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Chapter 6
WORKING CAPITAL FINANCE
The management of cash
Holding cash
The optimum level of cash represents a balance between two factors:
Liquidity – The ability to pay bills as they fall due and take advantage of opportunities
immediately
Profitability – Minimising the holding cash
An idle asset will produce more return if it is invested
Reasons for holding cash
Transaction motive To ensure liquidity/ To meet day-to-day expenses
Where cash is held to provide sufficient liquidity to meet current day-to-day financial
obligations (e
...
payroll, the purchase of raw material)
Precautionary motive To meet unplanned expenditure
Where cash reserve is held in order to give a cushion against unplanned expenditure,
rather like buffer/safety level inventory
...
g
...
g
...

A detailed forecast of cash inflows and outflows incorporating revenue and capital items

Cash flow forecast can be prepared based on:
 A receipt and payments forecast
 A statement of financial position forecast
 Working capital ratios
Cash budget is a commitment to a plan for cash receipts and payments for a future
period after taking any action necessary to bring the preliminary cash forecast into
conformity with the overall plan of the business
...

Cash budgets are used to:
 Assess and integrate operating budgets Functional budget/ Operational budget
 Plan for cash shortages and surpluses
 Compare with actual spending

Cash budget
Typical format

Cash flow forecast/ cash budget
 Cash flow forecast are central to the management of cash
 They show expected cash inflows and outflows over a period and highlight
anticipated cash surpluses and deficits
 Their presentation assists managers in the planning of borrowing and investment
and facilitates the control of expenditure
 Computer spreadsheets allow managers to undertake ‘what if’ analysis to
anticipate possible cash flow difficulties as well as examine possible future scenarios
 To be useful, cash budgets should be regarded updated as a result of comparing
estimated figures with actual results, using a rolling cash budget system
Cash flow problems
Company may experience cash flow problems for a number of reasons;
 Sustained losses in the business such that cash resources have been drawn-down
 Difficulties in dealing with inflating costs combined with an inability to raise sales
price proportionately
 Over trading and inadequate financing of growth
...

 Seasonal trading against ongoing costs
...

 Unplanned one-off large items of expenditure
...

 Poor credit management
Cash flows problems
Cash flow problems can arise in various ways:
- Making losses
- Inflation
- Growth support
- Seasonal business
- One-off items of expenditure
- Asset replacement

Easing cash flow problems
- Postphoning capital expenditure
- Acceralating cash inflows
- Selling non-essential assets
- Longer credit
- Rescheduling loan repayments
- Deferring corporate tax
- Reducing dividend payments

Borrowing Short-term
Potential sources of short-term funding include:
 Debt factoring and invoice discounting
 Bank overdraft, but bank overdraft:
 Is technically repayable on demand
 Normally carries a flat charge for the facility and high variable interest rate on the
balance
 Short term loans; but these:
 May require security
 Can have fixed or variables rates of interest
Investing Short-term
Sources of Surplus Funds
Surplus fund may arise:
 Overfunding – proceeds which are not yet fully required may have already been
received from a share/debt issue
 Disposal of surplus assets or divisions: and/or
 Operating surpluses
Investing Surplus Funds – Factor to consider
Cash surpluses should not simply be left in the company’s bank account as this produces
a very low return
...
(e
...
Treasury bills)
Factors to take into consideration for investing surplus funds include:
 Amount of fund available
 Required level of liquidity, which is measured by how quickly the investment can
be converted back into cash
 Risk tolerance, which include consideration that shareholders’ funds should not be
gambled with (placed in investment that are too risky)
 The expected return on the proposed investment, with the return being limited
because of the requirement to select low risk investments
Short term investment
 Money market deposit (i
...
bank deposit)
 Certificate of deposit - Issued by banks, entitle the holder to interest plus principal, can be sold when needed
...
g
...

It assumes that cash is used at a steady rate during the year, which will often not be the case

Assumptions:
• Cash use is steady and predictable
• Cash inflows are known and regular / Constant demand for cash
• Day-to-day cash needs are funded from current account
• Buffer cash is held in short-term investments
The formula calculates the amount of funds to inject into the current account or to
transfer into short-term investments at one time:

Where:
Cₒ = transaction costs (brokerage, commission, etc
...


The model suggests that when interest rates are high, the cash balance held in noninterest-bearing current accounts should be low
...


Drawbacks of the Baumol model
(a) In reality, it is unlikely to be possible to predict amounts required over future periods
with much certainty
...
There may be costs associated with running
out of cash
...

Another cash management model is Miller-Orr model, which recognises that cash inflows and outflows

Miller Orr Model vary considerably on a day-to-day basis (unlike the Baumol model)
...
This is the strength of the Miller Orr model
...

 The firm’s cash balance is allowed to vary between a lower limit set by
management judgment and upper limit calculated by the model
...

 If the upper limit is reached, an amount of equal to the difference between
the upper limit and the return point is used to buy short-term investments
...

Miller -Orr work as follows:

1
...

2
...
Using the spread, an upper limit of cash balances is agreed
...
The cash balance is managed to ensure that the balance at
any point in time is kept between the lower and upper limits
...
g buy securities
or transfer fund to a deposit account

Cash balance increased e
...
e
...
g combining group borrowing requirement
- ''Pooling'' of cash surpluses and deficits
- Netting of foreign currency exposures
- Netting if interest rate exposures
- Management by specialised staff / Employ experts
- Increasing negociating power with banks
- Focus on profit centre
- Improve exchange risk management

Treasury management
Definition
The efficient management of liquidity and risk in a business including the management
of funds (generated from internal and external sources), currencies and cash flow
...
Therefore, it could transfer funds from subsidiaries which have
spare cash
 Reduction – Borrowing can be arranged in bulk at more favorable rates
 Aggregated – Cash may be aggregated together and invested at better rates
 Long term objectives – Decisions will be taken in line with the tactical and strategic
objectives of the group as a whole rather than by individual subsidiaries
 Increased negotiating with banks
 A specialist treasury department can employ experts with knowledge of dealing in
forward contracts, futures, options, Eurocurrency markets, swaps, and so on
...

The role of the treasury function
The treasury function of a firm usually has the following roles:
Short-term management of resources
 Short-term cash management – lending/borrowing funds as required
...

 Investment decisions, including investment appraisal, the review of acquisitions and
divestments and defence from takeover
...

 Interest rate risk management
...

Many larger organisations will often operate a separate treasury department, separate
from the finance department
...


Advantges of decentralised treasury management
- Finance matches local assets
- Greater autonomy for subsidiaries
- More responsive to the needs of individuals operating units
- No opportunities for large sum speculation

Overtrading (Undercapitalisation)
Overtrading occurs when a company attempts to expand its turnover rapidly without
having sufficient capital backing, especially medium and long term finance
Undercapitalisation occurs when a business grows very rapidly without increasing its level of long-term finance
...

Possibilities to consider include:
 Reducing the inventory holding period for both finished goods and raw materials
 Reducing the production period
 Reducing the credit period extended to accounts receivable and tightening up on
cash collection
 Increasing the period of credit taken from suppliers
Change the funding policy
Since overtrading is more likely if an aggressive funding policy is being followed,
adoption of a matching policy or a more relaxed approach to funding could be
appropriate
Reducing business activity
If necessary, a company could choose to level off or reduce the level of its business
activity in order to consolidate its trading position and allow time for its capital base to
build up through retained earning



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