’ discount offer for early payment or to forego the discount (and make use of the credit period).
All Rights Reserved
Ch. 5: 45
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Costs of foregoing early discount: Estimated using annual percentage rate (APR) or
annual percentage yield (APY)
See Example 5.5 in textbook.
Trade Creditors (cont.)
All Rights Reserved
Ch. 5: 46
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Other Forms of Short-term Financing
Bank Overdraft Standby cash flow to cover a firm’s daily working
capital requirement Provided by banks Firms can withdraw funds from the Current Account in
excess of the credit balance up the approved limit set by the bank
Interest Rate = Base Lending Rate (BLR) + Spread
All Rights Reserved
Ch. 5: 47
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Other Forms of Short-term Financing (cont.)
Trust Receipts Used by a firm (also know as ‘buyer’) to finance local
purchases and importation of goods Document executed by a customer (pledger of goods
or documents of title) Goods released to the firm by the bank, so that the
firm may sell the goods and pay the proceeds from the sale to the bank
Upon receipt of the TR document, the bank will lend the firm funds to pay the trade creditors/suppliers for the goods purchased.
All Rights Reserved
Ch. 5: 48
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Banker’s Acceptance Issuance bill of exchange drawn by a firm to its
order, and accepted by the bank, and payable on a specified date
Another form of short-term financing that allows firms to take delivery of goods from the suppliers faster to meet market demands
In the case of the firm that is a seller/exporter, it can arrange for BA for its customers so that it can have access to immediate funds for working capital.
Other Forms of Short-term Financing (cont.)
All Rights Reserved
Ch. 5: 49
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Letter of Credit Undertaking by the bank, acting in accordance with
the instructions of the borrower, to pay a stipulated amount of money stated in the letter of credit to a named beneficiary against presentation of stipulated documents and in full compliance of the terms and conditions of the credit.
LC issued by bank to the suppliers acts as a form of guaranteed payment. The supplier will be able to collect the payment when all conditions of the LC are met.
Other Forms of Short-term Financing (cont.)
All Rights Reserved
Ch. 5: 50
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Letter of CreditTypes of LCs available include: Irrevocable LCs—such LCs cannot be amended and
not cancelled without the agreement of all parties to the LC
Standby LCs—funded only if the buyer does not pay the seller as agreed upon
Revolving LCs—used for regular shipments of the same commodity to the same customer (importer). This means that a credit facility is set up with the LC balances drawn down against the credit facility balance
Other Forms of Short-term Financing (cont.)
All Rights Reserved
Ch. 5: 51
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Transferable LCs—the first beneficiary can transfer all or part of the original LC to a third party
Assignments of proceeds under an LC—the original beneficiary assigns the proceeds to the end supplier
Back-to-back LCs—original LC that has been received by the firm from its customer, who then uses that LC as security to establish another LC, drawn on the firm in favour of its creditors
Other Forms of Short-term Financing (cont.)
All Rights Reserved
Ch. 5: 52
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Term Loans
Represent intermediate term debt Duration ranging from 5 to 15 years Usually carries fixed monthly repayments and
interest is pegged to BLR
Interest Rate = Base Lending Rate (BLR) + Spread
All Rights Reserved
Ch. 5: 53
Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Term Loans
Other Charges Compensating balance—amount of money that a
bank may require the firm to maintain in a non-interest bearing account.
Deposit concerned may be used by the bank to off set any unpaid loan owing by the firm to the bank
Has the effect of increasing the Effective Interest Rate on the loan, measured by:
Interest Rate = Base Lending Rate (BLR) + Spread
Proceeds
Nominal interest